How Will Commercial Real Estate Be Affected by SOFR?
Last July, the United Kingdom’s Financial Conduct Authority announced that the London Interbank Offered Rate (LIBOR) may cease to exist at the end of 2021. LIBOR has been used as a global benchmark for a “risk free”debt rate in recent history and is used in about $200 trillion of U.S. financial instruments, including many in commercial real estate. The death of LIBOR follows years of scandals and manipulation accusations against banks whose submissions determine the rates.
Within the United States, LIBOR is set to be replaced by SOFR — the Secured Overnight Financing Rate. SOFR is a product of cooperation between the New York Federal Reserve Bank and the Alternative References Rates Committee (ARRC), a group of independent private banks and bankers convened by financial sector public agencies. This rate will be determined through actual transactions completed in overnight borrowing, which ideally would be less prone to manipulation than LIBOR, as LIBOR is determined by quoted estimates and not transactional rates.
The question becomes- what could this mean for current debtors, lenders and other instrument holders? It is difficult to tell this early; the New York Fed won’t publish SOFR until April 3, 2018. Nevertheless, the New York Fed has published several reports delineating the methodology of SOFR, as well as historical data constituting approximate SOFR rates over the past three years. However, the New York Fed has not yet determined exactly how to determine forward-looking interest rates, noting only that rates will be based on SOFR derivative markets (CME announced they will launch SOFR futures beginning May 7, 2018).
Outside the methodology changes in determining the SOFR rate, implementation will also have to be handled slightly differently, as it will at first be only an overnight interest rate rather than the multiple rates (overnight and term) published by LIBOR. However, ARRC anticipates that creating a single floating rate based on compounded daily averages over the required term will ameliorate this issue. The benefit of the expected three-year transition period also includes the possibility to tweak the implementation of SOFR to meet requirements by borrowers and lenders. The potential detriment is in negotiated instruments that use LIBOR benchmarks that currently have maturities past year-end 2021, the expected timing of the end of LIBOR publication. While only affecting floating rate instruments, these situations could prove difficult to maneuver as it is a unique and interesting scenario to say the least.
As to how SOFR will affect commercial real estate, early projections and backward-looking analysis have shown that SOFR rates will likely produce slightly less volatility than LIBOR rates, which could influence a slight uptick in floating rate debt instruments in the real estate market. Additionally, the market-based determination will be inherently less susceptible to manipulation and corruption, which will hopefully ease concerns for early adopters to the benchmark.
Overall, it is unlikely that the transitional frame from LIBOR-based rates to SOFR-based rates will create any major shift in debt underwriting, benefiting heavily from the 3+ year transitionary phase and continual analysis and flexibility enabled by ARRC through its implementation. The main concerns for debt holders will mainly arise from instruments whose term lasts past LIBOR’s sunset that do not have contractual language regarding a successor rate. Luckily, the timeline should allow any instrument holders to amend the contracts to reflect these system changes.