For years, banks around the world have been using one specific type of interest rate calculation known as LIBOR to determine their short-term loans from bank to bank. However, a change is currently underway, with a shift to a different benchmark known as SOFR.
Here’s what you need to know about the LIBOR to SOFR transition and its impact on commercial real estate.
Why Did LIBOR Transition to SOFR?
LIBOR, or the London Interbank Offered Rate, is a benchmark interest rate used by major global banks for short-term loans to other major global banks. It is an agreed upon standard to indicate borrowing costs between banks. The rate changes per day and is calculated by the Intercontinental Exchange (ICE).
However, LIBOR has recently transitioned to SOFR, or the Secured Overnight Financing rate. LIBOR has been used for decades around the world to calculate interest in financial contracts, showing up in business transactions and commercial loans, among other instances. But recent scandals surrounding LIBOR have led industry experts to seek out more transparent and reliable alternatives. One issue is that LIBOR is based on the judgment of a human panel, rather than market data, which makes it a less credible measure.
“Unlike LIBOR, which is based on panel input, SOFR is based on transactional data and a wide measure of borrowing cost,” said Nicole Patel, First Vice President of Four Pillars Capital Markets. “So it’s a benchmark used by banks to price consumer and corporate loans, and it’s based on the rates that big banks pay each other for overnight borrowing data. The SOFR data is published daily and accessible to everyone.”
Because SOFR relies on market data rather than a panel, like LIBOR, it is considered more transparent and reliable. The LIBOR information, Patel argued, “is kind of word of mouth versus data.” With SOFR data being accessible to everyone, Patel added, “it should be less susceptible to market manipulations, which was the problem that we ran into with LIBOR.”
“Because LIBOR is based off of the input from a panel — as in humans — it was more of an estimation, and there was a bunch of controversy around whether or not there was manipulation,” Patel continued.
Chanakya Dissanayake, Managing Director and Head of Investment Research at Acuity Knowledge Partners, added, “Regulators made the decision to switch to more robust, transaction-based reference rates because of an erosion of market trust following the LIBOR manipulation scandal discovered in 2012 and the declining rate of active/underlying transactions of which to base LIBOR calculation after the 2008 financial crisis.”
The scandal Dissanayake is referring to was a highly publicized scheme in which bankers at major institutions, including JP Morgan Chase, Deutsche Bank, Citigroup, Barclays and the Royal Bank of Scotland, worked together to manipulate LIBOR. This rigging created distrust in the financial industry and led to a series of fines, lawsuits and regulatory actions, and there is evidence that the scheme dates as far back as 2003.
“The transition to transaction-based reference rates, such as SOFR, should restore market trust, as these rates are less susceptible to manipulation,” Dissanayake asserted.
When Is LIBOR Switching to SOFR?
The switch from LIBOR to SOFR is already underway. The deadline was December 31, 2021. However, Patel explained that there’s a “sunset period” that extends to June, 2023. What this means is that as of today, no new LIBOR contracts can be made, but LIBOR legacy contracts can continue on until the deadline in 2023, said Patel.
Dissanayake further explained that The Financial Conduct Authority (FCA) would allow for some leeway in “tough legacy contracts” that are more difficult to transition over to SOFR. For these contracts, Dissanayake said, “the LIBOR benchmark administrator [will] publish synthetic sterling and Japanese yen LIBOR for one-, three- and six-month tenors throughout 2022.”
Other LIBOR legacy contracts that use USD will also be allowed to continue through June 2023, Dissanayake noted, allowing them more time to transition over.
How the LIBOR to SOFR Transition Affects Commercial Real Estate
The LIBOR to SOFR transition affects commercial real estate and commercial real estate finance because many CRE loans have interest rates that are based in LIBOR, said Brian Hwang, former Director of Lender Relationships at Lev.
“Every LIBOR-based loan needs to have proper language in the loan documents to ensure a smooth transition for the interest rate once LIBOR goes away,” said Hwang. “Every loan document is different. There is no one-size-fits-all. The documents are custom negotiated, usually. So it really is up to each borrower to connect with their lender, take a look at their loan documents, talk to their attorney, and understand what language is already in their loan documents.”
Hwang also said it’s likely many of the lenders have already proactively reached out to borrowers to add transition language and update them of the changes.
“It should be a seamless transition when LIBOR goes away,” Hwang said. “And the interest rate should theoretically be net neutral to both the borrower and lender.”
Nonetheless, if borrowers haven’t already heard from lenders regarding their loan documents and the transition away from LIBOR, it’s a good idea to reach out and ensure the transition will be smooth and seamless.
LIBOR vs SOFR: Key Differences
Breaking it down further, some of the key differences between LIBOR and SOFR include:
- Based on bank submissions using a limited number of transactions, along with an expert panel judgment
- Bank-to-bank lending rate, which includes credit risk
- $500 million USD of daily trading in transactions within a 3-month wholesale funding market
- Forward-looking term structure
- Currency options: USD, GBP, EUR, JPY, CHF
- Based on market transactions
- Secured with U.S. Treasuries
- Risk-free rates
- Over $1 trillion of daily trading in the overnight Repo market
- Overnight, backward-looking, with no term structure as of 2021
- Currency options: only USD
- LIBOR replacement
The Transition from LIBOR to SOFR Is Underway
With the goal of preventing market manipulation, banks around the world are switching to SOFR. Although the change has already been implemented, it may take some time to see the actual effects, but commercial real estate investors should keep an eye on any new financial documents to see how the changes will affect their finances.