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SOFR: Secured Overnight Financing Rate in Commercial Real Estate
Most commercial real estate loan interest rates are currently set by using the LIBOR (London Interbank Offered Rate) as a benchmark. LIBOR is calculated by measuring the interest rates at which banks lend to each other (specifically short-term, unsecured lending). However, due to a variety of reasons, banks are set to stop reporting LIBOR rates by the end of 2021, and SOFR (Secured Overnight Financing Rate) is the reference rate that will replace it.
- SOFR is Set to Replace LIBOR By 2021
- Why a Replacement for LIBOR is Needed
- How The Federal Reserve Developed the Secured Overnight Financing Rate (SOFR)
- How SOFR Could Impact Commercial Real Estate Loans
- Questions? Fill out the form below to speak with a commercial real estate loan specialist.
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SOFR is Set to Replace LIBOR By 2021
Most commercial real estate loan interest rates are currently set by using the LIBOR (London Interbank Offered Rate) as a benchmark. LIBOR is calculated by measuring the interest rates at which banks lend to each other (specifically short-term, unsecured lending). However, due to a variety of reasons, banks are set to stop reporting LIBOR rates by the end of 2021, and SOFR (Secured Overnight Financing Rate) is the reference rate that will replace it.
Why a Replacement for LIBOR is Needed
Over the last few years, banks have been increasingly reluctant to report LIBOR rates, partially due to the fact that banks are doing significantly less unsecured lending than they did in the past, and partially due to the LIBOR scandal of 2012. The scandal was uncovered when regulators discovered that LIBOR had been intentionally manipulated by banks in for several years in order to increase their profit margins. This lead to serious investigations of banks including Barclay’s, Bank of America, Citibank, Credit Suisse, HSBC, UBS, and others.
Multiple bankers were charged with fraud, due to the fact that they would often collaborate with traders in order to increase margins on trades. Since LIBOR is used to set interest rates for credit cards, student loans, residential mortgages, and commercial real estate loans (among many other kinds of debt), this manipulation likely had a negative affect on both average consumers and institutional real estate investors. Some experts believe that the scandal may also have significantly contributed to the 2008 financial crisis.
How The Federal Reserve Developed the Secured Overnight Financing Rate (SOFR)
In the aftermath of the LIBOR scandal, the Federal Reserve decided that American loans and financial products needed to be benchmarked with a more reliable index— one that would would regularly be reported and would not easily be subject to manipulation. To do this, they formed the Alternative Reference Rate Committee (ARRC) in 2014.
By mid-2017, the Committee recommended the use of the Secured Overnight Financing Rate, or SOFR. Unlike LIBOR, which measures interbank lending, SOFR measures the overnight trading rate for the repurchases (repos) of U.S. treasury bonds. Since the exchange of U.S. Treasury Bonds is unlikely to stop anytime soon (unlike unsecured interbank lending), the ARRC saw this as a more stable source of market interest-rate information.
How SOFR Could Impact Commercial Real Estate Loans
While LIBOR will be reported until the end of 2021, both commercial real estate lenders and borrowers are naturally anxious to understand how the switch could impact interest rates. This is especially of interest for borrowers who have floating rate loans, including floating-rate CMBS financing as well as the many variable rate Fannie Mae® and Freddie Mac® Multifamily loans currently on the market.
Some are also concerned due to the fact that inaccuracies have been found during calculations of SOFR during the last 12 months. If SOFR is not widely adopted due to these issues, most adjustable commercial real estate loans have a built-in switch mechanism that will kick in if LIBOR is no longer calculated. In most cases, this will result in the loan being pegged to a spread based on the prime rate, the lowest bank interest rate available to consumers. However, this automatic switch is not ideal, as it could lead to a variety of issues and inconsistencies.
Questions? Fill out the form below to speak with a commercial real estate loan specialist.
Related Questions
What is the Secured Overnight Financing Rate (SOFR)?
