SOFR: The New Replacement for LIBOR

LIBOR vs. SOFR: What You Need to Know

For decades, the basis of the interest rates for loans— particularly for commercial real estate loans, has been the London Interbank Offered Rate, more commonly known as LIBOR. In essence, LIBOR is the rate which banks charge each other for short-term loans. Currently, LIBOR is the basis for over $370 trillion of financial products in five different currencies. However, LIBOR is rapidly being phased out by the Secured Overnight Financing Rate, or SOFR. By 2022, LIBOR will have been completely replaced, as major banks have no longer agreed to submit rates past that point in time. This could significantly affect real estate loan rates in the U.S. But why is LIBOR being replaced— and how will SOFR be different? In this guide, we take a look at both of these questions and examine how it could affect the market for multifamily and commercial real estate financing.

Why LIBOR is Being Phased Out

LIBOR is being phased out for a variety of reasons— but generally, each of these reasons speak to the fact that the rate is no longer as reliable as it once was. First off, due to the fact LIBOR is self-reported by banks, it’s vulnerable to manipulation, as banks often decide to report rates that are advantageous to their trading activities. This was a major issue during the LIBOR scandal, which reportedly began in 2008 and came to a head in 2012.

During the LIBOR scandal, major British banking institutions, including Barclay’s, were accused of manipulating the rate, as well as colluding with traders and hedge fund managers in order to set rates in ways that would be allow them to make more money during trading. Evidence also suggests that LIBOR rates spiked on days when adjustable-rate mortgages were re-adjusted, leading to banks being able to charge artificially high interest rates. Some analysts believe that the LIBOR-fixing scandal also may have contributed to 2008 banking and financial crisis. As a result of the scandal, a number of bankers faced criminal convictions and banks were fined approximately $9 billion.

In addition to the unreliability of LIBOR and its history of scandal, unsecured lending between banks is significantly less common than it used to be, so even if banks were reporting accurately, the volume of unsecured inter-banked transactions is not large enough to derive an accurate rate. In fact, banks are now significantly more hesitant to report LIBOR than they used to be, as they could be penalized for reporting an erroneous rate.

How SOFR Was Created

The Alternative Reference Rate Committee (ARRC) was created by the Federal Reserve in 2014, with the intention of creating a more accurate reference index. In June 2017, the ARRC decided that it would recommend SOFR, a reference rate created by the Federal Reserve Bank of New York (FRBNY) and the U.S. Treasury Office of Financial Research (OFR). SOFR is based on the overnight trading rate for U.S. treasury bond repurchases (repos). It incorporates repo trading from three major source, and excludes the bottom 25% of trading rates to increase accuracy, as these trades are more likely to be special trades which would not accurately represent the overall trading rate. In May 2018, the CME group began selling SOFR futures, which should lead to an increase in confidence in the rate.

SOFR is relatively similar to the EFFR (Effective Federal Funds Rate), an which measures unsecured borrowing between banks in U.S. dollars, as well as unsecured borrowing (also in dollars) between other entities, typically GSEs (government-sponsored enterprises). Despite this, SOFR is somewhat more unstable than the EFFR, likely due to end-quarter balance sheet adjustments among banking institutions, which leads to less market activity.

How SOFR May Affect The Real Estate Lending Industry

In the long term, switching to SOFR is likely to have a positive impact on commercial and multifamily real estate investment— but, in the short term, there could easily be a few hiccups. In fact, in April 2018, the Federal Reserve Bank of New York admitted that it had included incorrect data in its calculation of SOFR, an incident which certainly did not increase market confidence in the new index. In addition, since many real estate loans (both commercial and residential) that are tied to LIBOR have terms that go past 2021, it’s uncertain what will happen to these loans during after LIBOR is no longer reported, especially with SOFR trending slightly higher than LIBOR, much of the time. LIBOR and SOFR are not directly tied, which adds another degree of uncertainty to the situation.

In the best case scenario, a clean swap could occur without much disruption, but it’s possible that fallout could include legal action such as class-action lawsuits, or even the creation of an adjustment spread that would even out the differences between the two indexes, especially if LIBOR and SOFR begin to track each other more closely during the next 12-18 months. Alternatively, an entirely new index could be used, such as SONIA (Sterling Overnight Interbank Average Rate), an index based on overnight trading rates for the pound sterling. LIBOR could also temporarily be replaced with Ester (the European Central Bank’s euro short-term rate).