The transition from London Interbank Offered Rate (LIBOR) to Secured Overnight Financing Rate (SOFR) has led to major changes in the pricing of global financial products. Although LIBOR will continue to be published until June 30, 2023, major banks are encouraged to no longer issue new LIBOR-based loans as of December 31, 2021.
While there are several other alternative indices that are beyond the scope of this memo, SOFR is the primary interest rate benchmark that will replace LIBOR. Unlike LIBOR which is set by surveying a handful of banks, SOFR is a market-driven index of actual transactions in the overnight repo market.. Thus, SOFR is said to be more representative of the market, more resilient, and less susceptible to manipulation than LIBOR.
With LIBOR tied to more than $350 trillion of contracts globally and nearly $200 trillion of US dollar contracts, this is one of the biggest and most significant events in the history of financial markets. And it’s important that your commercial real estate firm is prepared to adapt to this change.
But what does the shift from LIBOR to SOFR mean for the commercial real estate industry? And how can your firm prepare for the impact on your loans? Read ahead to find out.
The Impact on Legacy Loans
Under the recent implementation of new U.S. regulatory guidance, banks are encouraged to no longer make any new LIBOR loans; however, legacy contracts may still reference LIBOR until the benchmark’s publication stops in June 2023. This rule affects legacy commercial real estate loans because many existing loans have LIBOR-based interest rates.
A 2019 survey by the Mortgage Bankers Association found that 92% of commercial mortgage lenders planned to transition away from the LIBOR benchmark. Once LIBOR is phased out, loans will be tied to a different benchmark with new regulations. In other words, your legacy loans that mature beyond June 30, 2023 will need attention..
There are three alternatives for legacy loans that currently mature beyond June 30, 2023:
- Modify existing loan documents to incorporate robust fallback language that identifies triggers events, an alternative reference rate, and any accompanying spread adjustment that will be automatically implemented after June 30, 2023.
- Modify existing loan documents to immediately transition to an alternative reference rate today.
- Do not modify the loan documents and let the loan convert pursuant to its terms after June 30, 2023. For loans that currently have robust fallback language, the index will convert based on the language in the loan documents. For loans that do not have fallback language, they will be subject to the recently passed Adjustable Interest Rate (LIBOR) Act.
The Impact on New Loans
Today, 77% of commercial lenders have adjusted 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 ability to choose a LIBOR alternative if needed.
Since the beginning of 2022, the majority of new loan issuances have shifted to SOFR-based rates. Essentially, the cessation of LIBOR means that new loans are required to use a new benchmark. Many borrowers and banks have begun to incorporate alternative benchmarks, like SOFR, to replace previous LIBOR-based rates.
Although there is still time before LIBOR is eliminated, lenders who are unable to agree on a replacement standard could temporarily experience slowdowns in commercial lending until they fully adapt to a new index. These slowdowns could impact the ability to get a new loan altogether or cause a rise in interest rates.
Preparing for the LIBOR to SOFR Transition
The transition from LIBOR to SOFR requires commercial real estate borrowers and lenders to have a thorough understanding of the new index and the potential effects the LIBOR discontinuation may have on their loans or interest rate swaps.
To prepare, borrowers should take inventory of their commercial borrowings and determine which loans, if any, have LIBOR-based interest rates. Also, you should begin having conversations with your lender(s) about alternative benchmarks, timelines, and the best path forward.
For additional preparation, you can engage with a debt management services provider, like Thirty Capital Financial, to help you gauge how the SOFR transition will impact your legacy and future loans and then create and implement a plan to ease the transition.
Read the checklist, Transitioning from LIBOR to SOFR for Commercial Real Estate, for a step-by-step guide to successfully navigate the transition from LIBOR to SOFR.