#2- Interest Rates, Debt Financing, Supply Chain, and the Future

Inflation has been a popular topic surrounding the US Economy over the last several months.  As the Coronavirus pandemic spread and shutdowns followed, the United States government enacted such fiscal policies as the Coronavirus Aid, Relief and Economic Security (“CARES”) Act and the Payroll Protection Program. Meanwhile, the Federal Reserve reduced interest rates to near zero percent. The goals of these policies were primarily to keep citizens and businesses afloat and allow for a quick recovery when the country eventually re-opened.  Largely, these actions have been effective, but the sudden revitalization of the economy has also led to significant strains on the supply-chain that have in-turn caused inflation and other issues. There are a variety of ways that the economic trends of the last eighteen months have affected the construction industry, but for the scope of this paper we will specifically discuss the relationship between low interest rates, debt financing, the struggling supply-chain, and the outlook on future construction projects.

Equity financing and debt financing are two key terms for developers within the construction industry.  Equity financing is the concept of a real estate developer investing their own capital, or the capital of other investors, to purchase and develop a property in exchange for an equity share in that property. Conversely, debt financing occurs when a developer borrows money from a bank or other financial institution to fund the purchase of the property (Black, 2018). There are pros and cons to each, and both forms are often utilized on your typical development project. However, when money is cheap to borrow (as is the case with near zero percent interest rates from the Fed), positive leverage increases, and debt financing becomes more attractive; Miles, Netherton, and Schmitz (2015) state that, “Such ‘positive’ leverage occurs when the cost of debt financing is lower than the overall return generated by the property.” This means that if the expected return on investment is greater than the interest rate, then justifying the decision to borrow is that much easier. Therefore, low interest rates have been incentivizing developers to utilize debt financing and continue building. Figure 1 below illustrates March 2020’s sharp drop in “Effective Federal Funds Rate”, which is the name for the interest rate set by the Federal Reserve (Chen, n.d.).

Figure 1: Effective Federal Funds Rate December 2018 – August 2021 compiled by the FRED (Federal Reserve Economic Data) Database

So far so good, right? Lower rates mean more building and more building means more backlog! That is undoubtedly true.  However, as is the case with most situations, there are also costs that come with these benefits.

In this instance, the cost has been a barren supply-chain; the continued push for construction paired with the global economy’s reignition have made materials extremely difficult to obtain, manufacture, and ship. Products like polyiso roofing insulation are typically available “off-the-shelf”, but instead are taking anywhere from six to nine months to procure because of raw material shortages. Additionally, due to high demand, pricing on raw materials has been increasingly volatile with higher-than-normal levels of inflation occurring.  Figure 2 shows aluminum’s one hundred and five (!) percent rise in price from April 2020 ($1,426/ton) to September 2021 ($2,933/ton).  To manage the rising costs, many aluminum wall panel manufacturers have switched to a “pricing in effect” model, which means quotes are not held for the standard 30–60 day period, but rather the customer is charged the actual price of aluminum on the day of the order.  This makes quoting and executing projects much more complicated.

Figure 2: Aluminum pricing December 2018 – September 2021 compiled by tradingeconomics.com

Rising prices and inconsistent supply-chain mean more risk associated with building and development.  Depending on the point in a project’s construction cycle, these risks could be dispersed between developers, owners, general contractors, and subcontractors alike.  However, as more contractors have become aware of supply and pricing issues, the more they are doing to protect themselves against it on upcoming projects.  This will leave owners and developers with a hard decision: is it worth it to pursue a project in the current market? Would it be more prudent to put projects on hold and wait for the market to stabilize? Some are proceeding because of the cheap cost of money, but others don’t want to pay premium pricing and deal with the risks.

So how will this affect the next two to four years in our industry? That remains to be seen, but it would be sensical to assume that owners will not want to take sole ownership of the economic risks currently associated with construction projects.  If distribution of that risk cannot be agreed upon, then there will be some projects that are put on hold. Meanwhile, for the economy to cool-off and inflation to decrease, interest rates cannot remain near zero forever. As a result, there is high potential for a drop-off in available work, and many contractors are recognizing that fact. It may not be felt immediately, but eventually the economic policies related to the Coronavirus pandemic will reach the construction industry.

This is a highly complex topic and the relationships described above are only a narrow snapshot of the actual picture of the market.  As a result, I don’t have any type of suggested course of action, but rather wanted to bring some of these issues to light.  Regardless of the complexity, it is important for company owners and leaders to track these trends and strategize when and how to secure backlog and protect their businesses.

Authored by:

Matt Verderamo

28 September 2021

Works cited:

Black, D. (2018, June 15). Commercial real estate debt vs. equity financing – advantages and disadvantages. Black Collie Capital. Retrieved September 28, 2021, from https://blackcolliecapital.com/commercial-real-estate-debt-vs-equity-financing/.

Chen, J. (2021, September 28). What is the federal funds rate? Investopedia. Retrieved September 28, 2021, from https://www.investopedia.com/terms/f/federalfundsrate.asp.

Miles, Mike E.; Netherton, Laurence M.; Schmitz, Adrienne. Real Estate Development – 5th Edition: Principles and Process (p. 406). Urban Land Institute. Kindle Edition.

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