Since the fourth quarter of 2007 when the commercial mortgage-backed securities market effectively seized up, there has been concern that lax underwriting in residential lending would bleed over into commercial real estate loans. Furthermore, if the latter underwriting was indeed less than stellar, how much exposure would U.S. banks and brokers face from commercial real estate loans?

According to a recent report by Fitch Ratings, “Commercial real estate and CMBS exposures will likely exacerbate credit problems at U.S. banks, many of whom are already facing significant risk from troubled residential real estate exposures.”

As of the fourth quarter of 2007, losses on large bank commercial real estate loans had expanded to 48 basis points, up from 7 basis points in the previous eight quarters — largely attributable to the risky construction sector. Fitch expects losses for all commercial real estate loans to increase by 75 basis points on average beyond fourth-quarter levels. In context, construction loan delinquency rates typically average about 60 basis points, but were up to 3% in the fourth quarter of last year.

“Individual performance at the large banks in 2008 will ultimately depend on each company’s diversification by property type, the quality of underwriting and stress testing, market conditions, geographic dispersion and loan loss reserves allocated for commercial real estate,” researchers state in the report.

Of the five major sectors, office makes up 31% of CMBS collateral followed by retail (30%), multifamily (17%), hotel (9%) and industrial (5%).

As far as recessions go, the good news this time around is that the office sector was not overbuilt as it was in the late 1980s. Metro areas with the highest current vacancy rates include Atlanta at 21.3% and Dallas-Fort Worth at 20.9%.

The outlook for the retail sector, which makes up 30% of CMBS collateral, is much weaker. “New space is being completed at a much faster rate than can be absorbed, and this trend will accelerate during the current year,” reports Fitch. The trend has resulted in vacancy rates of up to 11.4% in Memphis followed closely by 10.8% vacancy rates in both New Orleans and Jacksonville, Fla. The most overbuilt residential markets, including certain Florida cities, the Inland Empire and Sacramento in California, may also experience weakness in retail.

The sickly trends in residential will have an invigorating effect on multifamily, which makes up 17% of CMBS collateral. In short, when people lose their homes or find homes unaffordable, they rent. The highest vacancy rates in this sector are currently in Houston (11.4%) and Raleigh, N.C. (10.8%). One question mark for multifamily remains the shadow supply of failed condos that could be converted into apartment projects.

Unlike office, retail or multifamily, the key driver in the hotel sector is GDP, the font of business and leisure travel. If GDP indeed does decline, so will hotel occupancy rates. Hotels make up 9% of CMBS collateral. Despite supply that outstrips demand in both 2007 and 2008, however, the outlook for the lodging sector is relatively stable. The reason? Few new rooms were added in the post-9/11 years and as a result revenues per available room will likely climb higher.

And finally the industrial sector, which makes up 5% of CMBS collateral, is dependent upon global trade, which is likely to enjoy continued growth in the near future due to the weak dollar. This sector, reports Fitch, has seen some slight overbuilding but the upward pressure on vacancy is not expected to be severe.

So where is CMBS performance and activity headed? “Certain players may retrench their activities somewhat, particularly over the near term, in light of the current dislocations,” Fitch reports. “However, over the longer term, this type of activity fits into banks’ core underwriting and funding strategies. For brokers, this activity remains a key part of their distribution-focused product offering to institutional investors.”