The Sunset of LIBOR and the Rise of SOFR: What You Need to Know
For years, interbank offered rates, including USD LIBOR (London Interbank Offered Rate), have been the most-referenced benchmark interest rates in the world. However, global indexing is moving to risk-free rates, including the Secured Overnight Financing Rate (SOFR) in the United States, with pivotal milestones taking place between now and the end of 2021.
Here’s what this transition means for the multifamily sector, dates to watch for, and steps to take now. View higher resolution version of timeline above here.
What is SOFR?
SOFR is based on overnight repurchase agreements, with cash borrowers posting U.S. treasuries as collateral with an agreement to buy them back at a specified date.
- The daily SOFR can be subject to spikes, so agency lenders will use a 30-day compounded average to smooth out volatility based on recommendations from the Alternative Reference Rates Committee (ARRC).
- SOFR has no credit component, so the market will likely accommodate by charging some additional spread for new SOFR-based products.
While enough futures and swaps activity has transpired since 2018 to develop the shorter part of a term curve, the longer part of the curve will be addressed by fourth quarter of 2020, particularly as the CME and LCH clearing houses convert their discounting methodology. With that, it is anticipated that the term curve will not be ready for use in trading until the first half of 2021 at earliest.
What Does the Transition to SOFR Mean for Existing Loans?
In multifamily lending, Fannie Mae and Freddie Mac have already begun a two-phase transition from LIBOR to SOFR and have begun closing SOFR-based loans. All existing loans with maturities after 2021 are expected to transition to SOFR in the next 14 months. As loans transition from LIBOR to SOFR, a spread adjustment will be made to reduce value transfer between the two indices. The spread adjustment will impact the loan’s effective rate and the loan’s “long trail of contracts”— all underlying loans and derivatives maturing after 2021.
As each variable-rate loan likely has an interest rate hedge, it’s important to understand what exposure looks like for these derivatives: the trigger for a fallback, the fallback rate, and how you will adjust the spread for that rate. Will there be a mismatch in the methodology and timing of transitioning a loan and hedge? Of course, we hope not to see mismatches, but much of this depends on fallback language in the loan and derivative documents. Upcoming revised definitions and a related supplement and protocol by the International Swaps and Derivatives Association (ISDA) are expected to be efficient and easy to adopt. But borrowers will need to understand the fallback language for their specific debt and derivative products, as well as how best to synchronize them as appropriate.
Fallbacks are just one of many things to look for in loan language. Loan documentation might require noteholders to approve the transfer to a new loan index, for instance, or the loans may have to stay on LIBOR even beyond 2021 as some banks may continue to use this index.
How Will the Transition to SOFR Impact New Loans?
For new SOFR loans, the big question has been how we’re going to price. Will investors add to the spread to compensate for SOFR’s lack of a credit component? For that early price discovery, one can look at Freddie Mac K Certificates, the agency’s most recent floating rate certification for indicators. Since December 2019, Freddie Mac has been dividing the certificates into a LIBOR class and a SOFR class — each with about a billion dollars of underlying LIBOR-based loans.
Initial guidance on new loans suggests that SOFR-based loans would price approximately 6 to 7 basis points wide of LIBOR-based loans, which is in line with the average basis of Freddie’s LIBOR and SOFR classes. Coincidentally, this also maintains roughly the same initial coupon at today’s rates. During the first month of trading, pricing has varied, with SOFR loan spreads ranging from as much as 6 to 7 wide of LIBOR loans to slightly inverted at times.
Dates to Watch
Despite some COVID-19 related delays on interim milestones and specific requirements, like those related to Federal Home Loan Banks and the CARES Act’s Main Street Lending Program, the overall LIBOR/SOFR timetable is moving forward on schedule.
As of September 30, Freddie Mac and Fannie Mae now only accept applications for SOFR-indexed loans.
As of October 16, the CME and LCH clearing houses switched from LIBOR to SOFR discounting. Also, in October, ISDA published its fallbacks protocol and definitions.
Frequently Asked Questions about the Transition to SOFR
- How are Commercial Lenders Responding?
Right now, it looks like commercial lenders are waiting to see how things play out on the agency side before moving forward with their own SOFR lending programs.
- How Will the Transition Impact Construction Lending?
As many underlying construction loans involve smaller banks and regional banks, SOFR has not been a requirement unless the lender has specified such. Even though these banks have not yet indexed to SOFR, all construction loans should have fallback language that allows for the flexible use of an alternative index.
- How Will the Transition Affect Long-Term Multifamily Rates?
Many long-term aspects of the LIBOR/SOFR transition are difficult to forecast right now. However, with SOFR derived from repurchase agreement activity and the Federal Reserve signaling near-zero rates through end of 2022, now may be an opportune time for this transition.
- Is LIBOR Going Away Altogether? What About Other LIBOR Alternatives?
Even as some banks and loan documentation continue to use LIBOR and alternative indices, like Ameribor, gain favor among players such as regional and community banks, SOFR has been the choice of agency lenders.
— Blake Lanford, Managing Director, Walker & Dunlop