How the End of LIBOR Will Impact the Commercial Real-Estate Industry
With the London Inter-Bank Offered Rate having officially reached its end, how will the commercial real-estate industry be impacted?
For many years, LIBOR, or the London Inter-Bank Offered Rate, served as a globally accepted benchmark, deriving rates from the U.S. dollar, the British pound, the Euro, the Swiss franc and the Japanese yen — all based on estimated transaction rates. This index has played a major role in a variety of financial products, including commercial real-estate mortgages.
However, this is all about to change. Earlier this year, it was announced that LIBOR would be phased out, with the vast majority of settings discontinued after December 31, 2021, and overnight and 12 months USD settings discontinued after June 30, 2023.
While questions over LIBOR's validity and highly publicized banking scandals have made the phase-out welcome news to some, there is no denying that the end of LIBOR will have a significant impact on commercial real estate.
LIBOR's influence on commercial real estate
LIBOR rates have long been used as a benchmark rate for determining interest rate charges for both commercial and residential mortgage loans, including new construction loans. Floating rate lenders would typically set rates as "LIBOR plus x%" — with the additional percentage being determined by factors such as the creditworthiness of the borrower and the loan duration.
The problem, however, is that LIBOR's rates were essentially based on estimates. While it was meant to track loan rates between international banks, so few loans were being performed that LIBOR panel members were asked what they would hypothetically expect to be charged for such transactions. This made the index easily prone to manipulation, resulting in the scandals that have led to the phasing out of the benchmark.
Notably, many have already begun preparations for transitioning away from LIBOR. A 2019 survey by the Mortgage Bankers Association found that 92 percent of commercial mortgage lenders were planning to transition away from the benchmark.
77 percent had also adjusted language related to LIBOR in new loan documents. For example, documents used in floating-rate transactions often name an alternative rate, or give the lender the ability to choose a LIBOR alternative if needed.
Despite these positive signs, less than half of those surveyed were confident in what they would use as an alternative — a problem that has persisted in 2021.
What are SOFR and other alternative benchmarks?
Right now, there remains some uncertainty regarding which benchmark will be used to replace LIBOR. SOFR (Secured Overnight Financing Rate) is currently expected to be used in the United States and the United Kingdom, in part because its rates are based on observed transitions — not estimates.
Prepared by the Federal Reserve Bank of New York, one of the biggest factors contributing to SOFR's momentum is its adoption by Fannie Mae and Freddie Mac, which have been issuing securities backed by SOFR-based loans for the last few years. The introduction of the H.R.4616 - Adjustable Interest Rate (LIBOR) Act of 2021 also aims to ease the transition by using SOFR for existing LIBOR contracts that don't have a defined fallback option.
However, this hasn't led to a consensus by any means. Other potential replacements that have gained some traction include the Bloomberg Short Term Bank Yield Index (BSBY), which is based on anonymized transactions and executable quotes; Ameribor, which uses a volume-weighted transaction average; and the ICE Bank Yield Index, which uses a rolling 5-day window to aggregate data from primary and secondary market transactions. Notably, BSBY has already been used by JPMorgan Chase and Bank of America.
While there is certainly still plenty of time before LIBOR is completely phased out, lenders who are unable to agree on a new standard to follow could temporarily experience slowdowns in commercial lending until they fully adapt to a new index.
Currently, the sheer number of LIBOR alternatives available and the lack of a clear consensus on which to use could pose challenges as commercial real-estate investors try to engage with different banks.
Related: You Are Your Best Real-Estate Asset
What comes next for commercial real estate?
The dust hasn't fully settled in the wake of the LIBOR scandals — and it will still be some time before LIBOR rates no longer play any role in the commercial real-estate sector.
However, investors and lenders in this space would do well to start making transition plans now. While H.R. 4616 is expected to pass and help reduce transition risk for legacy transactions, lenders and investors shouldn't leave their contracts up to chance. Financial instability and even litigation are possibilities for commercial real-estate lenders who aren't proactive in addressing these issues.
There are also concerns that transitioning to a new, non-LIBOR-backed rate could cause significant changes to the loan itself. Lenders must be careful to ensure that changes to legacy loans are ultimately fair to all parties — otherwise, either lenders or investors could suffer significant financial harm, resulting in serious problems for commercial real estate.
Many others in the industry are already taking steps to mitigate risk for contracts that won't have matured before LIBOR ends entirely. The sooner both investors and lenders start making plans, the better they will be able to navigate these shifts in the market.
Entrepreneur Editors' Picks
'No One Believed' This Black Founder Was the Owner of a Liquor Brand in 2012. He Launched to Great Acclaim — Then Lost It All. Here's How He Made a Multi-Million-Dollar Comeback.
Inspired by Elon Musk's Twitter Takeover, Here Are 10 Marketing Tactics That Will Help You Make the Most of Big Changes to Your Company
These Brothers Transformed a High School Project Into the Largest Online Soccer Retailer of All Time. Here's What the World Cup Means for Business Now.
'I Just Lost All My Life Savings': Michigan Woman Lost $15,000 in Facebook Marketplace Car Scam
This Founder Was Dismayed by Food Waste in the Restaurant Industry, So She Started a Zero-Waste Grocery Line That Now Caters Events for Nike
Netflix's Secret Club Allows Members to Preview Content Before Anyone Else — But There's a Catch
Franchising Could Be the Secret to Reaping the Rewards of a Down Economy. Here Are 5 Reasons Why.