By Thomas B. Eriksen, AttorneyThis article originally appeared in the July 6, 2018 edition of the Vancouver Business Journal.
Interest rates have been at historically low levels since the Great Recession of 2008 – 2009. As the economy has recovered, the Federal Reserve has kept interest rates artificially low in an effort to keep the economy growing and avoid another recession. Builders and developers have benefitted greatly from this low cost of capital. Now that the economy is in its tenth year of expansion and with unemployment at historic lows, the Federal Reserve has signaled it will increase interest rates in 2018 and beyond in order to avoid overheating the economy and the potential inflation that often comes with low unemployment.
How does the building and development industry react to and cope with an environment of increasing interest rates?
As interest rates rise, homebuilders face increased challenges as potential homebuyers find it more difficult to obtain financing or cover the higher monthly home payments. Homebuilders can respond with a number of strategies.
Homebuilders that build products at multiple price points, from starter homes to luxury homes, are best suited to address buyer concerns over increasing interest rates by adjusting their product mix to meet changes in demand.
Homes at the lower end of the market are most susceptible to increased interest rate costs. As demand weakens for entry level homes, homebuilders can move up market, where buyers are less impacted by rising interest rates.
Finally, homebuilders can develop relationships with lenders to assist homebuyers obtain mortgages.
Project financing for commercial development in a stable interest rate environment can be challenging. Add projected interest rate increases to the mix during the entitlement and construction period and the risks inherent in development are greatly increased.
Obviously, one of the most significant impacts of rising interest rates is increased financing costs during the construction period. Rising interest rates can also lead to increased material costs and labor costs, as suppliers and subcontractors also deal with increased financing costs.
Increased financing, material, and labor costs will impact cash flow – working capital needs – during the construction process. This can lead to slow payments by developers and builders to their subcontractors and suppliers, which places additional financial pressure on their operations. If a company begins to see its accounts receivable aging increase noticeably, it is necessary to be proactive to assure prompt collections, so that the company can meet its financial obligations in a timely manner.
Inverted Yield Curve
As interest rates rise, many economists closely watch the yield curve for signs as to which direction the economy is heading. The yield curve is the comparison of the interest rates on short term debt instruments with interest rates on longer term debt instruments. Typically, longer term debt instruments carry higher rates than shorter term debt instruments to reflect both the time value of money and risks inherent in tying up investment funds for a long period of time As short term interest rates rise, the yield curve tends to flatten out. When short term interest rates are higher than longer term interest rates, this is known as an “Inverted Yield Curve.” Many economists say that an inverted yield curve is often an early indicator of an economic recession.
As short term interest rates rise, builders and developers should watch the yield curve closely for signs of an impending recession. That information can then be factored in when making decisions regarding development timelines of projects and whether to undertake projects.
Building and development is a challenging and demanding endeavor under the best of circumstances. Adding increasing interest rates only adds to the challenge of bringing a project in on time and on budget.