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The Data Is In: The Credit Crunch is On | Why Isn’t Construction Labor Pricing Declining with Demand?

Market Monitor

The Data Is In: The Credit Crunch is On 

The predicted credit crunch, precipitated by general unease about current economic conditions and the shoring up of bank balance sheets after recent institutional failures, is upon us. The latest Federal Reserve data reveals that U.S. banks have been tightening lending standards, with most banks reporting that they have increased standards for business and real estate loans across the board.   

According to the Senior Loan Officer Opinion Survey on Bank Lending Practices conducted quarterly by the Federal Reserve, as of 1Q 2023, the majority of banks had tightened lending standards for commercial real estate loans, with 69% reporting tighter standards for construction and land development loans. The same was true for loans made to existing multifamily projects: The net percentage of domestic banks tightening standards had increased from near zero in 2Q 2022 to 57% in 1Q 2023. That marked the highest rate over the past 10 years, outside the height of COVID-19 in 3Q 2020 (64%), when banks were employing more conservative lending measures amid significant economic uncertainty.  

The data suggests that banks are becoming more cautious in their lending practices. That has broader implications for businesses, commercial real estate investors and households seeking to access credit. However, this caution could be seen as positive, as it may help prevent excessive risk-taking and reduce the likelihood of a future credit crisis. The lack of credit in the marketplace is viewed as deflationary and is helping to do the Federal Reserve’s bidding without the implicit need for further rate cuts.   

The Federal Reserve data also reveals that banks’ demand for loans has abated across most categories. The survey found that demand for business loans had weakened to a level matching the height of the pandemic, with nearly 40% of banks reporting weaker demand from large and middle-market firms. Notably, demand for real estate loans weakened dramatically over 1Q 2023, with 62% of banks reporting lower demand for construction and land development loans. Demand for multifamily loans fared better relative to the broader industry but was still down more than 50% from Q3 2022.  

Commercial Loan Demand by Multifamily

Net Percentage Domestic Banks

Source: Net Percentage of Domestic Banks Reporting Stronger Demand for Commercial Real Estate Loans Secured by Multifamily Residential Structures, Board of Governors of the Federal Reserve System 

Exacerbating this issue is the further decline in deposit balances within commercial banks. Since the Fed began raising interest rates in early 2022, nearly $1 trillion in deposits has been withdrawn from U.S. commercial banks, creating additional challenges for developers and investors to access critical construction debt capital. 

We will continue to monitor the challenges in accessing credit more broadly; however, this growing dislocation provides further investment opportunity to fill in some of the holes left in the marketplace by conventional bank lenders. In future installments of the Market Monitor, we’ll discuss some of the additional reverberations that the impending office loan maturities may have on bank balance sheets, which could further limit access to the broader credit markets as well.   

Why Isn’t Construction Labor Pricing Declining with Demand?

As my colleague Ken Lodge observed earlier this month, construction pricing has remained flat despite a slowdown in new construction starts. This week we’re looking at some of the reasons, and the impact that could have on pricing of new multifamily construction. 

U.S. Construction Employment, 2000-Present 

Construction labor

Source: U.S. Bureau of Labor Statistics 

U.S. construction employment has had its ups and downs since 2001 (see chart above). After peaking in 2006, it plunged after the Global Financial Crisis (GFC). Many construction workers left the industry with the feeling that dependable employment in the service and hospitality industries outweighed the lower wages. And it took until Q2 2022 for the number of construction workers to recover to pre-GFC levels.  

That means the glut of multifamily deliveries this year has been built by fewer workers in general—one reason construction spending has outpaced gains. Overcommitted subcontractors are managing less-experienced workers and struggling to meet scheduling demands amid lingering permitting delays and supply chain issues, leading to backlogs and frustration on construction sites. 

Shifting demand can lead to some cost savings, however. As work in some areas slows, traveling subcontractors can be hired at below the local market rate in the booming markets of Austin, Nashville and Phoenix in which we operate. We look for and work with general contractors who know the local market well, know the subcontractor base, both local and traveling, and know how to avoid complications such as subcontractor default. Another cost-saving measure is the increasing use of building information modeling software, employed in commercial high-rise construction but now being adopted more for wood-frame construction. It helps streamline planning, coordination of work teams and project time. And while 3-D printing of buildings is still in its infancy and has so far been limited to single-family construction, the hope is that off-site prefabrication can support cost savings as well. 

However, beyond the practical consequences of a labor shortage and the impact on pricing, there are bigger-picture challenges: Overall productivity in the construction industry has declined, too, for several reasons, along with declines in trade union participation and vocational education. And the industry struggles against the long-held belief that a college degree is the only path to middle-class success, even as college enrollment appears to be dropping. This despite factors in its favor such as high wages with low barriers to entry and work that is unlikely to be automated or impacted by artificial intelligence anytime soon.  

For these reasons I believe that, in general, labor will remain constrained and continue to prevent meaningful decreases in pricing, at least in the short term. The twin forces of inflation and interest rates are working to stifle new starts, even though subcontractors are still working through deliveries and don’t necessarily feel the pain yet. Over the next months, I’ll be watching for new housing starts and movement in the construction lending markets to determine whether either, or both, could begin to put downward pressure on construction labor costs.  

This article is intended for informational and educational purposes only and is not intended to provide, and should not be relied on, for investment, tax, legal or accounting advice. The information is provided as of the date indicated and is subject to change without notice. Origin Investments does not have any obligation to update the information contained herein. Certain information presented or relied upon in this article may come from third-party sources. We do not guarantee the accuracy or completeness of the information and may receive incorrect information from third-party providers.