Ryan Speirs
“Building is about getting around the obstacles that are presented to you.” The quote from Jeremy Renner rings true in today’s unique economic environment. Post-pandemic economic re-sorting will certainly impact the commercial real estate industry — especially with increasing inflationary pressures, continued supply chain challenges and rising interest rates.
Additionally, the converging 10-year and two-year U.S. Treasury yield curve may suggest a potential recession in the coming year or two, based on historical patterns.
At times like this, there are various considerations for construction borrowers to consider:
Post-pandemic construction growth may slow.
Coming out of 2020, we saw a lot of pent-up demand for commercial real estate (CRE) construction. We saw record construction activity in 2021. One particular sector for growth has been industrial construction. As online consumer demand has surged, so has the need to warehouse goods sold online and shipped to doorsteps. Locally, almost $1.2 billion in new industrial construction value has been added to the market through the end of 2021.
While the industrial sector continues to experience strong growth, with over 9 million square feet of industrial product under construction and low inventory (2.2 percent vacancy), supply change challenges remain.
CRE trends follow residential construction trends.
Demographics drive so much of the economy, especially residential housing demand. Utah has been the fastest-growing state in the U.S. over the past decade. Utah’s population grew 18.4 percent from 2010-2020. There were nearly 59,000 new people who moved to Utah in 2021, a 1.8 percent growth rate. And net migration was nearly 35,000, accord-
ing to census data.
But housing inventory is too low to meet the demand. In fact, the state has experienced a housing demand and supply mismatch since 2010. This drove the Beehive State’s home values up 29.9 percent over the past 12 months, bringing the Utah median home price to
almost $550,000.
But for the first time in 11 years, interest rates for 30-year, fixed rate mortgages moved above 5 percent, as Freddie Mac reported in mid-April. The rate of price increases is likely to moderate with the rising rates. Trends affecting residential real estate will also spill over into commercial real estate.
While single-unit construction permits increased 17.9 percent in Utah from 2020 to 2021, the rising interest rates will likely spur a drop in residential building permits. With the decline in residential construction, the cost of building materials and supplies may follow, which could be favorable for new CRE.
Yet rising interest rates may taper construction growth. Some construction borrowers may put projects on hold or reduce their scope.
The cap rate remains at record lows, but that could change.
Across the U.S., the average commercial real estate capitalization (cap) rate is at a 20-year low across all sectors — office, industrial, retail, multifamily, hotel and senior housing.
Many CRE investors have bid up prices, but it’s unclear now whether prices will continue to increase. It’s possible that inflation and the rising interest-rate environment may overturn the long-term decline of the national cap rate and reduce the pace of price appreciation. As the Federal Reserve raises interest rates, financing costs are increasing and may result in reduced CRE demand.
Quality shouldn’t suffer in spite of rising prices.
Federal Reserve Economic Data reveal soaring costs of construction materials. The cost of lumber was up 22 percent in March compared to a year ago, and the cost of steel in the same period surged 30 percent. It can be tempting for companies to find ways to reduce expenses.
“The bitterness of poor quality remains long after the sweetness of low price is forgotten,” Benjamin Franklin wisely said. With inflation at record highs, some construction companies try to save costs by using lesser-known contractors. In the end, they may end up paying more. Larger and more reputable contractors can offer pricing power because of their loyal subcontractors. They can be better at helping clients stay within their budget.
Now is the time to shore up reserves.
Borrowers need to demonstrate to banks that they have strong cash flow and ample reserves. Right now, rents are high and occupation rates are strong. On average, Utah rents increased 17.2 percent from 2020 to 2021 depending on property type, according to the Kem Gardner Public Policy Institute. In the short term, companies can take advantage of the favorable leasing environment by socking away excess funds as leases begin to roll over. This can help prepare companies for uncertainty in the near term and position them for possible future acquisition activity.
Be ready for changes in office space.
When the pandemic hit, many CRE companies benefitted from their existing long-term office leases with their tenants. As leases come up for renewal in the coming years, some tenants may reevaluate the space they need. Some businesses offering more flexible arrangements with employees are adding so-called “hotel space” for employees to share. This is true at some Zions Bank and Zions Bancorporation buildings, where some employees who primarily work remotely can reserve temporary office space when they work in-person. Future construction trends may include these office features while companies such as WeWork are positioned to benefit from this growing trend.
Utah’s fundamental strengths will cushion the blow of a potential recession.
Even if we enter a recession, Utah will be better insulated from it than other markets, due to our low unemployment, in-migration and new businesses relocating to our state. Utah’s February 2022 unemployment rate was 2.2 percent, compared to the U.S. rate of 3.6 percent. The state’s annual total employment increased by 4.2 percent, or 66,000 jobs. The top industry sectors leading the job growth were leisure and hospitality (17,700); trade, transportation, and utilities (13,600); and construction (5,900). The Beehive State’s diversified economy continues to be a source of strength through economic fluctuations.
Ryan Speirs is senior vice president and Real Estate Banking Group manager at Zions Bank. He has more 18 years of experience offering solutions to commercial real estate borrowers in the metro Salt Lake City market.