Interest rates raise worry about defaults

Lenders making closer review

As interest rates rise, and banks and other lenders may fret these days about consumers' ability to repay home mortgages, they have another concern: the commercial real estate market.

Investors and lenders are looking more closely at the loans they make for properties such as malls and office buildings and wondering whether some borrowers might default because of rising rates that in some cases can erode property values.

There isn't a crisis yet in commercial lending -- there haven't been reports of an unusual number of failed mortgages. But the industry is uneasy because of the huge amount of lending during the years-long real estate boom, and because it's hard to anticipate which loans will sour.

"We are being more aggressive and the impact of that aggressive lending is unknown, given that we don't know how quickly and to what extent rates will back up and how fast property values will decline," said Lisa Pendergast, real estate analyst at RBS Greenwich Capital Markets. She added: "Usually, when rates back up, property values tend to decline as well."

Commercial borrowers are vulnerable to higher rates because they tend to refinance rather than pay off their real estate loans, and in an environment where rates are rising, new loans become more expensive or harder to get. Moreover, if a commercial property has lost value, a lender may require the borrower to put up more money for a new loan.

The size of commercial loans -- they can range from $1 million to $900 million -- make them harder to pay off. So, many borrowers routinely pay back loans by refinancing with new mortgages.

Bad time for borrowers

The increase in interest rates for some borrowers could not come at a worse time. Fixed costs have increased for everything from insuring a building and repairing it to heating it. And these costs can't all be passed on to tenants in the form of higher rent.

"Your expenses will rise as well in a rising interest rate environment," Pendergast said.

Lenders are not the only ones worried. Many of the loans are resold on Wall Street as securities to investors including insurers, pension funds and mutual funds who, in effect, become lenders.

Jeff Given, portfolio manager at John Hancock Funds, which invests in securities that pool commercial real estate loans, agreed: "It is something investors are keeping in the back of their minds."

Last year, investors bought $169 billion of securities backed by commercial property mortgages, according to Roger Lehman, real estate analyst at Merrill Lynch & Co. Pendergast estimates that about $550 billion worth of securities backed by commercial real estate loans are held in portfolios of investors such as insurers and mutual funds.

There are "definitely some credit concerns regarding the increased leverage we are seeing in loans," said Larry Kay, a director at Standard & Poor's, which tracks securities pooling the property loans. "I don't think it will be a test in the near-term because of the abundance of capital and the current attractiveness of real estate as an investment, but longer term we do have credit concerns."

Early data compiled by Kay, in fact, show certain loans have so far weathered the rise in interest rates, in part because many lenders are willing to offer cheap credit. This could change, though, if investors shift their attention to another market, such as stocks; that would shrink the pool of money available for the new loans borrowers need to refinance.

Less collateral

Meanwhile, the increased leverage Kay speaks of suggests borrowers are putting up less of their money when buying a property. Some of this is due to the major influx of lenders willing to back real estate investments and provide borrowers with a second loan for their property purchases.

The growing pool of willing lenders came while interest rates were at historic lows -- two factors that helped send prices higher in recent years and have some industry participants concerned.

"We may have a property that does not justify the valuation it did two years ago," said Anthony Gramza, estate broker and head of AMG Commercial Mortgage Brokers of Penfield, N.Y. "Lower interest rates created a situation in some cases where people paid more then what the property was really worth," he said.

The industry is also concerned that borrowers might not be able to qualify for another loan to pay off their mortgages because their properties have lost value. Also, some borrowers may not be able to handle the higher monthly loan payments that come with higher interest rates because they cannot immediately raise their rents.

The greatest worry is that borrowers might abandon their properties, in much the same way as in the late 1980s and early '90s, when owners walked away from malls and office buildings because they could not find lenders to provide money for another loan. Many of these lenders themselves were overburdened with bad real estate debt, leading to the real estate bust of the late '80s that prompted the U.S. government to intervene with the creation of the Resolution Trust Corp.

Right now, anyone looking for money to buy a mall or an office building doesn't have to search far to find a lender, which makes credit inexpensive. But, this may change if investors shift their money from real estate to stocks.