Hybrid and remote work is here to stay, driving lower demand and high vacancy rates for office buildings, and making it more difficult for office building landlords to gain enough revenue to pay high interest rates on their loans. iStock illustration

Regional banks in Massachusetts reported an increasing share of troubled office loans in their Q4 earnings calls, a trend that may continue in the next few quarters. But the banks also report the increase is manageable, given that troubled office loans are a small share of total loans.

M&T Bank in its latest earnings statement said its criticized commercial real estate (CRE) loans jumped to $12.6 billion in the fourth quarter of 2023, compared to $11.1 billion a quarter ago. The bank identified more criticized loans after it completed a review of 60 percent of its CRE loans, including the loans acquired from People’s United Bank and maturities in the next 12 months.

M&T CFO Daryl Bible said during the earnings call that the bank expects further increases in criticized CRE loans in the coming quarters as this year’s loan maturities will negatively impact their books as high interest rates persist, while borrowers’ capacity to pay weakens.

M&T is not alone. Massachusetts banks, including Eastern Bank and Rockland Trust, are moving to sell some of their CRE portfolio amid increasing nonperforming CRE and commercial and industrial (C&I) loans. They also raised their allowance and provision for credit losses and loan loss reserves to cushion the impacts of non-paying borrowers.

Smaller Banks Take Smaller Risks

The rise in criticized, non-accrual and nonperforming loans are mostly due to acquisitions of other banks, rather than the core franchise of these banks, said Arthur Loomis, president of community bank consultant firm Loomis & Co.

“For example, M&T bought People’s United. M&T is an extremely conservative lender. … People’s had a bit more risk profile. Further, M&T, because it is so conservative, oftentimes quickly builds loan loss reserves in anticipation of upcoming perceived loan portfolio weakness to better smooth out their earnings performance,” he said.

Loomis said that nearly all conservatively run banks lend, as a matter of policy, 65 percent loan-to-value (LTV) on CRE and C&I loans, and banks that adhere to that “rarely get into trouble.” The lower the LTV ratio, the lower the risks and costs associated with a loan. But if a bank is more liberal – accepting loans with LTVs of 70 percent to 80 percent with no additional collateral – may be vulnerable to a real estate occupancy weakness.

Commercial real estate brokerage firm Hunneman in a recent report noted that Greater Boston had a 16.4 percent office vacancy rate as of the end of 2023, due to substantially lower demand despite the removal of some inventory in the market. It reported that five of the 11 office building sales in Boston saw a significant discount in sale prices.

Loomis noted that smaller banks, like community banks under $15 billion in assets, have smaller levels of CRE loans and nonperforming loans, and most are owner-occupied properties.

Steve Carpinella, president of Cobblestone Risk, which does loan portfolio reviews for community banks under $5 billion, shared the same view. “Since our company focuses on small community banks, we are not observing the impact of troubled office properties to the extent larger regional banks are,” he said.

Banks Have Some Options

Hunneman’s Director of Research and Strategy Mark Fallon said hybrid and remote work is here to stay, which is driving the lower demand and high vacancy rates for office buildings, and making it hard for office building landlords to get revenue stream enough to pay high interest rates on their loans.

“Tenants will require 15 percent to 20 percent less space, and there are no significant demand driver on the horizon,” he said.

Unable to keep their properties and the costs associated with it, some landlords can also transfer the office buildings and the cost burden back to their lenders.

Banks usually try to restructure loans that are nonperforming during times like these, sometimes stretching the maturities and looking for other workouts so as to not encourage a fire sale, Loomis said; “when they restructure, they closely but patiently wait to see if the loan can be restored to a performing status.”

Bible said during M&T’s earnings call that borrowers of criticized loans were able to pay some of their obligations through modifications at loan maturity, such as replenishment of reserves, loan paydowns and enhanced recourse. This led to the bank putting a lid on the growth of non-accrual and nonperforming assets.

Banks also have the option to foreclose on the property, or they can sell the loan agreement (or the note) to another financial institution that will then own the loan and collect the debt balance from the borrower. Fallon said Hunneman is seeing more tri-party sales, paydowns and note sales from banks with troubled office loans.

“Most of the time, a bank takes a loss,” Fallon said. “If they are in a position where they are taking back the keys to a building, that generally coincides with a loss in value. The loss severity is usually very high as they need to place management, leasing and pay the operating expenses for and extended time. Most bidders see banks as distressed seller and will pay much less than a private seller.”

Nika Cataldo

If the Federal Reserve decides to go through with interest rate cuts this year, Loomis said possible declines in borrowing costs will give borrowers some relief. For Fallon, the rate cuts can spur demand for purchasing properties or even development or redevelopment due to the lower financing costs.

“It may encourage CRE or office demand as companies will have access to cheaper capital, and thereby use that capital to invest in themselves and grow,” Fallon said. “Lower interest rates may also help close the wide bid or ask gap that is stymieing many [interested parties] from buying properties.”