How the End of LIBOR Will Impact the Commercial Real-Estate Industry
The opinions of entrepreneurs’ contributors are their own.
The LIBOR, or the London Inter-Bank Offered Rate, served as a globally accepted benchmark for many years and derived the rates from the US dollar, the British pound, the euro, the Swiss franc and the Japanese yen – all based on estimates Transaction rates. This index has played an important role in a wide variety of financial products, including commercial real estate mortgages.
However, this is set to change. Earlier this year it was announced that LIBOR would be phased out, with the vast majority of hires being discontinued after December 31, 2021 and night and 12 month USD hires after June 30, 2023.
While questions about the validity of LIBOR and high-profile banking scandals welcome the exit, it cannot be denied that the end of LIBOR will have a significant impact on commercial real estate.
Influence of LIBOR on commercial real estate
LIBOR rates have long been used as the reference rate for determining interest rates for both commercial and residential mortgage loans, including new home loans. Variable rate lenders would typically set interest rates as “LIBOR plus x%” – with the additional percentage determined by factors such as the borrower’s creditworthiness and the length of the loan.
The problem, however, is that LIBOR rates were essentially estimates. Although it was intended to track lending rates between international banks, so little lending was granted that LIBOR panel members were asked what they would hypothetically expect for such transactions. This made the index slightly susceptible to manipulation, which led to the scandals that led to the benchmark’s expiry.
In particular, many have already started preparations for moving away from LIBOR. A 2019 survey by the Mortgage Bankers Association found that 92 percent of commercial mortgage lenders plan to deviate from the benchmark.
77 percent had also adjusted the language related to LIBOR in new loan documents. For example, documents used in floating rate transactions often name an alternative rate or give the lender the option of choosing a LIBOR alternative if necessary.
Despite these positive signs, less than half of respondents were confident of what they would use as an alternative – a problem that will persist in 2021.
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What are SOFR and other alternative benchmarks?
There is currently some uncertainty as to which benchmark will be used to replace LIBOR. Secured Overnight Financing Rate (SOFR) is currently expected to be used in the United States and the United Kingdom, in part because rates are based on observed transitions rather than estimates.
Prepared by the Federal Reserve Bank of New York, one of the biggest factors adding to the momentum of SOFR is its acquisition by Fannie Mae and Freddie Mac, who in recent years have issued securities backed by SOFR-based loans. The introduction of the HR4616 – Adjustable Interest Rate (LIBOR) Act of 2021 also aims to ease the transition by using SOFR for existing LIBOR contracts that do not have a defined fallback option.
However, this has by no means resulted in consensus. Other potential successors that have gained in importance are the Bloomberg Short Term Bank Yield Index (BSBY), which is based on anonymized transactions and executable prices; Ameribor, which uses a volume-weighted transaction average; and the ICE Bank Yield Index, which uses a rolling 5-day window to aggregate data from primary and secondary market transactions. In particular, BSBY has already been used by JPMorgan Chase and Bank of America.
There is certainly still a long way to go before LIBOR is completely abolished, but lenders unable to agree on a new standard could experience a temporary slowdown in commercial lending until they fully adjust to a new index.
Right now, the sheer number of LIBOR alternatives available and the lack of a clear consensus on how to use them could pose a challenge as commercial property investors seek to partner with various banks.
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What’s next for commercial real estate?
The dust has not quite settled after the LIBOR scandals – and it will be some time before LIBOR rates no longer play a role in the commercial real estate sector.
However, investors and lenders in this area would do well to start creating transition plans now. While HR 4616 is assumed to exist and reduce the transition risk for legacy transactions, lenders and investors should not leave their contracts to chance. Financial instability and even litigation are opportunities for commercial real estate lenders who do not proactively address these issues.
There are also concerns that moving to a new, non-LIBOR-based rate could lead to significant changes in the loan itself. Lenders must ensure that changes to legacy loans are ultimately fair to all parties – otherwise, either lenders or investors could suffer significant financial damage, which could lead to serious commercial property problems.
Many others in the industry are already taking steps to mitigate the risk of contracts that are not due before LIBOR has fully expired. The sooner both investors and lenders start planning, the better able they will be to cope with these changes in the marketplace.
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