With Libor On Its Way Out, Commercial Real Estate Faces More Complex Lending Landscape
The deadline for lenders to phase out the Libor — the rate that determines the interest paid on the majority of commercial real estate loans — is less than three months away, and most lenders have coalesced around a new benchmark rate.
The Federal Reserve has endorsed a replacement in SOFR, which stands for Secured Overnight Financing Rate, but not required it, and lending experts say the presence of other rates in the market could potentially cause complications for borrowers seeking to find the best rate for their construction or acquisition loans.
“I think it's gonna be a little bit more difficult for a borrower to take three or four different loan quotes across different indices and look at them apples to apples,” Walker & Dunlop Managing Director Blake Lanford said in an interview.
Many lenders could offer a range of floating-rate options to borrowers after the Dec. 31 deadline, real estate finance experts told Bisnow, including the Bloomberg Short-Term Bank Yield Index, known as BSBY. BSBY, like Libor, is sensitive to credit and determined by loans riskier than those used to calculate SOFR, which is backed by the U.S. Treasury.
"SOFR can be advantageous to borrowers during times of crisis when Treasury markets rally," Commercial Real Estate Finance Council Executive Director Lisa Pendergast said.
Libor, short for London Interbank Offered Rate, has been the basis of interest rates for floating-rate loan underwriting across the commercial real estate lending market since the 1980s. But in the early 2010s, scandal surrounded the rate as regulatory bodies across the globe, including in the U.S., investigated how high-profile banks were manipulating Libor for profit.
The Financial Conduct Authority, the United Kingdom's financial regulatory body, subsequently laid out a deadline to eradicate the rate and replace it with something that couldn’t be easily manipulated — the end of 2021. The deadline to end the rate’s posting was delayed until June 2023, but the Fed plans to crack down on any use of it in deals starting in January.
“Libor itself is going to be published through June of 2023 such that existing Libor-based instruments that may not convert for one reason or another can still get those Libor fixings that they need to determine what the interest rate is for a particular pay period, stuff like that,” said Matthew Hoffman, director of the real estate team at Chatham Financial.
“There have been a lot of different phases to the transition, but think at a high level, the next two big ones in terms of the phase-out are the end of this year where, by and large, we don't expect to see much new Libor product, definitely no new loans, and a smaller number of hedges and then June of 2023, when Libor as we know it presumably goes away for all intents and purposes."
The shift away from any new Libor-based loans has significant impacts on commercial real estate loan underwriting. Due to the flexible nature of floating-rate loans, they are widely used throughout commercial real estate financing, and all commercial real estate collateralized loan obligations are floating-rate.
Over the past few years, deals like these have been typically written to allow for interest rates initially quoted over Libor to switch over to SOFR automatically as Libor is phased out, said Jason Shapiro, managing director for Miami-based lender Aztec Group.
“Everybody's aware that it's being phased out and the deadline is coming soon,” he said. “There’s language being built in that allows for the conversion.”
Increasingly, borrowers and lenders have begun abandoning Libor and switched to SOFR, experts say, but some deals are still closing pegged to Libor. Walker & Dunlop has not used Libor in any Fannie Mae or Freddie Mac loans since fall 2020, Lanford said.
“We are seeing some clients request SOFR as their index rate at closing, so they don’t have to deal with the potential headaches caused by transitioning away from Libor post-closing,” Christopher Kramer, senior managing director of the debt and structured finance group at Newmark, told Bisnow.
The upcoming change hasn't slowed deal flow, he said, because borrowers are still keen on taking out floating-rate loans — there is a nearly unprecedented amount of cash trying to do commercial real estate deals.
"Any noise caused by the phase-out is not preventing clients from moving forward with transactions,” Kramer said.
While many don’t predict a deal slowdown after the deadline, no one knows exactly how the lending market will behave come 2022, Commercial Real Estate Finance Council Senior Director of Research Raj Aidasani said.
“The answer is something that we may not see until next year, until this deadline comes and passes,” Aidasani said. “It's going to be a world in which we're going to see a multi-rate environment where we believe it'll be primarily SOFR and a small subset of banks out there using other credit-sensitive rates.”
Some smaller and regional banks have pushed back against SOFR, saying it could cost them returns they can't make up for with scale like bigger banks — JPMorgan Chase made its first loan offering pegged to SOFR last week. In a February 2020 letter to the Fed, 10 midsized banks suggested using Ameribor, another credit-sensitive rate as an alternative, Bloomberg reported.
"[When markets rally], a SOFR loan with a static spread adjustment will see that mortgage rate decline," Pendergast said. "And that is why regional and smaller banks are uncomfortable with SOFR — their financing costs are going to be rising in a crisis, while the cash flow that's coming off these loans declines.”
To remain competitive as lenders, regional banks, big banks and debt funds alike are likely to offer a variety of loans, Pendergast said. While the volume of deals set after the deadline will provide more insight into the future of floating-rate, leverage loans, at least for now, SOFR appears to be the preferred Libor alternative.
“[Many borrowers] seem to have it down," Pendergast said. "They know what they need or want and are moving forward in a very intelligent way about getting there … to the good, our borrowers tell us that loan quotes that offer SOFR and certain alternatives are becoming the standard, at least for now.”