A new report by Moody’s Investors Service warns that the commercial real estate finance industry could be setting itself up for a fall.

What troubles Moody’s are several key metrics, including annual property appreciation that hit 12% last year, the largest rise since 1978 — and commercial mortgage debt, as a percentage of GDP, which reached 15.8% in the fourth quarter of 2005, topping the record of 15% set in 1988 at the peak of the last real estate cycle.

Other cautionary signs: Moody's loan-to-value ratio on commercial mortgage-backed securities (CMBS) conduit loans hit 103.8% in the first quarter of this year, the highest level on record and a sign of increased balloon refinance risk, says Tad Philipp Moody's managing director for CMBS.

"And the share of conduit loans that is partially or fully interest-only has reached a new high of 70%, nearly triple the level of two years ago, and further contributing to increased balloon risk,” says Philipp.

“The percentage of conduit loans originated below a 1.30 debt service cover ratio was a record 53.4% in the first quarter of this year, signaling increased term default risk.”

Giving buoyancy to the market is the low level of commercial mortgage delinquencies, which remain at or near long-term lows, driven largely by the record level of property price appreciation. Cap rates (the initial yield sought by property investors) reached the lowest levels in 40 years. This powered appreciation far more than improving property market fundamentals.

Another plus for the market is that new construction is proceeding at a fairly benign rate of approximately 1%. The record levels of commercial mortgage debt issuance have therefore been chasing a fairly stable pool of assets, which is consistent with soaring property prices and plunging cap rates.

Overall commercial property fundamentals remain in fairly good shape. However, given the leveraging of the commercial property sector relative to prior cycles, it may now take less of a downturn to cause a meaningful real estate capital markets disruption, says Philipp.