LIBOR’s Dead End
The end of 2021 brought even more tumult to an industry navigating the impacts of COVID-19 and lingering work-from-home policies. One of the most widely used benchmarks for pricing floating rate debt, the London Interbank Offer Rate (LIBOR), began its final phaseout at the end of the year.
LIBOR is the interest rate at which major banks worldwide lend to one another. Tied to trillions in outstanding debt, LIBOR is particularly important for the real estate industry as it is used to both price construction loans and to establish interest rates on fixed-rate permanent loans for stabilized assets. The index is calculated as the average of rate estimates submitted by 15 banks overnight by asking “at what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11am London time?” Despite its use for nearly 40 years, the index became heavily scrutinized for its role in the 2008 financial crisis and potential concerns about collusion and rate manipulation amongst panel banks. The steady decline in sample size of surveyed banks underscored regulators’ concern about the viability of the index.
The most commonly accepted replacement is the Secured Overnight Financing Rate (SOFR). While LIBOR was based on estimates provided by individual banks, SOFR indicates the cost of borrowing cash collateralized by Treasuries overnight in the repurchase agreement (“repo”) market. Since SOFR is calculated using transaction-level data, there is but limited room for manipulation.
The multifamily sector in particular has had a significant role in the transition given the importance of the agencies in the capital markets. While many lenders took a wait-and-see approach to the discontinuation, wanting instead to determine how the agencies would respond before reacting, both Fannie Mae and Freddie Mac ceased purchasing LIBOR-backed mortgages in 2020. The phaseout is largely impacting conventional multifamily investors since LIBOR is less commonly used in affordable projects due to tax credit investors’ hesitancy to take floating rate risk, although it is sometimes seen in Section 8 deals.
Despite the uncertainty, some believe that the time is right to execute the transition given the current low-rate environment. Yet, how existing loans with maturities beyond 2023 will be transitioned over to SOFR remains unclear. Many new originations today include fallback language that dictates the pricing methodology once the transition takes place. In most cases, this language includes a credit spread that minimizes any value transfer to the borrower or lender once the transition takes place. Those with floating rate exposure can also match their existing loans with other derivatives to hedge the pricing risk. Although the transition away from LIBOR-based indices may seem to add even more uncertainty to an already tumultuous two years, it suggests that the new normal is change itself.
By Emily Johansen (MUP '23), Associate Editor
Edited by Daniel Montoya (MUP/JD '24), Associate Editor
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