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LIBOR & SOFR Explained: A Must Know For Multifamily Investors

The first time I heard about LIBOR and SOFR, it was when our mortgage broker was doing a presentation on the current state of financing in the multifamily space. I was confused then, so I decided to go down a research rabbit hole. Dozens of articles and two cups of coffee later, I came out with a better grasp on what our mortgage broker was referring to when she mentioned these two indexes.

If you’re at all confused by these terms, don’t worry - you aren’t alone! And the objective of this article is to help you have a better understanding of what these terms mean and why they matter to anyone investing in multifamily real estate. There’s no better time to be doing a deep dive into LIBOR and SOFR (which sounds like sulfur to me), considering that we’re so close to June 30, 2023 (more on this later ;) ).

So without further ado, let’s do a deep dive into the murky waters of LIBOR, its fall, and the rise of its successor, SOFR.

What Do You Mean By “LIBOR”?

LIBOR stands for “London Interbank Offered Rate.” LIBOR is a benchmark rate used to calculate the interest rates on many commercial real estate adjustable rate loans, among other markets. “Corporate loans, government bonds, [and] credit cards” have historically been indexed off LIBOR. LIBOR is the interest rate on the money banks loan each other in the short term. According to Apartment.Loans, LIBOR was the basis for more than $370 trillion of financial products across five different currencies.

The thing is, LIBOR is calculated using an average of interest rates provided by member banks.

LIBOR was first introduced in the 1970s. It’s been heavily used since the 1970s and 1980s for transactions by “223 members and 37 firms as of 2008.” In 2021, the financial contract value involving LIBOR was estimated at $250 trillion. Bank of America was among this group of banks. Many of them were overseas banks that the U.S. has no control over, including Credit Suisse, Deutsche Bank, and Barclays Bank.

This led to fraud, and accusations of these banks misrepresenting their averages in order to game the system and generate more profit.

Bad Banks Are Bad For Business

After the Great Financial Crisis in 2007, U.S. borrowers became upset with the volatility in their mortgage rates that used LIBOR as an index. The U.S., having no control over overseas banks, saw this as a big problem.

In 2012, it was uncovered that Barclays Bank was committing fraud in the average interest rates they were reporting. The LIBOR rates were being influenced by this bank among others in order to allow them to charge higher interest rates to borrowers, and make more money. The cost of this fraudulent behavior was estimated to be $73,518,000 USD. Fannie Mae and Freddie Mac reportedly lost $3 billion dollars. After the US Department of Justice investigated the fraud for themselves, they discovered that multiple banks were in on it, and decided to find alternative benchmark rates to LIBOR.

As a result, it was decided by the powers that be to lean away from LIBOR and transition to a more reliable and accurate benchmark rate - Secured Overnight Financing Rate (SOFR).

In 2021, it was made official - The Alternative Reference Rates Committee (ARRC) decided that SOFR would be used instead of LIBOR to determine the U.S. adjustable-rate mortgage rates. Starting on June 30, 2023, these mortgage rates will no longer be determined using LIBOR.

But why is SOFR a more attractive option than LIBOR?

SOFR: A Superior Option?

SOFR is “a broad measure of the borrowing of cash overnight collateralized by Treasury securities, is based on actual transactions rather than a survey.” LIBOR, as we mentioned earlier, is forward looking, meaning it’s based on future projections. These future projections are determined through a survey of panel members who have a vested interest in reporting high interest rates. SOFR is based on past transactions and relies on a 30-day average. This is the main reason why SOFR is seen as more reliable and accurate.

SOFR is also considered to be more robust and representative than LIBOR. SOFR has a bigger sample size. While LIBOR has a sample size of $1 billion a day, SOFR has a sample size of $1 trillion a day.

Ramifications Of The SOFR Transition

Many of the existing LIBOR-indexed loans will have expired by the time LIBOR is phased out. This means that there won’t be any need for changes in the rate-pricing. But for the contracts that used LIBOR and won’t expire until after 2023, the reference rate will likely be adjusted. There’s a good chance there is “fallback language” in these contracts detailing how the loan should be priced if and when LIBOR rates become unavailable.

However, the transition may result in class-action lawsuits to settle contract disputes regarding the changes that borrowers will incur as a result.

It is widely seen as a good thing for commercial real estate investors that LIBOR is being replaced by SOFR.

But these benefits are more long term, and there may be some bumps during the transition. For example, in 2018, there was a sizable loss of confidence in the reliability of SOFR after the Federal Reserve Bank of New York confessed it used incorrect data to calculate SOFR.

SOFR will mainly impact only adjustable-rate loans, and Freddie Mac and Fannie Mae multifamily loans.

Fixed rate loans, like the majority of CMBS loans, are unlikely to be impacted assuming the transition from LIBOR to SOFR doesn’t cause a major change in interest rates.

Commercial real estate investors also benefit from the reduced risk of fraud. Since SOFR is more reliable and transparent, it is less likely to be manipulated. As mentioned earlier, SOFR is determined using a wider pool of transactions compared to LIBOR, meaning there is more accuracy in the rate.

SOFR to The Moon

Moving forward, investors need to prepare for the transition. Investors with exposure to variable rates should plan before the transition. Understanding how this transition will impact their particular loans and the “fallback language” in their contracts is essential once LIBOR is no longer accepted.

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