SOFR is Set to Replace LIBOR By 2021
Most commercial real estate loan interest rates are currently set by using the LIBOR (London Interbank Offered Rate) as a benchmark. LIBOR is calculated by measuring the interest rates at which banks lend to each other (specifically short-term, unsecured lending). However, due to a variety of reasons, banks are set to stop reporting LIBOR rates by the end of 2021, and SOFR (Secured Overnight Financing Rate) is the reference rate that will replace it.
Why a Replacement for LIBOR is Needed
Over the last few years, banks have been increasingly reluctant to report LIBOR rates, partially due to the fact that banks are doing significantly less unsecured lending than they did in the past, and partially due to the LIBOR scandal of 2012. The scandal was uncovered when regulators discovered that LIBOR had been intentionally manipulated by banks in for several years in order to increase their profit margins. This lead to serious investigations of banks including Barclay’s, Bank of America, Citibank, Credit Suisse, HSBC, UBS, and others.
Multiple bankers were charged with fraud, due to the fact that they would often collaborate with traders in order to increase margins on trades. Since LIBOR is used to set interest rates for credit cards, student loans, residential mortgages, and commercial real estate loans (among many other kinds of debt), this manipulation likely had a negative affect on both average consumers and institutional real estate investors. Some experts believe that the scandal may also have significantly contributed to the 2008 financial crisis.
How The Federal Reserve Developed the Secured Overnight Financing Rate (SOFR)
In the aftermath of the LIBOR scandal, the Federal Reserve decided that American loans and financial products needed to be benchmarked with a more reliable index— one that would would regularly be reported and would not easily be subject to manipulation. To do this, they formed the Alternative Reference Rate Committee (ARRC) in 2014.
By mid-2017, the Committee recommended the use of the Secured Overnight Financing Rate, or SOFR. Unlike LIBOR, which measures interbank lending, SOFR measures the overnight trading rate for the repurchases (repos) of U.S. treasury bonds. Since the exchange of U.S. Treasury Bonds is unlikely to stop anytime soon (unlike unsecured interbank lending), the ARRC saw this as a more stable source of market interest-rate information.
How SOFR Could Impact Commercial Real Estate Loans
While LIBOR will be reported until the end of 2021, both commercial real estate lenders and borrowers are naturally anxious to understand how the switch could impact interest rates. This is especially of interest for borrowers who have floating rate loans, including floating-rate CMBS financing as well as the many variable rate Fannie Mae and Freddie Mac Multifamily loans currently on the market.
Some are also concerned due to the fact that inaccuracies have been found during calculations of SOFR during the last 12 months. If SOFR is not widely adopted due to these issues, most adjustable commercial real estate loans have a built-in switch mechanism that will kick in if LIBOR is no longer calculated. In most cases, this will result in the loan being pegged to a spread based on the prime rate, the lowest bank interest rate available to consumers. However, this automatic switch is not ideal, as it could lead to a variety of issues and inconsistencies.