A Matter of High Interest
November 08, 2023
By Gloria Lloyd and James Drew – St. Louis Business Journal | Nov 8, 2023

The delayed effects of interest rate hikes by the Federal Reserve since March 2022 are being felt across St. Louis as developers build fewer projects and say that banks are handing out fewer loans.

Developers said banks are becoming more selective about which projects they finance. As a result, they’re finding that projects that would have worked in 2022 don’t make sense this year, and the ones that do move forward are taking longer. Although developers who talked to the Business Journal said that the current market environment is affecting every developer, the actual impact depends on the types of developments being pursued, their stage in the life cycle and how creative the developer is at finding financing in the current interest environment.

A few years ago, “there was so much bank debt that it was like picking apples off an apple tree. But now, not so much,” said Larry Chapman, CEO of St. Louis-based Seneca Commercial Real Estate. “The banks don’t have ready access to capital because of what the Fed’s been doing.”

But with 44 years of experience developing, Chapman has seen far higher interest rates, in the 1980s. The anomaly is really the low interest rates of the last few decades, he said, not this year’s higher rates.

The effect can already be seen in the number of projects headed toward construction. Fewer projects are on track to start this year in the city of St. Louis, where some of the region’s largest projects are typically built. Projects that have moved forward are smaller than the ones that began construction last year. So far, building permits issued this year are on track to fall slightly from last year’s total of 5,305 to 5,238 permits, according to figures from the city and a Business Journal analysis.

The city also tracks dollar amounts for projects that are issued building permits, and those have fallen even farther behind the trend of the past several years, indicating that projects getting off the ground are smaller than in years past. Developers are on track to be issued permits to construct $756.6 million in projects in 2023, nearly half of the $1.4 billion in permits the city issued last year, records show. The number hasn’t dipped that low since 2019, when the city issued 5,419 building permits for $614.7 million in projects.

Higher interest rates aren’t the only possible cause of the fall in building permits, however. The city changed its incentive guidelines this year to prioritize projects by geography and project type, with a special emphasis on incentivizing affordable housing, and that change might have impacted the city’s numbers, developers said. None of the figures cited include the roughly $1.7 billion National Geospatial-Intelligence Agency’s western headquarters. That data isn’t made public.

When developers and banks prioritize projects that have the potential to be most successful, projects become more attractive to build in growth areas, developers said. So far this year, St. Charles County, which has added population while the city has lost residents, is on track to issue a higher number of building permits year over year. The dollar volume of those permits already exceeds that of last year: $263.2 million so far this year compared to $259.7 million for all of 2022. If the dollar volume were to continue on that pace the rest of the year, building permits in the county would hit $308.9 million.

St. Louis County’s data on building permits was not readily available.

“You can just look at the deal volume, and it has come down and will likely continue to come down as as the economy resets,” said Paul Larson, CEO of St. Louis-based development firm Larson Financial Holdings.

The lending shift

Commercial real estate lending in the St. Louis metro area, including projects under construction, continues to expand, albeit at a slightly slower pace, according to Carl White, a high-ranking official with the Federal Reserve Bank of St. Louis.

Using data through Sept. 30, total commercial real estate balances equaled $18.1 billion across the 56 banks headquartered in the St. Louis area.

That’s up from $17.8 billion at the end of the second quarter – a 1.8% increase, said White, senior vice president of the St. Louis Fed’s Supervision, Credit and Learning Division.

But the rate of growth in commercial real estate balances is slowing, from 12.7% annual growth as of June 30 to just over 10% as of Sept. 30. White noted that the figures include all commercial real estate lending by the 56 banks, which in some cases may include lending outside the St. Louis area.

Demand for commercial real estate loans began to slow during the third quarter, likely due to the Federal Reserve raising the federal funds rate from nearly zero last year to 5%-5.25%, said Chris Eckelkamp, vice president of commercial lending at the Bank of Washington in Franklin County.

“I just think that takes awhile to take effect,” he said.

The Fed’s interest rate hikes, designed to combat inflation by slowing the economy, have coincided with uncertainty about the future of commercial office space as companies adopt policies to get Covid-19 remote workers back into the office.

Royal Banks of Missouri CEO Mitch Baden said the University City-based institution hasn’t pulled back on commercial lending, but is changing its approach.

“There are certain segments that we are not aggressively pursuing right now – retail and office centers,” he said.

During the pandemic, Royal Banks moved away from retail, hotel and office lending and shifted toward multifamily properties, he said. The bank still has loans to hotels and assisted living facilities in its portfolio, but those sectors have recovered since 2020 and a lot of those properties are owned by the companies that operate them, Baden said.

“Almost half of our CRE loans are owner-occupied. We have substantial business from them. We just don’t have the real estate. We have the deposits and we have their operating lines (of credit). We can monitor what is going on with the operating company and make sure there isn’t a lot of additional risk,” he said.

Tim Schoemehl is senior managing director of Integra Realty Resources’ St. Louis office and manages the Kansas City office. The offices of the national firm typically do about 700 to 800 commercial real estate appraisals per year, with about 80% related to lending, he said.

This year, the volume of appraisals for lending deals is down 25% to 35% compared with 2022, Schoemehl said.

“When you see the rate increases from the Fed, you see that make an impact in the volume and when they take a pause, sometimes the volume picks up again,” he said.

Schoemehl said Integra Realty is still seeing lending deals for multi-family housing, small strip shopping centers and “built-to-suit” developments such as construction of fast-food restaurants.

“We’re certainly not seeing any new speculative office development and generally not a lot of new speculative retail either. If you have tenants lined up for the majority of the space, those kinds of deals could work,” he said.

