Commercial real estate in Rochester: ‘Pockets of greatness,’ as well as challenges

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Commercial real estate across the U.S. is in limbo — or purgatory, depending on who you speak to or what you’re reading — with inflation, high interest rates and work-from-home scenarios causing upheaval in the sector. Experts in Rochester, however, say the city and region have held up well amid and describe the overall market as “steady” despite significant challenges in downtown office space.

Federal Reserve rate hikes aimed at combatting inflation and the staying power of work-from-home arrangements and online shopping spurred by the coronavirus pandemic have caused a downturn in commercial real estate across the US. Downtown office space in Rochester has been impacted by some of those same issues, though not to the extent felt in larger metropolitan areas, and much of the suburban market has been minimally impacted.

“It’s steady and there are certain asset classes that are really quite strong, but interest rates … labor costs and the inflation effect on construction are having an impact,” said Charlie Vita, executive vice president and chief lending officer at Canandaigua National Bank (CNB), of the state of commercial real estate in the region.

Vita said there are regional issues, largely in major cities, but CNB is not seeing defaults and past-due accounts or any major issues with loan quality. He said CNB has not pulled back on lending and remains “fully engaged in the market and doing business” despite the recent challenges.

“The whole commercial real estate market has slowed up a bit, but we came off a market where it was growing at kind of an exponential pace,” Vita said. “The pace of building is slowing but there’s still building.”

Andrew Gallina, president of Gallina Development Corp., said the commercial real estate sector is “in flux,” with office space, particularly downtown, suffering due to work-from-home and hybrid work arrangements. With fewer employees in the office, less office space is needed, creating an imbalance between supply and demand.

Gallina said the pendulum could swing back in the other direction, but it’s too early to tell and the sector is currently in a period of contraction that he called “very significant.”

In addition to the rise in remote work, challenges for developers and investors range from interest rates to inflation, labor shortages and supply chain issues, but Vita said developers and the bank have largely been able to navigate those issues.

Good projects are still good projects and people are still building and doing things,” Vita said. “Deals still are making sense, but not every deal is making sense and that’s what is causing the market to slow up a little bit.”

Commercial real estate as whole has been stable, Vita said, but the performance of various sectors differs. One bright spot is multifamily properties, Vita said, adding there’s still significant activity in the space, including new construction. Gallina said warehousing, flex space and industrial buildings are “actually quite strong and performing very well.” Local vacancy rates are about 2.5% in multifamily and 8% in industry, according to Vita.

“There’s very low vacancy and that’s why a lot of investors have migrated to that type of product rather than office space,” Gallina said, adding small residential is also performing well.

Retail is a bit more mixed with “pockets of greatness and pockets that are challenged,” according to Vita, who pointed to strip centers with strong anchors as high performers. Though the bright spots exist, Vita said it wasn’t all positive.

“I don’t want to paint it too rosy. There are specific asset classes that are challenged, and office space is one of them,” Vita said. “Office space is a weaker asset class right now. There are still pockets of very strong office space but compared to the other asset classes there’s higher vacancy and more repurposing going on.”

Nationwide, roughly $1.2 trillion of US commercial real estate-linked debt is possibly troubled – defined as having a debt equal to at least 80% of the marked-to-market value – due to high leverage and falling property values, according to an August report from advisory firm Newmark Group. Much of that is related to weakness in commercial office space, and there’s growing concern that defaults could spike as property values decline and owners’ costs continue to rise.

Experts are suggesting in some regions valuation reductions as high as 40% in the office space sector, but Vita said Rochester isn’t seeing the same challenges as major metropolitan areas. Areas such as Western New York are not feeling the same level of pain, Vita said, noting much of the downtown towers in Rochester had been repurposed before the market changed.

“We’ve been absorbing it for a number of years,” Vita said. “It’s been kind of a combination of multifamily and reduced office space. It’s not what it once was in terms of the way it is utilized.”

Vacancy rates for downtown office space are above 19%, however, which still presents significant challenges. However, Vita and Gallina noted the suburban office market is not suffering from the same issues as the downtown spaces and much of it is performing well.

Asked about the appetite for new office space at the moment, Gallina said “that’s pretty much a hard no” when it comes to downtown development, but there is some development in the suburban markets, particularly medical and build-to-suit projects.

“You have the kind of double whammy there with increased costs and increased financing costs,” Gallina said. “New construction and new projects are cautiously proceeding in some markets, but you won’t see anything like that downtown other than renovations.”

Gallina said it’s hard to quantify the impact of work-from-home on the office space sector, particularly downtown, but noted studies and research done on the downtown market indicate the volume of workers in the office on any given day is roughly 50% lower than pre-pandemic levels.

“And that has rippling effects through our whole economy. It affects everything,” Gallina said.

With the contraction in office space, property owners are looking to fill space with other tenants, but turning office space into residential units or other repurposing is “a heavy lift,” Gallina said, noting it can be both challenging and expensive.

Downtown office buildings are experiencing what Gallina called “tremendous vacancy issues,” and reductions in property values and even possibly defaults are likely if things don’t change. Gallina expressed significant concern about the current state of office space and downtown overall.

“Downtown needs to be warm, inviting, a vibrant place that’s exciting,” Gallina said. “A place that people want to not only live but work. That’s where we are struggling a little bit.”

Gallina pointed to Rochester Downtown Development Corp. and efforts to establish a business improvement district (BID) as a possible solution to creating a more vibrant downtown, adding there’s significant stakeholder support for the move. Gallina said the BID could alter the perception of downtown, improving cleanliness and landscaping, creating events and promoting downtown.

“The status quo is not acceptable,” Gallina said. “We can change this, but we can’t sit idly and watch things deteriorate. There’s urgency. There’s a very high level of concern in the business community about downtown occupancy and going in the wrong direction.”

In the coming year, Vita said developers will have to rework business models and reconsider the economics of any deal. Interest rate risk management will be a critical aspect of any development, along with keeping costs low to combat labor issues, inflation on materials and supply chain challenges.

“Those are definitely things that need to be managed,” Vita said. “And structure can help some of that. Longer amortization on some of these projects and interest rate risk management tools can help. So can buying right and contingency planning.”

Vita said some projects are likely to require more equity moving forward as well, noting “a little more equity and a little longer amortization” can help offset cost increases. Vita added “it’s probably more important than ever to spend time with your banker” to talk through some of these options and potential changes to business models.

Looking a little further into the future, Vita said the rate cycle will improve. Most economists are predicting some sort of rate relief next year, with most penciling in rate cuts around mid-2024.

Matthew Reitz is a Rochester-area freelance writer.