In 2022, the SOFR (Secured Overnight Financing Rate) emerged as the new benchmark interest rate for floating commercial real estate loans, replacing LIBOR (London interbank offered rate).
SOFR is the rate applied on overnight loans collateralized by US Treasury securities. These loans are part of a multi-trillion-dollar repo market that provides vital liquidity and offers concrete pricing information—something that its predecessor did not do.
The move away from LIBOR and towards SOFR could have profound impacts on commercial real estate loans, promising improved stability and better representation of market interest rates.
Shortcomings of LIBOR
In 2008, renowned American-British economist Willem Buiter famously described LIBOR as the rate at which banks “do not lend to each other,” highlighting the limitations of this metric.
Notably, LIBOR was estimated via a survey of 18 banks rather than actual transactions. These banks were asked to gauge their cost of funds (how much they spend to acquire funds to lend to clients).
The highest and lowest four responses were discarded to create a trimmed average, which was then broadcasted to all market participants.
Over the past few years, LIBOR has been heavily scrutinized due to two main reasons:
As the economy faltered during the Great Recession, reports of LIBOR manipulation started surfacing.
- In 2012, it was revealed that five banks—Deutsche Bank, Barclays, UBS, Rabobank, and Royal Bank of Scotland—had manipulated the rate for their financial benefit. Some analysts say they have been doing this since 2003, intentionally understating their LIBOR submissions to seem more creditworthy. Other manipulation cases included attempts to push LIBOR submissions up or down depending on a bank’s derivative portfolio to gain extra income or reduce payments.
- Additionally, in 2017, the Financial Conduct Authority (FCA) concluded that activity levels in the market were insufficient to provide an objective basis for its calculation. This, along with BREXIT, made LIBOR obsolete as a benchmark indicator.
Transitioning to SOFR
In June 2017, the ARRC (Alternative Reference Rates Committee) recommended that LIBOR be replaced with SOFR. About a year later, in July 2018, the first financial instruments utilizing SOFR were issued.
The transition was initially gradual, but US banks are now required to end their use of LIBOR for new loans made after 31 December 2021. Existing loans are permitted to remain on this old benchmark.
However, the publication of LIBOR will end by 30 June 2023.
With the necessity to switch from LIBOR to SOFR becoming evident, credit agreements rapidly started adding fallback language—defined as “contractual provisions that specify the trigger events for a transition to a replacement rate, the replacement rate, and the spread adjustment to align the replacement rate with the benchmark being replaced,” which in this case is LIBOR. [p1]
After all, even if the LIBOR rate is no longer available, lenders and borrowers need to continue pricing their loans, and they want to do that similarly as they have been used to.
The transition was challenging. For many market participants, converting a LIBOR loan to SOFR was more complex than expected.
Initially, banks often rounded up and determined that one-month LIBOR was equal to SOFR +0.1%. But after analyzing a multitude of transaction records over several years, Bloomberg finally announced an adjusted rate on 5 March 2021: One-month LIBOR equates to SOFR + 0.11448%.
The evolution of SOFR
Because it relied on previous transactions, SOFR was initially criticized for being a backward-looking rate. Another problem was that, unlike LIBOR, SOFR did not offer the capacity to secure a fixed rate of interest for up to three months in advance.
Those looking to SOFR sought a reliable, predictive rate. But with market participants using the benchmark in its early years, there needed to be more data available to create an accurate forward-looking rate.
The SOFR market gained traction in 2018 and 2019, trading at the upper limits of the Federal Funds Target Range, especially during times when the demand for cash was extreme, like at the end of a month or quarter.
Unfortunately, this became a recurring problem, although the difference was usually insignificant (barely more than a few basis points).
But on 16 and 17 September 2019, an unprecedented event occurred: Increased treasury issuance caused the SOFR rate to spike to 5.25%. That was 3% over its cap limit of 2.25%. This was caused by corporate taxes becoming due at this time and heightened stress on the money market.
The Federal Reserve Bank of New York swiftly acted on the issue and provided supplemental liquidity to the market by initiating its repo operations. As a result, SOFR trading was back in line with the Target Range only 48 hours later.
The additional liquidity stayed in place after the markets stabilized, and the previous issues did not recur by the close of December 2019. SOFR kept getting better throughout 2020. That extra liquidity was withdrawn, and SOFR didn’t surpass the upper limits again.
After the implementation of this intervention, SOFR started to mature fully, trading near the lower limits of the Target Range.
In July 2021, the CME Group was named the administrator of term SOFR rates (on the recommendation of the ARRC). This was essential for successfully transitioning to using only SOFR as an index rate.
With trillions of dollars in loans and derivatives tied to LIBOR, it’s not surprising that the search for a replacement benchmark interest rate took almost a decade. However, despite the numerous obstacles SOFR encountered, these obstacles were overcome with thoughtful solutions, even if it took some time.
As a result, borrowers can now be fully confident knowing their floating rate loans are priced utilizing transparent data from one of the largest and most liquid markets.
Although SOFR is gradually becoming the preferred benchmark rate, it has yet to be legally mandated. As a result of this fact, many other rate options have emerged—though none can boast traction on the same level as that of SOFR.
How SOFR affects commercial real estate loans
With LIBOR expired, businesses and investors that have secured (or want to obtain) commercial real estate financing are understandably curious about how it will impact their borrowing rates.
This matter is of particular concern for those who have taken out (or want to take out) floating-rate loans such as Freddie Mac Multifamily Loans, Fannie Mae Multifamily Loans, and floating-rate CMBS financing.
Despite the deadline being just months away, much of the US commercial real estate industry has yet to transition a significant amount of LIBOR-tied loans over to SOFR, according to a report published in September 2022.
For context, the Alternative Reference Rates Committee recorded $6.2 trillion in outstanding LIBOR-based US business and consumer loans at the end of 2020. Of those loans, an estimated $3.2 trillion will expire after June 202.
While there is no official count on how many are transitioning to SOFR lending arrangements, industry experts agree that it is a significant number.
Numerous creditors have started contacting borrowers to make the switch to SOFR go smoother by the cutoff date of 30 June 2023. But a good percentage of LIBOR loans have yet to be transitioned.
Moreover, market turbulence, reduced staff, and increasing activity in the commercial real estate sector will likely divert the attention of borrowers and lenders from this task.
Industry analysts also think that because LIBOR-based loans are usually short-term loans (three years on average), many creditors assume that borrowers will have already paid off their debt before June 2023.
In addition, many commercial real estate borrowers and lenders have contractual arrangements to automatically swap out LIBOR by the deadline. Hence, there was no need for them to begin an early transition.
But with the deadline approaching, there should be a significant increase in the transition rate in 2023.
What you can do
To ensure a smooth transition from LIBOR, a good majority of loan agreements contain fallback language providing lenders with the flexibility to set terms. Many of these loans will automatically transfer to a comparable SOFR rate.
If your contract does not have this clause, your lender may amend the document to clarify the switch. Reach out to your lender and ensure all aspects of the transition plan are thoroughly discussed.
With LIBOR’s imminent expiration, market participants must take the necessary steps to switch to alternative rates such as SOFR and adjust their existing contracts referencing LIBOR.
Even though the adoption of SOFR is elective, these precautions should be taken to continue providing accurate information and prevent any potential liabilities going forward.
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