What is LIBOR: London Interbank Offered Rate and How is it Used In Commercial Real Estate Financing?
LIBOR is primarily used as a reference rate for other debt instruments. Some examples of commercial real estate financial instruments include short-term bank loans and floating-rate commercial real estate loans. LIBOR is also used as an index for floating rates lending so banks can mitigate risk by tying loans to an index that fluctuates, while simultaneously reducing borrowing costs by lending off of a lower-cost (short-term) index.
LIBOR is directly and immediately impacted by financial conditions across the globe including fluctuations in currencies, monetary policy, and so-on. As a result, lenders use LIBOR to adjust the floating interest rates. Using a floating rate that is tied to the LIBOR index offers a lender protection. Lenders benefit from rising interest rates, as opposed to fixed interest rates that remain the same regardless of an increase or decrease in the market interest rates as driven by micro and macro economic conditions.
Additionally, lenders add a margin, or percentage points, to the LIBOR index when calculating the borrower’s interest rate. This margin remains fixed over the period of the loan. Therefore, if a borrower takes out a loan with a 3% margin and a LIBOR index of 5.5% then the floating rate would be 8.5%. However, if the LIBOR index increases by 2% before the loan has been paid off, then the new floating rate would be 10.5%.
It should be noted that the margin always remains at the same rate of 3% -- that is the lender's profit. Because the margin is determined by the lender, lower margins are only offered to the most creditworthy. In contrast, higher margins are required for higher risk loans (this is how lenders manage their risk-adjusted returns).
LIBOR can be tracked in multiple currencies (USD, EUR, GBP, JPY, CHF) and is also available in seven different maturities (1 day, 1 week, 1 month, 2 months, 3 months, 6 months, 12 months).
LIBOR is Being Replaced With SOFR
As a result of several factors, including the LIBOR scandal of 2012, major banks will stop reporting LIBOR in 2021. The Federal Reserve has decided to replace LIBOR with the Secured Overnight Financing Rate, or SOFR. In August 2018, Fannie Mae issued the first securities backed by SOFR. Experts believe that SOFR will be a more reliable and accurate reference rate, and that it may be somewhat less volatile than LIBOR. Right now, however, most commerical loans are still linked to LIBOR.