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LIBOR: London Interbank Offered Rate
The London Interbank Offered Rate, or LIBOR, is the interest rate central banks in London are charged for short-term borrowing.
What is LIBOR: London Interbank Offered Rate and How is it Used In Commercial Real Estate Financing?
LIBOR is primarily used as a reference rate for other debt instruments. Some examples of commercial real estate financial instruments include short-term bank loans and floating-rate commercial real estate loans. LIBOR is also used as an index for floating rates lending so banks can mitigate risk by tying loans to an index that fluctuates, while simultaneously reducing borrowing costs by lending off of a lower-cost (short-term) index.
LIBOR is directly and immediately impacted by financial conditions across the globe including fluctuations in currencies, monetary policy, and so-on. As a result, lenders use LIBOR to adjust the floating interest rates. Using a floating rate that is tied to the LIBOR index offers a lender protection. Lenders benefit from rising interest rates, as opposed to fixed interest rates that remain the same regardless of an increase or decrease in the market interest rates as driven by micro and macro economic conditions.
Additionally, lenders add a margin, or percentage points, to the LIBOR index when calculating the borrower’s interest rate. This margin remains fixed over the period of the loan. Therefore, if a borrower takes out a loan with a 3% margin and a LIBOR index of 5.5% then the floating rate would be 8.5%. However, if the LIBOR index increases by 2% before the loan has been paid off, then the new floating rate would be 10.5%.
It should be noted that the margin always remains at the same rate of 3% -- that is the lender's profit. Because the margin is determined by the lender, lower margins are only offered to the most creditworthy. In contrast, higher margins are required for higher risk loans (this is how lenders manage their risk-adjusted returns).
LIBOR can be tracked in multiple currencies (USD, EUR, GBP, JPY, CHF) and is also available in seven different maturities (1 day, 1 week, 1 month, 2 months, 3 months, 6 months, 12 months).
LIBOR is Being Replaced With SOFR
As a result of several factors, including the LIBOR scandal of 2012, major banks will stop reporting LIBOR in 2021. The Federal Reserve has decided to replace LIBOR with the Secured Overnight Financing Rate, or SOFR. In August 2018, Fannie Mae® issued the first securities backed by SOFR. Experts believe that SOFR will be a more reliable and accurate reference rate, and that it may be somewhat less volatile than LIBOR. Right now, however, most commerical loans are still linked to LIBOR.
10-year Historic 1 Month LIBOR
This chart represents the historic price fluctuations of the 1-month LIBOR over the last 10 years.
Related Questions
What is a mini perm loan in commercial real estate?
A mini perm loan in commercial real estate is a loan used to finance an income-generating commercial property that has recently been built, but does not yet have the income to qualify for permanent financing. It allows the borrower to pay off their construction loan, while giving the property time to generate more income. A variety of property types qualify for mini perm loans, including multifamily apartments, retail, office, and industrial properties. Mini perm loans can technically be classified as bridge loans, but they typically offer somewhat lower interest rates and generally have substantially longer terms.
What are the advantages of a mini perm loan?
The main advantage of a mini perm loan is that it allows the borrower to pay off their construction loan, while giving the property time to generate more income. Additionally, mini perm loans typically offer lower interest rates and longer terms than bridge loans. This makes them an attractive option for commercial borrowers who want to ensure that their property will be financed from day one.
Sources: www.commercialrealestate.loans/commercial-real-estate-glossary/mini-perm-loans, /commercial-construction-loans, /permanent-financing, /commercial-real-estate-property-types, /apartment-loans, /retail-property-loans, /office-building-loans, /industrial-property-loans, /commercial-bridge-loans
What are the disadvantages of a mini perm loan?
The main disadvantage of a mini perm loan is that it is a short-term loan, with terms of between 2 and 5 years. This means that the borrower must refinance the loan within this time frame, or risk defaulting on the loan. Additionally, mini perm loans may have higher interest rates than permanent loans, and may not be available to all borrowers. Non-recourse mini perm financing is generally only reserved for well qualified borrowers, and may come with higher interest rates.
What are the eligibility requirements for a mini perm loan?
The eligibility requirements for a mini perm loan vary depending on the lender, but generally speaking, the borrower must have a good credit score and a solid track record of successful real estate investments. Additionally, the property must have been recently built and must have the potential to generate enough income to qualify for permanent financing. The loan amount and terms will also depend on the lender, but typically, mini perm loans are offered with terms of up to five years and loan amounts of up to 80% of the property's value.
What are the typical terms of a mini perm loan?
In most cases, mini perm loans will have terms of between 2 and 5 years, which should give a commercial property more than enough time to reach sufficient occupancy to qualify for a permanent loan from a bank, life company, or CMBS lender. Some mini perm loans are interest-only, which can be ideal from a borrower’s perspective, especially since the property may not be generating much income yet. In other cases, mini perm loans may have 20 or 25-year amortizations. In certain cases, mini perm loans may have terms longer than 5 years, but these often have ‘incentives’ to encourage borrowers to pay them off earlier, rather than later.
These longer-term mini perm loans can be divided between hard mini perm loans and soft mini perm loans. Hard mini perm financing has a hard 7-year balloon date, after which the borrower must pay off the principal or default, whereas soft mini perm financing may carry longer terms (say 10 years+), with increasing incentives to pay off the loan. While some mini perm loans may be non-recourse, non-recourse mini perm financing is generally only reserved for well qualified borrowers, and may come with higher interest rates.
What are the typical interest rates for a mini perm loan?
Interest rates for mini perm loans can vary depending on the lender, the borrower's creditworthiness, and the type of loan. Generally, mini perm loans have interest rates that are higher than permanent loans, but lower than construction loans. Hard mini perm loans may have interest rates that range from 6-10%, while soft mini perm loans may have interest rates that range from 8-12%.