Commercial Property
Is Now Under Pressure

The value of commercial real estate, which nearly doubled in the past seven years, is now starting to decline due to the credit crunch, according to a report released yesterday by Moody's Investors Service.

The report found that the value of commercial property declined 1.2% in September from the previous month. Particularly hard hit were apartments in the West and office property in most states other than California.

The report is an early sign that the commercial-property sector is being dragged down by the growing reluctance of lenders to extend credit for anything related to real estate, which in turn could create a new drag on the economy and additional problems for investors. Declining commercial-property values could lead to an increase in default rates on commercial real-estate loans and on commercial mortgage-backed securities.

No one is predicting that defaults in the commercial sector will come close to rivaling those in the housing sector. The default rate for commercial mortgage-backed securities is about 0.4%, compared with a 20% default rate for subprime, or high-risk, home loans, the hardest hit segment of the residential mortgage market. And commercial rents in many markets continue to rise.

Tad Philipp, a Moody's managing director, says he wouldn't be surprised to see the commercial-mortgage default rate double or triple, but he notes that still won't be "alarming" because historically the default rate is about 1%.

Still, the latest trends "might represent the inflection point in commercial real estate values given the ongoing liquidity crunch," the report states. Commercial-property values are primarily being hurt by the increasing cost and declining availability of financing. Given the higher cost of debt, buyers need to pay less to get the return on equity they want.

Even a slight decline in values could make it difficult for property owners to refinance their mortgages, especially if they have been paying only interest on their existing debt and not paying down principal. Such interest-only mortgages have become increasingly popular.

Defaults also would likely increase if the economy slumps and drives down commercial rents. Already there are signs of slowing in some markets. Available sublease space swelled to 77 million square feet in the third quarter from 73 million square feet nationwide in the second quarter, the first national increase in five years, according to Grubb & Ellis Co.

Mr. Philipp predicts there will be "more downs than ups" in coming months.

The decline in property values reported by Moody's comes after years of sharp increases. In July, for example, investors paid $510 million, or a record $1,600 per square foot, for the 33-story office tower at 450 Park Ave. in Manhattan.

Some surveys indicate prices are still rising. For example, commercial property appreciated 2.2% in value in the third quarter, according to an index published by the National Council of Real Estate Investment Fiduciaries. NCREIF looks at appraised value while Moody's bases its values on actual sales, according to Moody's executives.

Other research firms have found sales volume to be clearly declining. Real Capital Analytics said in an October report that the credit crunch derailed a number of transactions in the third quarter of this year, and that sales volume for office buildings dropped below $8.5 billion in September, compared with an average of $11.5 billion in the Septembers of 2005 and 2006.

-- Jennifer S. Forsyth contributed to this article.

Email your comments to rjeditor@dowjones.com.