Author: Chris Moore, Managing Director, Chatham Financial
2022 has seen the LIBOR transition enter a new phase, with prudentially regulated banks no longer able to lend over LIBOR and most new floating-rate commercial real estate (CRE) loan originations now indexed to SOFR-based rates. While some tenors of LIBOR will continue to be published by its administrator until mid-2023, LIBOR’s discontinuation and obsolescence for CRE financings specifically seems a foregone conclusion. Given where we stand with the transition, it’s a good time to take stock of how the transition impacts CRE borrowers.
CRE borrowers have seen the impact of the transition most clearly in new loan originations. While Agency borrowers became accustomed to seeing SOFR-indexed loans from Freddie Mac and Fannie Mae in the fourth quarter of 2019, LIBOR alternatives did not begin to make their way into other CRE financings in a meaningful way until the second half of 2021. There still isn’t market consensus on which specific alternative rate should be used, or even if there will be a single standard at all. Three distinct SOFR-based rates are observed in the market now: daily simple SOFR (which averages daily SOFR rates over an interest period), NY Fed 30-Day SOFR (which looks at daily SOFR compounded over the 30 days leading up to the start of a new interest period) and Term SOFR (a term rate published by the CME Group based on where SOFR futures trade relative to current SOFR). To add to the confusion, a vocal minority of lenders are advocating for non-SOFR LIBOR alternatives like the Bloomberg Short-Term Bank Yield Index (BSBY) and AMERIBOR, both of which are intended to be more reflective of lenders’ cost of funds.
This lack of standard has created confusion for borrowers as they struggle to understand how each alternative might compare with LIBOR and one another, and whether each alternative might generate
better or worse interest expense over the life of the loan. Borrowers should remember a few key points. Each of these rates tend to correlate well with LIBOR and with one another during normal market conditions. In distressed market conditions, when credit availability tightens, SOFR-based rates may fall relative to LIBOR, BSBY, and AMERIBOR, at least for a short period of time (as was observed at the start of COVID-19). SOFR-based rates historically have been lower than LIBOR by ~10 basis points (though the current difference is closer to 5 bps). Borrowers confronted with different LIBOR alternatives should also consider regulators’ vocal preference for SOFR-based rates and the broad adoption of these rates by most lenders. It’s likely that we’ll continue to observe SOFR in CRE loans in the coming years; its less clear that 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 also has created complications for borrowers looking to hedge risk on floating-rate loans, either at the requirement of lenders or electively. Short-term floaters to finance transitional assets often require an interest rate cap to allow a lender to underwrite a worst-case debt service coverage ratio, and balance sheet bank lenders often require swaps of floaters 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 wasn’t the case at the end of 2021, borrowers hedging SOFR-indexed loans can now reliably purchase SOFR-indexed caps and enter into SOFR-indexed swaps. Borrowers looking to hedge BSBY and AMERIBOR exposure will find that hedge products for those indices are less available and more expensive.
As standards for LIBOR alternatives in new loan originations are set and we move closer to LIBOR’s sunset in mid-2023, lenders are likely to shift focus to transitioning their legacy loan books from LIBOR to alternative rates. This will necessitate borrowers engaging with lenders as loan language governing LIBOR conversion is exercised or lenders look to amend loans lacking such language. In such situations, borrowers should be thoughtful with respect to what is asked of them by their lenders. LIBOR conversions in loans will likely contemplate an adjustment to the loan spread to reflect the basis between SOFR-based rates and LIBOR, and this adjustment should be scrutinized (broadly speaking, an increase in the spread on the order of 5–11 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 an associated hedge, so borrowers should also not agree to convert or otherwise amend a loan without understanding what is occurring with a related hedge and if there might be mismatches that change the loan economics in a negative way.
About Chris Moore:
Chris Moore is a member of Chatham Financial’s Real Estate team, leading one of the group’s hedge advisory, execution, and technology teams and managing comprehensive client relationships. Chris joined Chatham as a client consultant, working with privately held real estate investors to help them manage their interest rate and foreign currency risk. Prior to his work at 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.