Will rising interest rates, falling supply put damper on construction industry?

“Basically, we’ve had just a super rosy environment over the last three years.. From a development standpoint, it couldn’t have gotten much better.  When your biggest challenge is the happy trouble of trying to get materials, that’s a pretty good day,”  said Joe Downs, executive vice president and general manager, The Opus Group.

Downs was the featured speaker at last Friday’s monthly breakfast meeting hosted by CCIM Kansas City.

But, Downs said, the rosy environment has quickly changed with the rise of interest rates.

“It’s just a different environment, and it’s hard to reconcile because the supply and demand metrics seem so great.  The third quarter reports that the brokerage shops just issued, they’re phenomenal.  Another 2.5 million SF of warehouse absorption and record construction.  These are all deals that started before the last six months.  Things have changed really fast, really drastically,” he said.

“What we’re sensing and experiencing is that demand is still out there.  It’s hard to tell if that demand is today’s board level decisions or six or nine months ago board level decisions, but it’s still there,” said Downs.

He said that all of Opus’ properties that are unencumbered by leases are still experiencing strong prospect activity.

Downs predicts that the interest rate environment will start to put a damper on new supply.

“I think you’re going to start to see supply slowing down. . . . I think everyone is busy right now, but that pipeline for 6, 12, 18 months is a little less certain,” he said. 

Downs said it is getting harder and harder for developers to get construction loans as interest rates rise. 

“Lead times on materials are drastically different.  We just got a precast quote in Kansas City.  What was a 14 or 15 month lead time is now 6 months, 7 months so you can tell there’s early signs of [a slowdown in] the construction industry,” he said.

Downs said there is a sense that construction costs, which have risen steadily in the past three years, are starting to modulate, but it is too early to be certain.

“We’re sensing that costs are modulating.  Certainly some of the supply chain items are getting worked out.  It’s just going to take time, about 18 months, until we really know,” he said.

Values also have risen greatly in recent years.  Downs said values are approximately 150 percent of what they were just four years ago.  However, he said those values are starting to fall. 

Downs said rent is the only toggle left to pick up the slack created by rising costs and dropping values.

Downs said tenants currently are willing to pay increased rents.

“I would say in the last several months, we’re talking about 10, 15, in some places 20 percent rent growth from what we were quoting in the first quarter.  It’s just necessary to overcome what I was talking about on value and costs.  So things are still moving along, but it’s just a much more variable environment right now,” he said.

Downs said it’s a great time for the unlevered buyer.

Opus, which will celebrate its 70th year in business next year, has been active in the Kansas City market for more than 20 years.  Downs said Opus has built more than 30 buildings in the market.

He discussed some of its recent projects which include Westley on Broadway, a 256-unit mixed-use multifamily apartment building in Westport, which was delivered during COVID and is fully leased.

“It is super rare to get 1.7 acres in an urban environment.  Usually, we’re dealing on half an acre.  To be able to spread out like this and really create an asset of size and scale is significant,” Downs said.

Currently under construction is Briarcliff Apartments, another 256-unit mixed-use apartment project which Downs said will deliver in mid-2023.

Opus also currently is constructing Liberty Heartland Logistics Center, a five-building industrial project located in Liberty near I-35 and Highway 69.  Downs said Hallmark Cards, Inc. will anchor the project and take occupancy of an 850,000 SF build-to-suit distribution facility early next year. 

Downs said deals in the foreseeable future are likely to be more modest and very understandable.

“We’re very focused on understandable deals that are more simple and modest in nature and size to meet the demand and the great locations.  It’s kind of what you do when things are less clear around you,” he said. 

All eyes focused on Kansas City CRE wins

Last week at CCIM Kansas City’s monthly meeting, Michael Berenbom, managing partner, LANE4 Property Group; Jon Copaken, principal, Copaken Brooks; John McGurk, vice president of development, Milhaus; and Ora Reynolds, president, and CEO, Hunt Midwest, joined moderator Tim Cowden, president and CEO of Kansas City Area Development Council (KCADC), for a discussion of the state of the Kansas City market for the four major asset classes represented by the panel.

The panelists each spoke to the Kansas City projects that have them most excited. Reynolds began with Hunt Midwest’s logistics and industrial footprint and its continuing rapid growth.

“Definitely this cycle and people have written about it, is so different.  The cycle there can be a two-year cycle from when you source a deal to when you build it and lease it, instead of what took a 5, 10, 15-year cycle.  You tend to know what you have when you start with industrial when you start with a building.  You know when the end goal is,” said Reynolds.

Berenbom said he is excited about downtown Lee’s Summit.  

“Whether it’s office or retail we’re looking at, location matters, character matters, neighborhood matters, and downtown Lee’s Summit is one of those neighborhoods that has it.  Sometimes it’s hard to articulate exactly what that is, but we all know if we go spend time down there,” he said.

Copaken spoke about residential development, especially downtown, which has seen continued growth.  But, he’s especially pumped about the renewed discussion of a downtown baseball stadium.

“That’s the catalytic project that can really push things over the edge for the whole city.   It’s good to see that there’s ownership and people actually interested in making something happen,” said Copaken.

McGurk is looking forward to the streetcar extension. He also said he’s starting to see some really healthy rent growth in the multifamily market across the entire metro area, which historically has been a cheap housing market. 

“You’re also starting to see a lot of supply fall off a cliff.  Five years ago you would hear of 12, 15 projects in downtown.  Well, there are maybe three or four that are going to be under construction and delivering in the next three years.  Supply’s really falling off which is just going to increase that rent growth . . . . It’s harder to do deals, but the juice is worth that squeeze probably,” McGurk said.

However, McGurk believes there will continue to be a demand for multifamily housing.  He noted that there is a lack of availability of single-family houses, but also many millennial tenants like the multifamily lifestyle. 

“They like having new, and they like having all the amenities. It’s just a different generation and I’m sure it will change.  Household formation is mid-30s, late-30s now. I’m not saying we’ll have an oversupply in 15 or 20 years, but I think there’s a lot of runway still for sure in multifamily,” said McGurk.

Reynolds said the pandemic accelerated every trend for industrial, with brick and mortar retail moving to warehouse.  But, the pandemic also created supply chain issues.

“It used to be all about just-in-time inventory.  That was it.  Let’s be efficient.  Now it’s just-in-case.  It’s safety stock.  We need it, and we need redundancy as opposed to just in time, which has been amazing for the industrial world,” Reynolds said.

Berenbom said LANE4’s retail product held up well during COVID because LANE4 had the right type of retail assets—the neighborhood, service, convenience-based product.

“And I think that more and more we’re realizing that retail is an integral last-mile solution for a lot of people.  There’s a lot of products where free delivery on your doorstep works, and we’re learning that there are some that don’t.  And we’re learning other ones, like haircuts, are hard to do online,” Berenbom said.

Copaken said the effects of COVID are continuing for the office market.  The uncertainty of the market makes it hard for landlords to do business, especially as tenants ponder lease renewals and change in space needs.

“I think it’s really going to be a tough year for existing landlords to keep, maintain and figure out what to do with their existing tenants.  And, it’s going to be a tough year to work on new projects. The dynamics are not in our favor right now.  They’re really in the favor of tenants,” Copaken said.

Copaken said his firm is trying to create environments that are unique, that people want to be part of and that tenants will pay up to be part of.

“So, we’re renovating, we’re spending money, we’re improving assets.  That’s kind of the only bet we can make.. We’ve decided to put in improvements that make our older buildings as if they were new, and appeal to people who are definitely going to have to pay something more but they’re going to have to pay something more for that quality they want,” he said.