SOFR Replacing LIBOR
SOFR as the Replacement for LIBOR in Regards to Multifamily Financing
For decades the London Interbank Offered Rate, more commonly known as LIBOR, has been the basis of the interest rates for loans across many markets, multifamily apartment finance included. Often referred to as a "benchmark rate", LIBOR is the rate at which banks charge each other for short-term loans. LIBOR is currently the basis for over $370 trillion of financial products in five different currencies.
However, due to unreliability and market manipulation by the banks that LIBOR is based on, the Alternative Reference Rate Committee (ARRC) has recommended phasing it out in favor of a new benchmark rate. LIBOR is self-reported by banks and as such, is vulnerable to manipulation, as financial institutions as early as 2008 have often decided to report rates that are advantageous to their trading activities. Specifically, banks were accused of colluding with traders and hedge fund managers and setting rates in ways that would allow them to make more money during trade activities. There was also evidence that suggests that LIBOR rates spiked on days when adjustable-rate mortgages were re-adjusted, which enabled banks to charge artificially high-interest rates.
The Secured Overnight Financing Rate (SOFR)
Currently, LIBOR is rapidly being phased out in favor of the Secured Overnight Financing Rate, or SOFR. By the end of 2021, banks will no longer report the rates that are used to calculate the LIBOR index. By the start of 2022, this means that LIBOR will effectively cease to exist— a change that could significantly affect apartment and real estate financing rates in the U.S.
Its replacement, SOFR, is a reference rate created by the Federal Reserve Bank of New York (FRBNY) and the U.S. Treasury Office of Financial Research (OFR). SOFR is based on the overnight trading rate for U.S. Treasury bond repurchases and incorporates trading from three major sources. SOFR excludes the bottom 25% of trading rates in order to increase accuracy since these trades are more likely to be special trades that would not accurately represent the overall trading rate.
Switching to SOFR is likely to have a positive impact on the commercial and multifamily lending industry after the transition is finalized. SOFR is a more secure and stable benchmark for interest rates and free from reporting manipulation.
Related Questions
What is the difference between SOFR and LIBOR?
The main difference between SOFR and LIBOR is that SOFR is based on completed transactions, while LIBOR is based on self-reported quotes from financial institutions. This makes SOFR far less susceptible to manipulation and based on historical activity. Additionally, SOFR is calculated using a significantly larger data set than LIBOR, averaging between $2 and $4 trillion in volume on a daily basis, according to a 2020 report from The Brookings Institution. Lastly, SOFR does not include a credit risk premium in its calculation, while LIBOR does. Many analysts anticipate loan rates will include a credit spread to account for this change.
What are the implications of SOFR replacing LIBOR for commercial real estate loans?
The switch from LIBOR to SOFR could have a variety of implications for commercial real estate loans. In the short term, there could be some hiccups due to inaccuracies in SOFR calculations, and many loans that are tied to LIBOR have terms that go past 2021, so it's uncertain what will happen to these loans after LIBOR is no longer reported. In the best case scenario, a clean swap could occur without much disruption, but it's possible that the fallout of the switch could include legal action such as class-action lawsuits, or even the creation of an adjustment spread that would even out the differences between the two indexes. Alternatively, an entirely new index could be used, such as SONIA (the Sterling Overnight Interbank Average Rate) or Ester (the European Central Bank's euro short-term rate).
The switch to SOFR will mainly impact variable rate loans, including many bank apartment loans and a wide swath of Freddie Mac® and Fannie Mae® multifamily loans. In contrast, since most CMBS loans, all HUD/FHA multifamily loans, and many life company loans are fixed rate, the transition to SOFR should not affect them as much, unless the disruption caused by it were to actually cause a major fluctuation in interest rates themselves.
Sources:
How will SOFR replacing LIBOR affect apartment loan rates?
Switching to SOFR is likely to have a positive impact on the commercial and multifamily lending industry after the transition is finalized. SOFR is a more secure and stable benchmark for interest rates and free from reporting manipulation. Its replacement, SOFR, is a reference rate created by the Federal Reserve Bank of New York (FRBNY) and the U.S. Treasury Office of Financial Research (OFR). SOFR is based on the overnight trading rate for U.S. Treasury bond repurchases and incorporates trading from three major sources. SOFR excludes the bottom 25% of trading rates in order to increase accuracy since these trades are more likely to be special trades that would not accurately represent the overall trading rate.
In the best case scenario, a clean swap could occur without much disruption, but it’s possible that the fallout of the switch could include legal action such as class-action lawsuits, or even the creation of an adjustment spread that would even out the differences between the two indexes, especially if LIBOR and SOFR begin to track each other more closely during the next 12-18 months. Alternatively, an entirely new index could be used, such as SONIA (the Sterling Overnight Interbank Average Rate), an index based on overnight trading rates for the pound sterling. LIBOR could also temporarily be replaced with Ester (the European Central Bank’s euro short-term rate).
Despite these concerns, it’s important to remember that this shift will mainly impact variable rate loans, including many bank apartment loans and a wide swath of Freddie Mac® and Fannie Mae® multifamily loans. In contrast, since most CMBS loans, all HUD/FHA multifamily loans, and many life company loans are fixed rate, the transition to SOFR should not affect them as much, unless the disruption caused by it were to actually cause a major fluctuation in interest rates themselves, which isn’t particularly likely.
What are the benefits of SOFR replacing LIBOR for commercial real estate investors?
The main benefit of SOFR replacing LIBOR for commercial real estate investors is that it will help to reduce the risk of fraud and manipulation. LIBOR was manipulated by banks in the past in order to increase their profit margins, which had a negative affect on both average consumers and institutional real estate investors. SOFR is a more reliable and transparent rate, as it is based on actual transactions in the overnight lending market. This means that it is less likely to be manipulated, and will provide a more accurate and reliable basis for loan rates. Additionally, SOFR is based on a larger and more diverse set of transactions than LIBOR, which will help to reduce the risk of inaccuracies in the rate.
Sources:
How can commercial real estate investors prepare for SOFR replacing LIBOR?
Commercial real estate investors should be aware of the potential impacts of SOFR replacing LIBOR. They should also be aware of the potential inaccuracies that have been found during calculations of SOFR during the last 12 months. To prepare for the switch, investors should consider the following:
- Understand the potential impacts of SOFR replacing LIBOR on their loan products.
- Be aware of the potential inaccuracies in SOFR calculations.
- Understand the built-in switch mechanisms in adjustable commercial real estate loans that will kick in if LIBOR is no longer calculated.
- Understand the potential implications of the loan being pegged to a spread based on the prime rate.
For more information, please refer to the following sources: