Commercial Lending Is
Showing Signs of Strain

Rating services are flagging some of the first signs of strain in the booming commercial-lending market.

Moody's Investors Service Inc., which rates and monitors commercial mortgages that are packaged and issued as bonds, says in a report released this morning that the commercial-mortgage market is showing two disturbing trends. Loan-to-value ratios, which measure the amount of a loan in relation to its market value, and debt-service coverage ratios, which measure the monthly amount the borrower pays in relation to the property's cash flow, are carrying more risks than they ever have before, according to the report.

"People are borrowing an amount equal to what the property was worth five years ago," says Tad Philipp, Moody's managing director of commercial-mortgage finance and the study's lead author. "It's reached a point where we're no longer comfortable."

While many issuers in the commercial-finance market have applauded the record amount of commercial mortgage-backed securities issued in 2005, about $169 billion, Moody's says it views these signs as records that are often "best not broken." Commercial-mortgage loans had increased to 15% of the gross domestic product as of the third quarter of 2005. That level hadn't been reached since the peak of the nation's last commercial real-estate cycle, in 1988.

Mr. Philipp said this real-estate cycle, unlike the last boom, hasn't suffered from overbuilding. During the last cycle, buildings remained empty and commercial rents were weak for years. Moody's research found that average yields, or returns on commercial real-estate properties, are at their lowest since the American Council of Life Insurers started to report such data in 1965. This decline largely has been driven by the high volume of loans that banks are making; as banks are willing to lend more, buyers are willing to pay more for buildings.

While Moody's analysts weren't as concerned about the increasing percentage of commercial interest-only loans, Standard & Poor's Corp., which rates commercial mortgage-backed securities, issued a report saying it remains concerned about what effect such loans could have on the market. In 2005, many commercial real-estate owners refinanced their floating-rate mortgages with more affordable loans. S&P, a division of McGraw-Hill Cos., says it is concerned that borrowers who depended on interest-only loans may suffer when the balloon payments for these loans are due.

Moody's executives have tightened rating standards for some bonds. In some cases, the subsidiary of Moody's Corp. has declined to rate some bonds because it is concerned that investors should have more protection from the different levels of risk that the bonds present. Regulators of the banks that account for most commercial-mortgage lending are taking early steps to curb these trends. On Jan. 10, four federal regulatory agencies, including the Federal Reserve, collaborated to seek comment from the public on issuing commercial-lending standards because commercial real-estate loans account for an increasing concentration of some banks' portfolios.

While Fed governor Susan Bies called the current commercial real-estate market "relatively benign," she said that introducing guidelines is necessary.

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