What will happen to the financial system if US interest rates keep rising? That is a question many investors are pondering, given the recent sharp upward swing in US Treasury yields. There is plenty to fret about: higher rates could hurt US homeowners, for example, as well as delivering more pain for struggling municipalities.

However, there is another sector that investors should watch: commercial real estate. During the past three years, the CRE sector has not generally grabbed much attention, because events there have not been as dramatic as in subprime (in 2007-08) or sovereign debt markets (in 2010).

But the recent turbulence in Ireland, where the banks were devastated by CRE exposure, is a potent reminder of the potential for property loans to turn sour. And it is just possible that echoes of this problem might be seen elsewhere in 2011.

For one dirty secret in the financial world is that the lack of drama in the CRE sector has partly arisen because banks on both sides of the Atlantic have been “evergreening” loans – or in essence extending the maturities – and practising forbearance to avoid recognising losses.

Banks and borrowers have been able to conduct such evergreening because interest rates have been at rock bottom. But if rates rise, this evergreening will be harder to maintain. What makes this doubly pernicious is that any rise in rates might hit just as the sector is heading for a wave of refinancing.

To understand this, look at some numbers compiled by the Institute of International Finance, the Washington-based banking lobby group. The IIF calculates that in March 2008, there was about $25bn worth of pre-crisis investment grade commercial real estate in distress. By March this year, however, that number had exploded to $375bn (and has probably swelled since).

Thus far, the banks have “dealt with potential delinquency problems in part by extending loans until 2011-13”, the IIF notes. Or, in layman’s terms, they have swept it under the carpet. But while this avoided defaults, the IIF reckons that about $1,400bn of CRE loans must be refinanced before 2014. Alarmingly, “nearly half of these are at present ‘underwater’, ie have mortgages in excess of the current value of the property”, it adds.

If you are an optimist (say, a real estate broker) you might argue that property prices will soon rebound, enabling borrowers and banks to get out of this hole. Some bankers also think that the primary commercial mortgage-backed securities market will spring into life in 2011, after the recent freeze, to support this refinancing. After all, they point out, secondary CMBS prices rose in 2010, and actual real estate prices also rebounded in the UK and US.

But in practical terms, there is still little tangible sign that the primary CMBS sector is thawing. And while average UK and US prices have rebounded, they remain well below the peak – and outside prime locations in London and Manhattan are often falling. Thus, it seems hard to believe that all that $1,400bn refinancing will occur smoothly; barring a miracle – and indefinite rock-bottom rates – defaults will rise.

If so, that will hurt many small and medium-sized US banks. Moody’s, for example, estimates that US banks have barely recognised half their CRE losses, far less than for residential mortgages. Defaults could also damage European financial institutions. Last month the Bank of England’s financial stability report observed that a third of all UK banks’ global corporate loans were to CRE – and many of those loans have also been “evergreened”. (Apparently, “30 per cent of UK companies made insufficient profits to cover their interest payments in 2009”, the FSR observes.) DTZ Research estimates that there is a potential gap of $54bn between the value of UK CRE loans maturing and the amount of new debt that could be raised over the next three years. “Ireland and Spain also have large estimated CRE funding gaps,” the Bank adds. That could hit plenty of other European banks too.

Now, I am not suggesting that these woes could deliver anything like the shock that occurred from subprime, or that might yet emanate from sovereign debt; a “mere” $54bn funding gap – or a $375bn pile of distressed loans – is still manageable for the system as whole.

But if nothing else, these numbers could hurt some banks. And it illustrates an important point: that while a sense of peace might have returned to parts of the financial system in the past two years, this has been achieved only by virtue of government aid – and rock-bottom interest rates. If US interest rates keep “normalising” in 2011 (as US policymakers like to say) plenty of surprises might yet emerge from under the carpet. Including duff property loans in places other than Ireland.

gillian.tett@ft.com

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