If the Cap Rate Doesn't Fit, Bank Investors Will Have to Wear It Anyway

--value decline of 30% might cause default rate to rise to at least 5% By LINGLING WEI The bigger the balance sheet, the greater the impact of small changes in underlying assumptions. And balance sheets don't come bigger than those belonging to banks undergoing stress testing. One chunk of exposure is commercial real estate; banks and thrifts hold about $1.7 trillion of commercial mortgages. A benchmark used to value such assets is the capitalization, or cap, rate. This determines property values on the basis of rental income. Take an investor buying an office building with annual income of $15 million. If they offer $200 million, they are using a 7.5% cap rate, which is derived by dividing income by value. Increasing the cap rate implies a lower value for the building. Cap rates fluctuate depending on the economy and supply and demand for commercial property. During the last real-estate collapse in the early 1990s, cap rates increased to an average of more than 9%. But at the market's peak in 2007, investors were willing to accept cap rates as low as 4% on prime property, partly on the assumption that rents would keep rising. As banks conduct their stress tests, one big question is what cap rate they are using to value the properties that back their commercial-property portfolios. Most major banks haven't disclosed the cap rates they are using. One exception is General Electric. The conglomerate's finance arm, in a recent investor meeting, singled out cap rates in a presentation of how it valued its property ownerships and assessed potential loan losses. GE now uses the median 18-year cap rate provided by Property & Portfolio Research, which is about 7.5%. Analysts believe many banks also are using a 7.5% cap rate. But they warn that figure likely is too low given that this downturn is anything but median. Matthew Anderson, partner at Foresight Analytics, calculates that cap rates have risen to at least 8%, based on factors including recent property sales and the decline in shares of real-estate investment trusts. The average was 6% at the top of the market. A change in cap rates, combined with other factors such as an approximate drop of 15% in property cash flows, means commercial-property values overall might have fallen more than 30%. Individual distressed property sales have shown bigger declines. The recent sale by developer Harry Macklowe of 1540 Broadway, an office tower in midtown Manhattan, showed a price decline of more than 60% in just two years. A value decline of 30% might cause the default rate to rise to at least 5%, according to Foresight, partly due to the inability of owners to refinance. It also would reduce recovery rates. Only 1.6% of commercial mortgages held by banks were at least 90 days past due at the end of 2008. Banks still have plenty to fear. Write to Lingling Wei at lingling.wei@dowjones.com