With commercial real estate loans at percentages of high 6s and low 7s, there’s a recognition in the market that there’s a large volume of renewals of commercial real estate loans that are coming up, Schoemehl said.

“The existing loans were done at lower rates than what banks are able to offer today. So as those start to renew, back in the day people used to have cash-out refinancing. Now it’s more like you might have to have cash-in refinancing, where you have to bring money to the table to get your loan renewal done. A lot of people are not excited about that prospect,” he said.

Interest rates are “close to peaking,” predicted Scott Colbert, chief economist for Kansas City-based Commerce Bank, which has a large presence in the St. Louis region.

“The reason for that is the economy is cooling. The Fed recognizes this and the Fed doesn’t like to say it this way, but they know they have done a lot of damage; they just don’t know how much. So they’re stopping to pause for a period of time to see what the net outcome is of the biggest interest rate-hiking process they’ve had since 1980,” he said.

Finding new money

Although many developers are still working on projects that are taking longer to get to construction, several significant St. Louis projects have been dropped or indefinitely delayed in response to the interest rate environment. Most notably, St. Louis-based development firm Pier Property Group last month ended its plan to purchase and redevelop footwear retailer Caleres’ office campus in Clayton, which it had under contract, and convert it to a mixed-use redevelopment.

St. Louis Cardinals President Bill DeWitt III told the Business Journal last month that the plan to potentially build another apartment high-rise at Ballpark Village is on indefinite hold in part due to interest rates, along with inflation.

Even if current projects are moving forward, most developers are choosing not to pursue new projects they otherwise would have, since existing projects are taking more time and money.

“I have not started some things that I probably would have started in a different environment,” said Chapman, the CEO of St. Louis-based Seneca Commercial Real Estate. But all of Seneca’s existing projects are moving forward. “All of the fields we’ve got ourselves into have good fundamentals, and we’ll follow them through to the finish. And we are starting a new project. We’re just doing it in a very strategic way.”

Projects are taking longer primarily because it’s taking longer for developers to find financing, said Michael Hamburg, leader of Pier Property Group. Local regional banks that were essentially “closed for business” for a few months earlier this year have opened up loans again, but are now being more selective about which projects to fund, he said.

“You have to cast a wider net. If you were going out to four lenders before, you might have to go out to eight or nine now to find a fit,” Hamburg said.

In the absence of easy bank lending, developers have had to find new ways of financing projects. St. Louis-based commercial real estate firm Sansone Group, which has a focus on building industrial projects across the country but otherwise operates in all sectors, has relied less on banks for funding and more on private equity, said John Brown, the firm’s director of development and acquisitions. The company has also begun to self-fund some deals, building them on 100% equity, Brown said.

While the firm is still seeking out new projects, nearly all of them are taking longer to get to the finish line, he said. It used to be “I wouldn’t say easy, but a lot easier to get funding and capitalization,” Brown said. “Now getting capital on projects has been one of the tougher things for our process. The timeline is dragging out a bit.”

To move forward, a project has to be “dialed in” with a completely vetted business plan that matches what lenders want to fund, Brown said. The firm chooses “real deals that make a lot of sense rather than the deals that had to be just right and only happen with a very low cost of capital. That’s not really what we have. We have projects that we believe in and we will make work in any capital environment.”

As alternate financing and self-funding become more popular, it creates a tougher environment for small developers, said Larson.

“The smaller developers have just gotten crushed,” Larson said. “For every deal that’s getting started right now, there are four to five deals that we’re seeing that the brakes are being put on.”

That time-consuming search for financing has extended the typical timeline for projects, Hamburg said. And some projects that don’t fit into the “box” of what banks are looking for right now may have to wait a year to get off the ground, until lending opens up more.

Like many developers facing those issues, Hamburg has slowed Pier’s pipeline of projects to focus on finishing the projects currently in the hopper, becoming more selective and cautious when taking on new projects. Each development is also taking longer to complete, with more risks involved, he said.

Timing was part of the issue that prevented Pier from moving forward on buying the Caleres building. If Pier could have extended that timeline, Hamburg thinks it would have worked. Two city redevelopments that Pier has fully approved and are mostly ready to go, a redevelopment of Rock Spring School and an apartment conversion of a historic building on Kingshighway, are waiting on the final bit of financing and so are moving forward slower than usual, he said.

Not every developer has experienced those same effects, depending on what types of projects and funding they typically use. Larson Financial Holdings has seen its investor equity on projects increase by 8% this year, since the firm self-funds its projects through its Larson investor funds, Larson said. The firm has seen higher interest this year in its real estate funds, some of which offer a set 12% interest rate backed by the real estate, as those investors seek to find a higher rate of interest return than inflation, Larson said. As the company has bought land for various projects, the firm has less competition from other developers for those sites and has paid less, he said.

The silver lining for developers who are still pursuing projects is that rents have increased and will continue to increase due to higher interest rates that have helped create a scarcity of housing as people don’t want to sell houses with low-interest mortgages and rent them out instead, Larson said.

“The positive side of this for developers, if they can get past the problem of getting banks to actually lend them money, is that rent is increasing. If they have fixed-price contracts to build, they’re making more profits,” Larson said. “It’s a positive negative effect.”

Hamburg expects to see the number of projects in the works on the whole continue to decline over the next year and pick up again in 2025. But if developers bring all those delayed projects into production at once, it could cause supply chain issues due to sudden increased demand, Larson said. That will bring its own set of new issues developers will have to face when the time comes.

While interest rates could level out, Chapman and other developers believe it’s unlikely that they’ll fall to the lows seen in the past several years and decades, and developers and banks might have to adjust to a higher norm.

Chapman’s advice to younger developers: “Be ready for something more historically right and hang in there. Be ready when the opportunity presents itself, because it will.”

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