The fourth quarter earnings calls of regional banks with branches in Connecticut revealed an increasing share of troubled office loans, 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 a 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.

KeyBank and TD Bank also reported an increase in nonperforming CRE and commercial and industrial (C&I) loans, as well as establishing higher 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,” he said. “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.”

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.

Cushman & Wakefield in a recent report noted that Fairfield County had a 29 percent office vacancy rate as of the end of last year, due to substantially lower demand despite the removal of some inventory in the market. A CBRE report also showed that office vacancies in Hartford County ended at 27.4 percent in 2023 due to fewer tenants.

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.

Jim Fagan, senior managing director and managing principal for Connecticut markets at Cushman & Wakefield, noted that other CRE market segments, including multifamily and industrial, are not seeing the same issues.

Landlords Struggle to Fill Space

Landlords of office properties are feeling the squeeze from three sides, according to Fagan; first is the persistence of work-from-home setups prompting tenants to rent less office space.

Second is the higher cost of CRE loans due to elevated interest rates of 6 percent to 8 percent – higher than the 4 percent in previous years. Last is the high cost of attracting tenants to an office building, which can take three to four years of bleeding funds before a landlord sees some cash flow.

“It will take a landlord about two and a half years of no cash flow and costs for rebuilding and refurbishing the space, brokerage costs and other soft costs. Then once the tenant moves in and occupies the space, you’re also going to give them 12 months free rent,” he said. “It is almost unsustainable and it’s a long cycle … If you are going to rent for $40 per square foot, it might cost you around $100 to $125 a square foot.”

Unable to keep their properties and the costs associated with it, some Connecticut landlords are transferring the office buildings and the cost burden back to their lenders, Fagan said. He noted that this kind of arrangement was done with the buildings at 383 Main Ave. in Norwalk and 201 Tresser Blvd. in Stamford, where Purdue Pharma is located.

“They just transferred [the office buildings] back to their lender. The landlords basically said, ‘Look, we’re not going to put money in anymore and we don’t want to be in default on our loan. So we’re turning it back to you,’” Fagan said.

Such a decision will not immediately result in a loss on lenders’ balance sheets, he said, but banks will have to decide whether to keep operating the buildings as landlords or try to sell at a discount.

“They either own them and operate them, which I don’t think that traditionally a bank is very good at, or they’ll try to sell to new buyers at discounted prices,” he said.

But buyers are scarce, waiting to see when office building prices will bottom out. If the Federal Reserve decides to go through with the interest rate cuts this year, Fagan said the healthy Class A buildings with 90 to 95 percent occupancy rates will benefit, with chances of refinancing for some loans with maturities pushed back due to high-interest rates.

“[Buyers] aren’t jumping in with enthusiasm yet. They’re waiting to see how it’s all going to shake out,” Fagan said. “There is an expression in distressed markets: you don’t want to catch a falling knife, because you don’t know how low it’s going to go.”