High interest rates take growing toll as planned apartments, wind farms, shops are scrapped

Three years ago, when a local developer hatched plans for a 352-unit apartment building in West Philadelphia, the project was a no-brainer.

The city needed tens of thousands of affordable and reasonably priced housing units. Construction costs were a relative bargain since the structure would be built in pieces at a factory and assembled on-site. And interest rates were at historic lows.

Since then, Philadelphia’s housing crisis has grown more dire. But after pandemic-related material and labor shortages raised construction costs and the Federal Reserve’s flurry of interest rate hikes in 2022 and 2023 pushed borrowing costs to 23-year highs, the developer of the West Philly building scrapped the project.

Total costs had ballooned from $103 million to $131 million, according to Leo Addimando, managing partner of the developer, Alterra Properties, which announced last August that it was canceling the six-story apartment project.

“The final blow was definitely the spike in interest rates,” Addimando says. “Even if you gave me the property for free, we still couldn’t make the math work.”

High interest rates are compounding the effects of spiraling construction costs and forcing developers to scrap, significantly delay or shelve a growing share of projects across the U.S.

Among those affected are apartment buildings, renewable energy projects, shopping centers, mixed-use developments and office complexes.

The trend is making it more challenging for the nation to address a severe shortage of affordable housing, meet renewable energy goals and revitalize downtowns hobbled by the pandemic with new shops and restaurants, critics and some economists say.

What percentage of construction projects are late?

In December, nearly 30% of private and public construction projects had been significantly delayed, indefinitely stalled or scuttled over the previous six months, according to an American Institute of Architects’ member survey. That’s up from 22% in December 2022 and 15% in September 2019, before the pandemic upended the economy, AIA says. Those percentages are based on the projects' dollar value.

A relatively modest 4% of projects were outright ditched over those six months, the AIA survey said. But cancellations accelerated in the first quarter of 2024, according to ConstructConnect, a research firm. Such abandonments were up 70% for private projects compared with the same period in 2021 and 50% for public projects, the firm’s data shows.

And some delayed projects likely will be dropped eventually, says Anirban Basu, chief economist of Associated Builders and Contractors, a trade group.

Is the US economy strong right now?

Although the rash of developments axed or shelved doesn’t come close to levels reached during the Great Recession and real estate crisis of 2007-09, it’s unusual because the economy remains vibrant, Basu says. The U.S., for example, needs 4.3 million new apartments by 2035, but multifamily construction fell 14% in 2023 and is projected to decline another 20% this year, according to the National Multifamily Housing Council and the National Association of Home Builders.

And though the office vacancy rate hovers at an elevated 22% as more Americans work from home, demand is healthy for retail space, with a vacancy rate of just 4.1% in the first quarter, according to research firm JLL.

What is the renewable energy goal for the US?

Some Democratic lawmakers are especially concerned about the threat that high rates pose to multibillion-dollar green energy projects designed to mitigate the effects of climate change.

“Your decision to rapidly raise interest rates beginning in 2022, and the potential that they may remain too high for too long, has halted advances in deploying renewable energy technologies and delayed significant climate and economic benefits,” Sens. Elizabeth Warren of Massachusetts and Sheldon Whitehouse of Rhode Island wrote in a March 19 letter to Fed Chair Jerome Powell in March.

Asked about the letter the next day, at a news conference after a Fed meeting, Powell said, “Our mandate is for maximum employment and price stability and the other things that we do, and that’s what we’re trying to accomplish.

“That’s how we can best serve the public and leave the other issues, which in many cases are incredibly important, such as those you mentioned, leave those to the people who have responsibility for those.”

What will using higher interest rates do?

By rapidly hiking rates, Powell and other Fed officials have been credited with helping lower inflation from a 40-year high of 9.1% in mid-2022 to 3.5% in March 2024, based on the consumer price index (CPI). But there’s a delicate push-and-pull to its strategy, which aims to cool the economy and inflation by curtailing consumer and business demand.

Yet higher borrowing costs also crimp the private sector's ability to build housing and add other new products to the market. And that supply crunch can juice inflation.When developers cancel planned apartments, for example, landlords feel less pressure to keep rents stable so they don’t lose tenants to the new units. Rent has been the biggest inflation driver, contributing more than 30% to the COVID-induced run-up in prices, according to the CPI.

Interest rates aren’t the whole story.

How much have construction costs increased?

Hefty construction price tags pose an even bigger burden. But after climbing about 37% from 2021 to early 2023, those costs largely have stabilized and then dipped, notes Michael Guckes, senior economist of ConstructConnect.

Meanwhile, though, the Fed sharply raised its key interest rate from near zero to about 5.3% through last July, where it has held. From 2021 to early 2023, commercial construction financing costs more than doubled and have been volatile over the past year, ConstructConnect figures show.

“That scared the hell out of the market,” says Brett McMahon, CEO of Miller & Long, a construction company based in Bethesda, Maryland. “The uncertainty is just causing everybody to pause.”

He estimates that about one-third of the projects his firm is bidding on have been delayed as developers try to reduce costs or scale back blueprints.

When can we expect the Fed to lower interest rates?

As recently as March, the Fed tentatively planned to trim its key interest rate three times this year as inflation slowed. But in recent weeks, with progress on inflation stalling, Powell and other Fed officials have said rates are likely to stay higher for longer.

