Until recently, the biggest challenge facing iStar Financial Inc. was how it would handle billions of dollars of loans and funding commitments to condominium developers that it picked up when it acquired Fremont General Corp. a year ago, the kinds of assets that have higher chances of default in today's housing slump.

Now, the big question is whether iStar can maintain its investment-grade credit rating, on which its lending business is predicated.

That is why investors will be paying close attention when the company releases second-quarter earnings Thursday. The report will not only provide fresh clues about iStar's prospects but could also provide a broad overview of the financial health of the commercial real-estate sector nationwide.

"IStar is the bellwether name in the group" of lenders dedicated to financing commercial-property transactions, said UBS analyst Omotayo Okusanya. So far, the market for offices, shopping malls and the like hasn't seen the kind of devastating losses felt in the residential market. But the worsening credit markets and a weakening U.S. economy are starting to take a toll.

IStar, based in New York, is a real-estate investment trust that finances commercial real-estate deals, mainly by borrowing in the capital markets and then lending to real-estate buyers and developers. It also buys office towers and other facilities and leases them back to corporations. The loans it originates typically range from $20 million to $150 million and have maturities generally ranging from three to 10 years.

IStar is predicting a dramatic increase in the amount set aside for potentially soured loans. On July 18, the company forecast bigger-than-expected loan-loss provisions in the quarter -- estimated to be at $275 million, which would cause its results to come in below expectations.

IStar said during the earnings preview that it would earn between five cents and 15 cents a share for the quarter. Excluding $300 million of gains from asset sales, it would actually post a loss of between $1.45 and $1.55 a share. Analysts polled by Thomson Reuters had projected, on average, earnings of 76 cents a share.

IStar said the amount of nonperforming loans -- those at least 90 days past due -- would reach $1.3 billion in the quarter, or 13% of its loans outstanding and an increase of $285 million from the previous quarter. Of that increase, $185 million would come from loans it acquired from Fremont, and the rest would stem from loans iStar originated itself.

"While the Fremont portfolio continues to get worse, [iStar's] core loan portfolio also deteriorates at a rate that is worse than expected," said Jason Yablon, an analyst at REIT investors Cohen & Steers Inc. The key culprit: The credit-market turmoil has made it harder for iStar's borrowers to refinance and repay their loans.

Mr. Okusanya of UBS noted that iStar's nonperforming-loan ratio of 13% would exceed even the 10% industry average during the commercial real-estate bust of the early 1990s. "It's very scary that the number is at that level," said the analyst, who cut his rating to "sell" from "buy" after the company's preannouncement.

Meanwhile, the deteriorating credit quality in iStar's loan portfolio led Moody's Investors Service and Fitch Ratings last week to reduce the company's debt ratings to just a notch above junk status. (Standard & Poor's kept its views of iStar's credit-worthiness but warned of cuts if iStar's actual loan losses were to exceed provision levels or if its operating performance were to worsen substantially.)

As a result of the Moody's and Fitch downgrades, the covenants on about $8.2 billion of iStar bonds have come into play.

To avoid violating those covenants, said Jan Svec, a director in Fitch's REIT group, iStar's recurring earnings for the trailing 12 months -- which exclude one-time gains -- must be at least 1.5 times what it has to make on the coupon payments to creditors and preferred shareholders. Meantime, to support every dollar of its unsecured debt, it must have at least $1.20 in unencumbered assets, or those that are not pledged for borrowing. IStar currently is in compliance with those covenants.

IStar's debt, like that of many investment-grade finance companies, already is trading at junk levels; its shares are down 72% this year. Many analysts expect iStar to do everything at its disposal to protect its investment-grade ratings, because a junk rating would not only make it more difficult and expensive to access capital but would also scare away customers looking for stable sources of funding.

"We have worked hard to earn our investment-grade ratings and will focus on resolving issues within the portfolio, and will continue to run our business as an investment-grade finance company," said Andrew G. Backman, iStar's senior vice president of investor relations and marketing.

During a conference call July 18, iStar's chairman and chief executive, Jay Sugarman, said the company has about $1.4 billion in cash and available credit lines and is "not looking to raise money right now." At the same time, he said, the company is going to "keep all options open" for the rest of the year.

Write to Lingling Wei at lingling.wei@dowjones.com

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