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Even as almost 1 in 6 square feet of downtown Boston office space sits available for lease, local banks have said that any trouble in their urban office loan portfolios will be easy to contain. But questions are being raised about how much longer that will be the case.

A research paper by four academic economists, published last month by the National Bureau of Economic Research, flagged what the authors believed to be increasing credit risks in office loans due to declines in property values.

The researchers found out the average loan-to-value ratio of these loans was86 percent as of December. This means the property value behind the loans declined by 25 percent.

They also found 44.6 percent of mortgaged office properties in the U.S. are valued less than their outstanding loan balances, due to low demand for office properties and the increasing office vacancy rate.

‘An Absence of Alarm’

“I detect an absence of alarm [from banks]. There is a bit of a disconnect between the way banks are describing the environment that they’re heading into and preparing to respond to it, and the actual environment that they’re heading into,” said David O’Connell, a strategic advisor for lending at Boston bank consultancy Datos Insights.

A number of office loans going bad have the potential to transform into a bank run, he warned.

“When banks have to post the unfortunate news about their income statement and balance sheet and capitalization, they will be in danger of having a harmful fear-based response on the part of their depositors. Deposits are very mobile these days,” O’Connell said.

A Massachusetts Bankers Association spokesperson said in an emailed statement that local banks have strong underwriting practices that make them better equipped to handle credit risks. The statement said Massachusetts banks have loan-to-value ratios around 50 percent to 65 percent, citing S&P data, and that local banks have cushions due to their higher capitalization, and delinquencies are among the lowest.

“While challenges exist with some specific office properties, and certainly, those attract the ‘headlines,’ these types of properties generally represent a smaller component of a lender’s total real estate loan portfolio and further, a smaller subset of total office exposure. Within the office sector, certain office sub-categories such as Class A, suburban, medical office, and owner occupied have a much lower risk profile,” the Mass. Bankers statement said.

A look at local stock banks’ third quarter earnings show they have 5 percent to 6 percent of their CRE loan portfolio in the office segment – figures that can be further divided between urban and suburban offices, high-rise and low to mid-rise office buildings.

Eastern Bank revealed it has three non-performing office loans in Boston worth $26 million. Rockland Trust has $7 million in office loans in unspecified urban areas and $4.7 million in non-performing loans.

Citizens Bank had around $67.1 million worth of office loans in Boston’s central business district, and recorded $29.6 million loans “not in pay status” as of Sept. 30. Berkshire Bank had $479 million in office loans – $62 million of which were in Boston – and executives told investors the bank has “no exposure in high rise office buildings.” Brookline Bank had a $747 million investment office portfolio, with six office loans worth $64.9 million situated in Boston.

In Boston, demand for office space is declining as companies adopt hybrid work schedules. Research by commercial brokerage CBRE stated that Boston’s office market has a 15.8 percent vacancy rate.

A handful of office buildings in Boston are being converted into residential homes. But as previously reported in Banker & Tradesman, developers say few office buildings are readily converted to housing, and those that are often require complicated and time-consuming renovation work – projects that are not easy to finance unless the value of an office building collapses.

Will Rate Cuts Save Some?

In its statement, Mass. Bankers suggested that the Federal Reserve’s expected 75 basis-point rate cut this year could help cushion the blow on developers whose loans are coming due and will need to be refinanced.

“Our members understand commercial office collateral and their portfolios are positioned well to work out payment options with their borrowers to avoid worst-case scenarios. Repricing will take place over several years and the anticipated declining rate environment will be a positive factor as those discussions take place,” the statement said.

Brookline Bank President and CEO Darryl Fess said his bank understands and has weighed the risks of its office loans, and that its bankers are working out solutions with their borrowers – sometimes extending maturities or exploring other loan options.

“We talk with borrowers and work with them to make sure that they have a plan and that they know what it looks like, and then we can work together to make sure that everybody comes out OK,” Fess said. “Borrowers don’t want to have lose their properties, so there’s usually some common ground and way to make things better so that we have safe loans on the books and the developers and owners have loans that suit their needs.”

Nika Cataldo

But Datos’ O’Connell argued some banks may have already stretched maturity dates so far that the only option for the owner of a troubled office building could be to sell, even at a discount.

“Early on prior to the crisis, owners of those weak assets are in a position to sell those assets at a shallower discount. I would recommend considering selling them early and getting the pain over with,” he said. “Because once many banks are in trouble, the price just drops. Nobody wants [troubled office properties], and the people who do want them, who are thinking about arbitraging upon them, they sit and they capitalize on the mood and the volume of deteriorating assets and wait until the pain is worst so they can buy at the lowest price.”

Last year, office buildings in Braintree and Boston have sold for around half the price their sellers paid for them in prior years.

“I might be wrong, but I don’t think this ends well. We’ve got too little demand chasing too much supply. That always causes prices to go down, but the loans don’t get paid back,” he said.