By Peter Grant

Defaults are rising in a key corner of the commercial real-estate debt market just as borrowing costs are set to jump, raising the likelihood of a slowdown of the $11 trillion U.S. commercial property sector in 2017.

A financial crisis-era regulation is about to take effect that is expected to make some commercial real-estate borrowing more expensive and complicated, analysts said.

At the same time, interest rates have increased since the election of Donald Trump as the nation's 45th president last week and seem poised for a sustained rise from recent historic lows, which would further squeeze an industry built on borrowed money.

"I can paint a picture that it could be disastrous, with runaway inflation and high interest rates," said Charlie Bendit, co-chief executive of Taconic Investment Partners LLC, at a New York industry luncheon last week.

The worries raise fresh concerns for the commercial property market as it enters its eighth year of expansion.

Already, landlords are battling a slowdown in sales and rising vacancy rates of multifamily housing units across the U.S. and of office space in Houston, Washington, D.C., and other big markets. Commercial property sales volume was down 8.6% in the first nine months of 2016 to $345.4 billion, according to Real Capital Analytics.

Now defaults are on the rise as well. More than 5.6% of some $390 billion worth of commercial property mortgages that have been packaged into securities was more than 60 days late in payment in September, according to Moody's Investors Service. That was up from a 4.6% delinquency rate earlier this year.

The culprit: loose lending before the financial crisis. Ten-year loans issued in2006 and 2007 are now coming due, and many borrowers aren't able to pay them off despite rising property values.

In all, Morningstar Credit Ratings LLC predicts borrowers won't be able to pay off roughly 40% of the commercial mortgage-backed securities loans coming due next year. Suburban office properties and shopping centers are being hit particularly hard, said Edward Dittmer, a Morningstar vice president.

"We're seeing a lot of stress," Mr. Dittmer said.

Consider the Skyline office complex in Fairfax, Va. Vornado Realty Trust financed the property in 2007 with a $678 million mortgage that was converted into bonds.

Vornado was forced to restructure the loan in 2012 after the portfolio ran into trouble. Earlier this year, Vornado for a second time notified the loan servicer that "cash flow will be insufficient to service the debt," according to a regulatory filing. A Vornado spokesman declined to comment.

Similarly, a venture including New York investor Jacob Chetrit that owns a 1.2-million-square-foot office property on Seventh Avenue in Manhattan is negotiating an extension of a $136.9 million loan made in 2006. The space is about 15% vacant.

Victor Gerstein, a lawyer working for the venture, stressed that it is current in its monthly debt service and that there hasn't been a default. The owners are moving to increase the building's occupancy and "will be very well positioned to get a very attractive loan in the near future," Mr. Gerstein said.

Adding to the market's worries are new rules that go into effect on Christmas Eve under the Dodd-Frank regulatory overhaul requiring issuers of commercial mortgage-backed securities to keep at least 5% of the securities they create.

The so-called risk-retention rules likely will make borrowing more costly and complicated, raising the chances that some property owners won't be able to refinanceloans from the boom years.

"You couldn't have planned worse timing," said Tad Philipp, director of commercial real-estate research at Moody's.

Mr. Trump promised during his campaign to repeal Dodd-Frank, but analysts said that could take a long time and that certain provisions might remain on the books, including risk retention.

To be sure, banks, insurance companies and other finance firms have picked up some of the slack from the shrinking commercial mortgage securities business. More than half of the bonds issued in 2005 and 2006 for New York properties were refinanced by such lenders, according to a report earlier this year by CrediFi, a real-estate data and analysis firm.

But there are other problems flaring up as well. Regulators earlier this year warned that vacancy has been growing in the rental apartment market, and that higher interest rates in the next two years could damp price growth there.

"They're flashing a yellow light over the market," said Ely Razin, CEO of CrediFi.

Write to Peter Grant at peter.grant@wsj.com

(END) Dow Jones Newswires

November 15, 2016 12:48 ET (17:48 GMT)

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