Dominion Bond Rating Service says, in a new report, that U.S. regional and community banks’ exposure to commercial real estate (CRE) has been rising steadily over the past five years, resulting in material risk concentrations at some banks.

Banks with high exposure to CRE are likely to suffer higher loan and revenue losses in a down cycle than those with more balanced loan portfolios, the rating agency warns. DBRS reports that banking regulators are increasingly concerned about the financial health of banks that are accumulating large CRE portfolios. In fact, regulators are currently formulating guidelines to identify banks at high risk, along with practices and capital levels appropriate to manage the risks. The guidelines are expected to become available by the end of 2006.

The study points out that public disclosures requirements about CRE are not sufficiently detailed to help investors appreciate the risks. “First, disclosures include owner-occupied loans that distort banks’ true exposure by inflating the size of their CRE portfolios with commercial loans secured by real estate. Second, disclosures do not provide enough detail about the composition and geographic diversification of CRE loans for a meaningful analysis,” says Alan Reid, managing director of the U.S. Financial Institutions Group.

“However, CRE lending is safer and more benign today than during the last major real estate cycle that spanned the period from the late 1980s to the mid-1990s,” notes DBRS analyst and study author Les Muranyi.

“More disciplined lending practices, tighter and more effective regulatory scrutiny, positive structural changes resulting from the increasing role of CMBS in financing real estate, and the absence of the potential for adverse changes in tax laws all contribute to a safer environment. Hence, future cycles are likely to be less severe than those in the past,” adds DBRS analyst and study co-author Edward Soffer.

DBRS notes that CRE asset quality has remained very strong and among the best for all asset classes for the past five years in spite of the short economic recession and the post-September 11, 2001, dislocations.

The rating agency says that it believes that a few heavily concentrated banks with weak underwriting standards may elude regulatory scrutiny and suffer major losses in case of a severe market correction. “In general, however, DBRS believes that while heavily exposed banks could suffer material losses under the same circumstances, it is unlikely that the widespread carnage caused by the last major real estate cycle among banks and thrifts will be repeated,” it says.