What rising interest rates mean for construction in Philly

The development industry in the Philadelphia region has seen a busy few years. The fate of new office and retail construction is still to be determined, but after the initial shock of the COVID-19 pandemic, the housing and industrial markets boomed.

Many neighborhoods have seen a degree of developer attention unparalleled in their recent history, from Germantown and the western edge of University City, to Kensington and the neighborhoods north of Brewerytown. The remote work trend also fueled an aggressive expansion of warehouse infrastructure throughout the region, led by Amazon.

All this activity has been juiced by the extremely cheap cost of borrowing, as interest rates remained at historic lows during the rebound from the pandemic-generated crash.

But as inflation soared over the last year, the Federal Reserve has begun pumping the brakes on the economy, raising interest rates and making borrowing more expensive. These changes have had an outsized impact on real estate deals, which unfold over years and are dependent on large inflows of investment capital.

The borrowing environment is expected to only get tighter. A stronger than anticipated July jobs report led many Fed watchers to predict that a substantial further rate hike will come in September and that additional increases may now occur later this year instead of in 2023.

Climbing interest rates are already having an effect on home buyers, some of whom are finding themselves priced out of the market. But what will the effect on the larger development market in the Philadelphia region be?

Projects that are pretty far along in the development process probably won’t be impacted, but “it affects the pipeline,” said Bill Hankowsky, former president of Liberty Property Trust.

Developers face more dramatic cost hurdles than the Federal Reserve’s tightening. Two years into the pandemic, supply chains remain snarled and construction materials cost 19% more than they did a year ago, according to the National Association of Homebuilders.

In combination with rising interest rates, that means the cost to build is higher than anticipated, the cost to finance debt is higher, and what a tenant or buyer can pay will be lower.

The changing equation of development means that some projects won’t happen, especially if they are in the very early stages.

Real estate industry professionals say they have heard of acquisitions being canceled due to interest rate increases and a more unfavorable financial environment. Neighborhoods with a lot of new units opening may see a pause in new proposals as lenders wait to see how newly built or soon-to-open projects perform. Meanwhile, some financiers are becoming more conservative.

“I’ve heard that a number of lenders have pulled back and are on the sidelines [until they know] where interest rates are going to settle out,” Hankowsky said.

But developers say that they feel confident that construction in the Philadelphia area will not grind to a halt, even as rates continue to rise.

“The froth has come out of the market, but it still feels pretty healthy,” said Andrew Mele, managing director of Dallas-based developer Trammell Crow’s Northeast Metro Division. “People won’t be able to pay whatever they want for land now, because it’s becoming harder to make super aggressive assumptions. You have to be more plugged in to reality.”

Mele notes that Trammell Crow’s subsidiary, High Street Residential, recently developed a multifamily property in Conshohocken called Matson Mill and both leasing and rents have been strong. Given such indicators, he says, they plan to continue investing in residential projects in Philadelphia and throughout the Northeast. The life sciences and industrial warehouse sectors continue to look strong, too, in Mele’s estimation.

But on the lending side, development industry players say that bigger banks are getting more conservative. One source at a prominent national lender, who spoke on the condition of anonymity because he wasn’t authorized to address the matter, said that large banks have begun sitting on the sidelines. Even when they are already involved in a deal, if it comes up for renewal or modification, many large actors have been pulling back. There’s less construction loan capital available as a result.

Smaller, regional, and community banks and nonbank actors have remained more liberal in their lending.

“There will be some impetus to slow things down, deal by deal,” said Bernie Shields, regional president for Philadelphia and South Jersey with M&T Bank, which is a big player in the Mid-Atlantic and the New York metropolitan area. Projects with backers who aren’t well capitalized will probably struggle, he said, as will those that are less obviously supportable by rent growth or in areas where there’s a lot of nascent supply.

“We haven’t had somebody say [they are putting a] project on the shelf at this moment because of uncertainty around rates or costs,” Shields said. “But we all should expect to see some projects that were proposed being delayed.”

Interest rates have been very low for a very long time, and they still are modest by historic standards. No one interviewed for this article expected that the interest rates would be hiked to anything like 1980s levels, when they soared to double digits under Federal Reserve chair Paul Volcker. There have been signs that inflation is cooling, despite the July jobs report. If that trend solidifies, it could undercut the impetus for aggressive tightening.

For now though, the changing lending environment is likely to manifest in projects that aren’t proposed and permits not pulled. There will be rural areas where a new Amazon warehouse doesn’t sprout up, and outlying Philadelphia neighborhoods seeing a break from construction blitzes.

“It feels to me like the sands are sifting through the strainer and some things will definitely fall out,” said Lauren Gilchrist, managing director of Longfellow Real Estate Partners, a Boston-based life sciences firm. “But projects that were home runs — although they might wind up taking a bit of a haircut on the returns — but home run projects will continue.”

Editor’s note: A previous version of the story incorrectly spelled Trammell Crow. The error has been corrected.