With the anticipated sunset date of the London Interbank Offered Rate (LIBOR) a little over a year away, commercial real estate market participants are preparing for an important transition to a new way of calculating the interest rates for many commercial mortgages.
LIBOR is the index most often used in the pricing of some trillion dollars of floating-rate commercial mortgages, which is a significant portion of outstanding commercial mortgage debt. Commercial mortgage brokers typically don’t need to know all of the technicalities and intricacies of how this index works or, in the case of LIBOR, doesn’t work so effectively.
For those who make a living matching commercial real estate borrowers and lenders, however, it’s worth monitoring the transition as it has the potential to impact the economics of deals. The transition is complex and important for borrowers, lenders, brokers and service providers alike. It is well worth your time to get to know the mainline details of the transition before your clients ask about them.
The pending transition deadline is quickly approaching. Regardless of where the commercial real estate transaction process sits at that time, it will impact borrowers’ and lenders’ existing loans — as well as new originations — in various ways over the next 12 months.
For about 30 years, LIBOR has been the go-to rate for pricing all types of non-fixed-rate financial instruments, including mortgages, credit cards and a host of derivative products. These floating-rate mortgages are quoted based on a spread above the LIBOR rate. As such, the rate and spread quoted by a lender directly affects the cost of adjustable-rate borrowing and ultimately the profitability of your client’s venture.
LIBOR also has been controversial. The rate represents the average interest rates that banks can borrow from each other. Over the past several years, however, LIBOR has been subject to manipulation through bank collusion that led to a number of rigging scandals. Ultimately, in 2017, the Financial Conduct Authority in the United Kingdom urged institutions to move to other benchmarks by 2021, and will no longer require or encourage banks to publish these rates after 2021.
LIBOR will sunset by the end of 2021 and the U.S. market alternative recommended by the Federal Reserve-convened Alternative Reference Rates Committee (ARRC) is the Secured Overnight Financing Rate (SOFR). What this means is that mortgages made to commercial real estate borrowers and many other types of borrowers will no longer be tied to LIBOR but to SOFR.
The transition creates a two-fold problem for commercial real estate lending. First, it changes the interest benchmark for new adjustable-rate mortgages. This may alter the economics of these loans because the replacement index won’t produce an identical benchmark rate.
Second, a transition to a new index will impact preexisting mortgages that have been tied to LIBOR. For LIBOR-based loans that do not mature before 2021, the transition to a new rate is no minor detail. A new benchmark effectively alters the original terms of the contracts for adjustable-rate mortgages. The ARRC, in consultation with the industry, has put much effort into developing contractual fallback language to resolve some of the legal issues involved with transitioning loans that are tied to LIBOR. This work will continue past 2021.
For commercial mortgage brokers and lenders, a more immediate issue is nearly at hand. The government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, the two largest sources of capital for multifamily mortgages, will soon stop buying adjustable-rate mortgages tied to LIBOR. At the direction of their regulator, the Federal Housing Finance Agency, the GSEs will be the first source of commercial real estate debt capital that will move to a SOFR product.
Specifically, the GSEs have announced that all LIBOR-based multifamily mortgages must have loan application dates on or before Sept. 30, 2020, to be eligible for acquisition. GSE acquisitions of LIBOR-based multifamily loans will cease on or before Dec. 31, 2020.
How disruptive to the market this transition will be is the $64,000 question. Clearly, the more prepared the financial industry is for the transition, the better.
The mechanics of LIBOR and SOFR differ. The two indices don’t produce identical rates and may move differently, so borrowers and lenders may see an impact on interest rates. SOFR was chosen because it is viewed as less susceptible to manipulation, since it is based on real transaction data rather than the published rates of global banks.
ARRC is working to develop a spread adjustment to account for this difference, and to minimize any value transfer for existing contracts that transition from LIBOR to SOFR. For commercial real estate borrowers, an interest rate cap is often required or purchased with floating-rate loans. It’s important to note that the first caps for SOFR were priced for agency-backed loans in third-quarter 2020.
It also is unclear how seamlessly the industry will adapt to the change and whether this transition will delay any loan closings. How disruptive to the market this transition will be is the $64,000 question. Clearly, the more prepared the financial industry is for the transition, the better.
The Mortgage Bankers Association, for one, has focused on educating members and ensuring all of them — whether they are based in the single-family housing sector or commercial/multifamily — are prepared to handle the transition. Given that the GSEs are moving toward the use of the SOFR index for their adjustable-rate products in 2021, the mortgage market will soon get a preview of what transitioning to new products and closing new loans for conventional lenders will look like. Many believe there won’t be any serious hiccups.
Market participants and policymakers are squarely focused on providing the tools needed for a smooth transition for new and existing loans, which makes a significant disruption less likely. As 2021 approaches, however, the commercial mortgage industry will have to add LIBOR transition to its basket of tasks and market developments to monitor.
Although the transition hopefully will not harm the market for new adjustment-rate commercial mortgage originations, borrowers, brokers and lenders should pay attention to these issues. Understanding the high-level details and the landscape will be useful for the brokerage community to support its clients. ●