The Secured Overnight Financing Rate (SOFR) is a rate tied to the cost of interbank Treasury repurchases. It was created by the Federal Reserve and first published in April 2018, and is set to replace LIBOR (the London interbank offered rate) via a gradual phase-in period which began Jan. 1, 2022, and will end June 30, 2023. SOFR measures the overnight trading rate for the repurchases (repos) of U.S. treasury bonds, and is seen as a more stable source of market interest-rate information than LIBOR. Learn more about SOFR here.
How does SOFR affect commercial real estate financing?
SOFR is set to replace LIBOR by 2021, and this could have a significant impact on commercial real estate financing. Many loans include fallback language, which give lenders some flexibility in determining how to transition from LIBOR. A large number of loans will shift to a comparable SOFR automatically. If this clause isn’t in your mortgage, your lender may request an amendment to the document to clarify the transition. In most cases, this will result in the loan being pegged to a spread based on the prime rate, the lowest bank interest rate available to consumers. However, this automatic switch is not ideal, as it could lead to a variety of issues and inconsistencies.
As there are multiple possible scenarios, you should consider contacting your lender to discuss your specific financing packages if a transition plan is not clearly stated. Additionally, inaccuracies have been found during calculations of SOFR during the last 12 months, so it is important to be aware of this when considering SOFR as a benchmark rate.
What are the advantages of using SOFR for commercial real estate financing?
The main advantage of using SOFR for commercial real estate financing is that it is a more reliable index than LIBOR. SOFR is based on the overnight trading rate for the repurchases (repos) of U.S. treasury bonds, which is unlikely to stop anytime soon. This makes it a more stable source of market interest-rate information than LIBOR, which measures interbank lending. Additionally, SOFR is not subject to manipulation like LIBOR, making it a more reliable index for commercial real estate financing.
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What are the risks associated with SOFR for commercial real estate financing?
The main risk associated with SOFR for commercial real estate financing is the potential for inaccuracies during calculations. This could lead to inconsistencies in interest rates and other loan terms. Additionally, if SOFR is not widely adopted, most adjustable commercial real estate loans have a built-in switch mechanism that will kick in if LIBOR is no longer calculated. In most cases, this will result in the loan being pegged to a spread based on the prime rate, the lowest bank interest rate available to consumers. This could lead to higher interest rates and other issues.
You should consider contacting your lender to discuss your specific financing packages if a transition plan is not clearly stated. For more information, please see this article.
How does SOFR compare to other financing rates for commercial real estate?
SOFR is a benchmark rate that is calculated by measuring the interest rates at which banks lend to each other (specifically short-term, unsecured lending). It is set to replace LIBOR by the end of 2021, and is expected to be more accurate and reliable than LIBOR. SOFR is also expected to be more stable than LIBOR, as it is based on actual transactions rather than estimates. In addition, SOFR is expected to be more transparent than LIBOR, as it is based on a larger sample size of transactions. As a result, SOFR is expected to be a more reliable and accurate benchmark for commercial real estate financing rates.
In addition to SOFR, other financing rates for commercial real estate include the prime rate, the lowest bank interest rate available to consumers, and the CMBS financing rate, which is based on the performance of commercial mortgage-backed securities. Additionally, Fannie Mae® and Freddie Mac® Multifamily loans also have variable rate options.
What are the best strategies for using SOFR in commercial real estate financing?
The best strategies for using SOFR in commercial real estate financing depend on the type of loan you are looking for. For floating-rate loans, such as CMBS financing and Fannie Mae® and Freddie Mac® Multifamily loans, it is important to understand how the switch from LIBOR to SOFR could impact interest rates. To do this, borrowers should consider the potential inaccuracies in SOFR calculations and the built-in switch mechanisms that could kick in if LIBOR is no longer calculated. In most cases, this will result in the loan being pegged to a spread based on the prime rate, the lowest bank interest rate available to consumers.
For fixed-rate loans, borrowers should consider the potential for SOFR to increase over time. Since SOFR is based on the overnight trading rate for the repurchases (repos) of U.S. treasury bonds, it is likely to increase as the Federal Reserve continues to raise interest rates. Borrowers should also consider the potential for SOFR to be more volatile than LIBOR, as it is based on a single market rather than a variety of markets.