Worst to come in U.S. commercial real estate - S&P

NEW YORK Feb 1 (Reuters) - The worst may not be over for commercial real estate loans as vacancies remain high and rents decline, threatening the financial system with substantial losses, Standard & Poor's said on Monday.

"The fallout from commercial real estate exposures for banks has yet to run its course, in our opinion," S&P said in a report.

Although problems are already evident in the homebuilding and commercial construction sectors, they have yet to be felt in the larger mortgage lending and multifamily sectors because interest rates are low and cash flows are adequate to service debt, the rating agency said.

However, as interest rates rise and rent rolls decline further, delinquencies will rise and prices will fall further in these sectors as well, S&P said.

"Even though most highly exposed banks with weaker balance sheets are already rated below investment grade, more downgrades are possible," S&P said. Indeed, S&P already has negative outlooks on about 75 percent of the rated banks with the largest commercial real estate exposures, indicating they are at risk of a downgrade.

Despite the potential for heavy losses, however, most banks' capital is sufficient for them to pull through as long as the losses are realized over a few years and liquidity is maintained.

"Commercial real estate exposure generally tends to represent a higher proportion of smaller, largely unrated community banks' exposures," S&P said. "Therefore, there is a greater proportion of risks in the unrated banking sector." (Reporting by Dena Aubin; Editing by James Dalgleish)