Moody's is warning that commercial real estate has proven a volatile sector in previous economic cycles, providing a much greater potential to wipe out tangible common equity (TCE) than lending to many other industries.

'TCE is shareholder equity minus goodwill and other intangibles, and Moody's regards it as the best measure of a bank's cushion against insolvency in the event of swingeing losses,' said Les Muranyi, senior credit officer in Moody's financial institutions team.

'Although real estate loans are rising in line with other loans, not all loans are as volatile,' he said.

For example, in the last real estate cycle, the shift in values of office buildings from their peak to their trough was 56.6 per cent. Retail real estate proved significantly less volatile, shifting 26.4 per cent between peaks and troughs, while apartment buildings - the least volatile commercial property sector - changed only 18 per cent in value.

Moody's becomes concerned when it sees commercial real estate loans rising above 200 per cent of TCE, Mr Muranyi said.

Also, lending to commercial real estate has proven a particularly profitable business for banks, leading many new providers into the market, Moody's said.

'Commercial real estate financing - a specialised industry - is one of the most profitable businesses available to regional banks because the lending generates attractive fees and spread income,' Moody's said in a report. 'Moreover, it is typically conducted in the context of long-standing relationships with real estate developers and investors who also leave deposits and use other banking products.'

The report, Commercial Real Estate Assets in Bank Loan Portfolios; Assessing the Impact of Rising Risk Concentration, notes that US regional banks have been among the most aggressive lenders to commercial real estate.

The report notes that among southern regional banks - who are among the most significant providers of property loans - commercial real estate lending has risen from about 160 per cent of TCE in December 1996 to just under 250 per cent at the end of 2001.

Moody's said that the heavy concentrations of commercial real estate and construction lending could carry negative ratings implications.

So far, Moody's has not downgraded bank debt to reflect the rising risk concentration, although some banks' ratings outlooks have been altered to negative, while some banks have failed to achieve upgrades as a result of high concentrations of real estate lending.

Financial Times