The Current State of the LIBOR Transition in Commercial Real Estate

Author: Chris Moore, Managing Director, Chatham Financial

Chris Moore

2022 has seen the transition from LIBOR enter a new phase, with prudentially regulated banks no longer being able to lend in LIBOR and most new commercial variable rate (CRE) real estate loans are now pegged to SOFR-based rates. While some LIBOR tenors will continue to be published by its administrator until mid-2023, the discontinuation and obsolescence of LIBOR for CRE funding in particular seems a foregone conclusion. Given where we are with the transition, now is a good time to take stock of the impact of the transition on CRE borrowers.

CRE borrowers have seen the impact of the transition most clearly in new loan originations. While Agency borrowers grew accustomed to seeing SOFR-indexed loans from Freddie Mac and Fannie Mae in the fourth quarter of 2019, LIBOR alternatives only began to make their way into other CRE funding from significantly until the second half of 2021. There is still no market consensus on which specific alternative rate to use, or even if there will be a single standard at all. Three distinct SOFR-based rates are currently seen in the market: daily simple SOFR (which averages daily SOFR rates over an interest period), New York Fed 30-day SOFR (which examines the Daily SOFR compounded over the 30 days preceding the start of a new interest period) and Term SOFR (a forward rate published by the CME Group based on where SOFR futures are trading relative to the current SOFR) . To add to the confusion, a vocal minority of lenders advocate non-SOFR LIBOR alternatives like the Bloomberg Short-Term Bank Yield Index (BSBY) and AMERIBOR, both of which are intended to better reflect lenders’ cost of funds.

This lack of a standard has confused borrowers as they struggle to understand how each alternative might compare to LIBOR and each other, and whether each alternative might generate
better or worse interest charge over the life of the loan. Borrowers should remember a few key points. Each of these rates tends to correlate well with LIBOR and with each other under normal market conditions. In difficult market conditions, when credit availability tightens, SOFR-based rates may fall relative to LIBOR, BSBY and AMERIBOR, at least for a short time (as observed in the early of COVID-19). SOFR-based rates have historically been lower than LIBOR by around 10 basis points (although the current difference is closer to 5 basis points). Borrowers faced with different LIBOR alternatives should also consider the preference expressed by regulators for SOFR-based rates and the widespread adoption of such rates by most lenders. It is likely that we will continue to observe SOFR in CRE loans for years to come; it is less clear that this will be the case for BSBY and AMERIBOR.

Note: Due to lack of liquidity, forward curves for BSBY and AMERIBOR are not available/representative

The transition to LIBOR alternatives has also created complications for borrowers looking to hedge risk on variable rate loans, either at the request of lenders or at their option. Short-term floats to fund bridging assets often require an interest rate cap to allow a lender to guarantee a worst-case debt service coverage ratio, and balance sheet bank lenders often require float swaps to create a fixed rate profile. These caps and swaps have always been available for LIBOR-indexed loans, but the market for derivatives indexed to LIBOR alternatives is still developing. While this was not the case at the end of 2021, borrowers who hedge SOFR-indexed loans can now reliably purchase SOFR-indexed caps and enter into SOFR-indexed swaps. Borrowers looking to hedge exposure to BSBY and AMERIBOR will find that hedging products for these indices are less available and more expensive.

As the standards for LIBOR alternatives in new lending are set and we move closer to LIBOR extinction in mid-2023, lenders should focus on transitioning their legacy loan portfolios from LIBOR to lower rates. alternatives. This will require borrowers to engage with lenders when loan language governing LIBOR conversion is exercised or lenders seek to modify loans lacking such language. In such situations, borrowers need to be mindful of what is being asked of them by their lenders. LIBOR-to-loan conversions will likely consider a loan spread adjustment to reflect the basis between SOFR and LIBOR-based rates, and this adjustment should be carefully considered (generally speaking, an increase in spread of around 5 to 11 basis points when converting a loan from LIBOR to SOFR is reasonable). A LIBOR conversion in a loan will not automatically trigger a LIBOR conversion in related coverage, so borrowers should also not agree to convert or modify a loan without understanding what is happening with related coverage and whether it there may be asymmetries that alter the lending economy in a negative way.

About Chris Moore:
Chris Moore is a member of the real estate team at Chatham Financial, leading one of the group’s advisory, execution and technology teams and managing comprehensive client relationships. Chris joined Chatham as a Client Consultant, working with private property investors to help them manage their interest rate and currency risk. Prior to working in Chatham, Chris was a Peace Corps volunteer, working with small business owners in a rural part of the Dominican Republic. Chris graduated from the University of Pennsylvania with a bachelor’s degree in economics.

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