Developers are taking the shifting signals to heart. The Fed’s recent statements about the dimming prospects for rate cuts likely have led some companies to withdraw their proposals, Guckes says.

“I am concerned that potential owners and developers are becoming more pessimistic ... especially with the chances of 2024 interest rate cuts seemingly slipping away,” Guckes says.

As its costs spiraled higher in 2022 and 2023, Alterra, the developer of the Philadelphia apartment building, asked the current owner of the property to delay the land sale in the hope that rates would fall and to lower the purchase price.

“Ultimately, we could not come to any sort of agreement,” Addimando says. The interest rate that Alterra would have paid for a construction loan soared to nearly 10% from 5% in 2021, he adds.

Alterra, in turn, hiked its proposed rent 9.4%, from $3.50 a square foot to $3.83, putting a one-bedroom apartment at about $2,000 a month, Addimando says. But that wasn’t enough to offset the higher costs. And boosting rent a total of 15% to cover the increased expenses would have made the units pricier than rival apartment buildings a couple of blocks away that are in more residential neighborhoods and closer to area universities, he says.

By ditching the project, the company lost $2 million in preconstruction costs, Addimando says.

Not going to work out

In San Antonio, Texas, VIA Metropolitan Transit, the local transit authority, and DreamOn, a developer, scrapped plans to convert an old industrial building into about 110 apartments, including about half for lower-income residents, as well as shops, offices and self-storage space.

The $66.5 million development would have revitalized a distressed area between downtown and the West Side, DreamOn President Julissa Carielo said in a statement to the San Antonio Express-News.

With the rise in construction costs and interest rates, “It didn’t seem to (work) out anymore,”  VIA CEO Jeff Arndt said in an interview with USA TODAY.

Why are offshore wind projects struggling?

Escalating costs also have doomed several renewable energy projects designed to lower greenhouse gas emissions. In the past year or so, developers have backed out of three planned offshore wind farms in Massachusetts and Connecticut, and two in New Jersey.

The two, multibillion-dollar, New Jersey projects would have powered more than 1 million homes, according to its Danish developer, Orsted.

“The significant adverse developments from supply chain challenges, leading to delays in the project schedule, and rising interest rates have led us to this decision,” Orsted CEO Mads Nipper said in a statement.

Total construction and financing costs shot up 30% to 50%. Also, the vessel that Orsted contracted to build the wind turbines in the Atlantic Ocean was significantly delayed, as were certain turbine parts. Orsted had little choice but to drop the project, which would not have yielded a profit for the company, says Maddy Urbish, head of Orsted's U.S. public relations.

New Jersey Gov. Phil Murphy called the decision “outrageous” and said it “calls into question the company’s credibility and competence.”

Yet Orsted isn’t alone. Avangrid, a Spanish energy company, ditched the offshore wind projects in Massachusetts and Connecticut for similar reasons.

The scrapped plans are jeopardizing various state goals requiring that 40% to 70% of electricity come from renewable energy by 2030 as well as President Biden’s target of deploying 30 megawatts of offshore wind capacity nationally in a similar timeframe.

“It’s a tremendous challenge,” Dan Dolan, president of the New England Power Generators Association, says of the cancellations.

Developers recently submitted new bids for the New England wind farms but it’s not clear if they’ll face similar obstacles, he says.

Orsted, meanwhile, is still moving forward with offshore wind farms near Rhode Island and Long Island, New York. The New York project was also saddled with high construction and borrowing costs. But Orsted won the contract after the state allowed developers to submit new bids so they could receive a higher price for power from ratepayers to offset the costs, Urbish says.

Some builders are putting off projects and hoping interest rates will soon fall.

'Dramatically more expensive' to get construction loan

In Boston, Hudson Group recently was granted another year by the local zoning board to start building a 22-story, 115-unit apartment building near South Station. By then, the company hopes borrowing costs will have declined somewhat, says Noam Ron, a partner in the company.

"Interest rates are at the point where these projects aren't sustainable," Ron says.

Instead of earning at least a 6% to 7% return on the development, the project could yield 5% or less, undermining its financial viability, Ron says. As a result, virtually no lenders are financing large residential buildings in Boston, he says.

"I think it's going to take time for rates to come down but we hope they do," Ron says.

Meanwhile, he says, Boston grapples with a severe housing shortage. For residents, "It means rent is really expensive."

Other developers are seeking variances from local officials to cope with higher costs.

In Concord, New Hampshire, Mark Ciborowski wants to covert a former CVS pharmacy downtown into a seven-story complex of apartments, shops and a rooftop restaurant,  according to the New Hampshire Union-Leader.

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But the local zoning board denied his request to build the structure 88 feet high so he could include four floors of apartments to make the project financially viable. That exceeded the city’s 80-foot limit and violated a rule by partially blocking views of the State House from a nearby highway. Ciborowski recently asked the City Council to ease its height limit.

“I am really working hard to make the project work between construction costs and interest rates,” he told the zoning board, according to the Union-Leader.

Ciborowski didn’t return messages seeking comment.

What were the CPI report results?

Wednesday's report on the April consumer price index, a broad inflation gauge, bolstered hopes that the Fed could cut interest rates at least modestly this year.

Annual inflation overall ticked down from 3.5% to 3.4% and a core measure that excludes volatile food and energy items slowed from 3.8% to 3.6%, the lowest in three years.

Several economists said the data led them to maintain their forecasts for an initial rate cut in September.