Why CRE Developers Are Still Coming Up Smiling

You might call it survival of the fittest. Developers are managing to persevere through scores of global, domestic, and local challenges to expand construction pipelines and push projects forward. Despite all the obstacles, rising interest rates, inflation, a defunct supply chain, a looming pandemic, and war in Europe—US construction volumes grew in the year's first half. The uptick was driven by commercial new construction starts, according to the H2 2022 Construction Outlook report from JLL. 

The healthy construction activity illustrates a voracious appetite for commercial real estate, but developers are also playing catch-up after stalling construction during the early days of the pandemic. While development isn’t expected to completely recover to pre-pandemic levels until sometime in the second half of next year, the industry is growing at a healthy, sustained rate. 

The Official Stats

In the first half of the year, total new construction starts increased by 18%, with commercial projects up 14% and multifamily construction starts up 24%. Overall, new construction spending grew to nearly $140 billion. 

Until recently, commercial construction, including multifamily, drove total new development activity in the US. Single-family projects were slow to catch up, but in August, single-family home development unexpectedly improved. According to a survey of economists conducted by Bloomberg, single-family home development increased by 3.4%, growing to an annualized rate of 934,000 homes. This is only the second time this year that new single-family home starts have increased. 

The construction gains in the commercial and residential sectors are particularly impressive because they have occurred under a cloud of difficulties. In the first six months of the year, construction costs grew more than 10%, and research shows construction costs will increase another 10% to 14% in the next 12 months. At the same time, the labor pool has stagnated, creating a shortage of skilled workers. As a result, JLL forecasts a 6% to 8% increase in labor-related costs. 

At 30,000 feet, developers are also navigating higher costs of capital and supply chain challenges. To combat inflation, the Federal Reserve increased the Fed Funds rate five consecutive times this year, with more increases likely to come. Supply chain disruptions have extended construction schedules by several months. Newmark research, for example, found that industrial projects are taking five months longer than in 2019.   

Housing and Industrial Take the Spotlight

Without question, multifamily and industrial projects are driving the lion’s share of new construction activity. Spending on residential construction is up nearly 15%, while nonresidential construction spending is up approximately 5%. The momentum has carried into the second half of the year. In August alone, multifamily construction surged 28%. 

There is incredible housing demand across the country. The National Multifamily Housing Council estimates that the US needs 4.3 million apartment homes built by 2035 to meet current demand. The shortage has led to strong rent growth and occupancy rates. CBRE forecasts 8% effective rent growth this year and 95% multifamily occupancy. Higher interest rates are also helping to drive the incredible demand for rental housing. In September, mortgage rates reached 6% for the first time in more than a decade, keeping many would-be homebuyers in rental housing for the foreseeable future. 

While multifamily development was strong in the year's first half, the near-term outlook is still uncertain. A report from Reuters has found a 10% decrease in residential building permits, which could foretell a drop in new residential starts sometime next year. In addition, single-family homebuilders have expressed declining sentiment for nine straight quarters since the onset of the pandemic. However, several commercial reports, which include multifamily, are optimistic development will return to pre-pandemic levels in the middle of next year, and any delay in new starts could prove to be temporary. 

Like multifamily, industrial is benefitting from similarly strong fundamentals with a record-low vacancy rate below 3% and net asking rents that have grown more than 14% this year. Industrial development has been on fire for the last several years. Since 2019, industrial development has increased by 64%, driven by a 120% spike in demand, and this recent bout of construction challenges have not deterred developers. Through the first half of the year, new industrial construction starts are up about 4%, with the construction pipeline expanding by nearly 6%. While industrial developers continue pursuing opportunities, the construction challenges outlined here impact completions. Newmark research shows that new deliveries have only increased about 6%, despite record construction starts, due to delays. 

How Developers Are Managing 

The voracious demand and the accompanying rent growth have been the primary incentive for developers. However, increased construction costs are exceeding income growth. To offset these costs, developers are tapping into additional resources and leveraging technology to drive efficiency.  

The Infrastructure Investments and Jobs Act has been a significant win for developers. The bill will strengthen the economy and increase total demand for commercial real estate, particularly for industrial product. Funds from the legislation have already trickled down into developers’ pockets, and capital will continue to be disbursed through 2024. While the funds don’t directly impact commercial real estate, developers have applauded the legislation for creating more substantial infrastructure that CRE needs to thrive. 

Technology is also playing a critical role in managing cost increases on new development. Predictive analytics tools like Northspyre use a combination of automation and machine learning to manage routine development tasks and track critical data related to an individual project, including budgets, vendor invoices, and scheduling. This technology eliminates errors, streamlines the process, and forecasts potential challenges before they have time to create a headache. Smart construction management is part of the suite of tools developers use to offset increased costs and delays. 

Underwriting new development is never easy, but the vigorous construction activity shows that developers can manage through various issues. Understanding demand fundamentals, knowing available government incentives, and leveraging technology can unlock opportunities even when the path is turbulent.