Until they feel that banks are on the same page, some borrowers will stay away from LIBOR’s supposed replacement

By Mack Burke of the Commercial Observer – March 03, 2020

In 2017, the Secured Overnight Financing Rate (SOFR) was picked as the preferred successor to the U.S. Dollar London Interbank Offered Rate (LIBOR), the widely used benchmark reference rate index that’s been around since the 1970s and is scheduled to expire at the end of 2021.

Last summer, the Alternative Reference Rate Committee (ARRC), the entity that was tasked with choosing a new reference rate and settled on SOFR, released fallback language for markets to prepare for the transition. Following the release, major lenders and institutional players moved quickly to begin the shift to SOFR.

“Smart investors saw this [transition] coming for a couple of years now and tried to prepare accordingly,” said Rod Kritsberg, the co-founder and CIO of KPG Funds.

Last year, in December alone, there were numerous examples of the conversion. Some major investment banks began implementing ARRC fallback language in all their single-asset, single-borrower (SASB) CMBS securitizations, listing SOFR as the alternative, and on December 12, Freddie Mac issued a CMBS conduit that was all SOFR — the FREMF 2019-KF3 deal. A separate example came a day later on Dec. 13, when Royal Dutch Shell closed on one of the first credit facilities linked to SOFR, a $10 billion revolving credit facility coordinated by Bank of America and Barclays. And earlier this month, the Federal Housing Finance Agency announced that Fannie Mae and Freddie Mac would no longer purchase loans indexed to LIBOR in a move to encourage their approved lenders to adopt a new benchmark to help avoid any cash flow risks.

At the end of 2019, the Commercial Real Estate Finance Council (CREFC) estimated that around $1.3 trillion of commercial real estate debt is indexed to LIBOR, and of that amount, $200 billion is securitized, a majority of which — 53 percent — is agency CMBS, with SASBs following behind at 33 percent. LIBOR touches a much larger share of many other markets, but its phase-out is obviously significant in the real estate world.

For borrowers, there is currently a divide in the market over SOFR’s prospects, mainly around its duration flexibility, its liquidity as it relates to the market for purchasing caps and forward rate locks and spread adjustments to account for the differences between the two indices.

“[SOFR] should be ubiquitous, tradeable, syndicatable and assumable,” said Jake Reiter, the president of real estate investor Verde Capital. “It’s about its usability.”

“For the longest time you had paper in the LIBOR market that was based on risk and duration,” Reiter added. “SOFR is not controversial and it’s less readily manipulated, but how do we create and foster a forward-looking and liquid market for SOFR? It’s a wait-and-see, because you can’t control an underlying index.”

At the CREFC Miami 2020 conference in January, lenders worried that the market isn’t ready for SOFR, or that floating-rate borrowers aren’t as sophisticated on the issue as they should be at this stage. Major lenders also said investors are “laser-focused” on the LIBOR phase out and want the ARRC fallback language included in deals.

“Smart investors saw this [transition] coming for a couple of years now and tried to prepare accordingly,” said Rod Kritsberg, the co-founder and CIO of KPG Funds. “As a borrower, with an interest rate based on LIBOR, plus a spread, the goal in loan negotiations is for the total rate to stay the same when SOFR replaces LIBOR. The concern is that with current LIBOR being so low, coupled with tight spreads, the new SOFR rate and corresponding new spread doesn’t exceed the total interest rate on existing LIBOR loans. Many lenders push back on a negative spread in loan documents. The hope is that lenders take that into account when the changeover comes and work it out with borrowers.”