From LIBOR to SOFR: An Update on The Effect on Borrowers

For years, LIBOR (London Interbank Offered Rate) has been a familiar component of commercial real estate lending in the U.S. Soon, though, LIBOR will vanish in the U.S., making way for a benchmark rate known as SOFR (Secure Overnight Financing Rate).

Follow along to learn why the LIBOR-to-SOFR switch is being made and how it will affect commercial real estate lending.

Why is LIBOR being replaced?

LIBOR is a collection of interest rates based on estimates from as many as 18 major global banks. The estimates refer to the banks’ envisioned costs to borrow money from other banks.

For decades, LIBOR had been used to set interest rates for U.S. financial products such as adjustable-rate loans, mortgages and corporate debt, Forbes explains.

Because of its role in aggravating the 2007-09 financial crisis and in fueling rate-manipulation scandals, LIBOR is being retired in the U.S.

As of January 2022, one-week and two-month LIBOR tied to the U.S. dollar are no longer being published by the ICE Benchmark Administration, which handles regulated benchmarks like LIBOR. Publishing of overnight, one-month, three-month, six-month and 12-month LIBOR linked to the U.S. dollar is supposed to end in June 2023.

“Lenders and servicers must stop using LIBOR by [June 2023],” according to the Consumer Financial Protection Bureau, “and most are expected to switch to using another comparable or substantially similar index by this date.”

What will happen once LIBOR is officially phased out?

Once LIBOR is phased out, most U.S. lenders are expected to shift to SOFR.

The Federal Reserve Bank of New York and the federal Office of Financial Research designed SOFR in conjunction with the Alternative Reference Rate Committee, a group of private-industry and public-sector representatives guiding the U.S. transition from LIBOR to SOFR.

The New York bank publishes SOFR, which reflects the cost of overnight borrowing of cash that’s backed by Treasury securities in the repurchase agreement (repo) market. SOFR is viewed as a secured, risk-free rate, whereas LIBOR is an unsecured benchmark that builds in credit risk related to banks’ estimates of the cost to borrow money.

The LIBOR-to-SOFR change may or may not lead to a change in interest rates for existing financial products, the Consumer Financial Protection Bureau says.

“Lenders and servicers are generally required to select a replacement index that is comparable or substantially similar, so your interest rate under the new index should also be comparable or substantially similar,” says the Bureau.

Under SOFR, your rate for an existing fixed-rate loan isn’t meant to change. But it may change if you have an adjustable-rate loan, such as a commercial mortgage or a business loan. As for new loans, their rates are typically based on SOFR.

LIBOR-based loans that automatically renew this year generally will convert to SOFR-based loans.

What happens to SOFR when interest rates rise?

When the Federal Reserve increases or decreases its benchmark rate for overnight borrowing between banks (known as the federal funds rate), it can cause rates for SOFR-based lending products to go up or down as well.

According to research published by the University of Technology Sydney, “the dynamics of SOFR are closely linked to the dynamics” of the Fed funds rate. 

How will SOFR being the standard benchmark for rates affect commercial real estate?

For decades, LIBOR was the standard benchmark for commercial mortgages and construction loans.

In some cases, commercial real estate borrowers have loans in place that are automatically converting to SOFR. In other cases, LIBOR-based loans already have been replaced by SOFR-based loans.

Alternatively, some borrowers have moved away from variable-rated LIBOR or SOFR loans and toward fixed-rate loans. Commercial real estate loans often are tied to variable rates.

Government-sponsored entities and major lenders in the multifamily market, Fannie Mae Multifamily and Freddie Mac Multifamily, announced in January 2023 that they were transitioning from LIBOR to SOFR for legacy floating-rate loans and securities. After June 30, 2023, the lenders will rely on the spread-adjusted, 30-day-average SOFR for legacy floating-rate loans and securities.
Discover our investment solutions for multifamily borrowers or contact the Broadmark Realty Capital team today!