Commercial mortgage lenders are starting to move toward the Secured Overnight Financing Rate (SOFR) as the new benchmark for new floating-rate originations. Market participants who spoke with Real Estate Capital USA raised the potential for some operational or integration issues around the transition – and some things to watch out for as the December 31 sunset for LIBOR nears.
Here are five things to know about what comes next.
1- Problems aren’t a foregone conclusion, but are a possibility given the scope of the transition
Banks are under substantial pressure to follow the guidelines set out for the LIBOR to SOFR transition and appear to be falling in line, Lisa Pendergast, executive director of the Commercial Real Estate Finance Council, told Real Estate Capital USA. But the concerns about the transition are more than just rewriting loan documents to account for new language.
“I think we are in a good place, and we’re starting to see folks talk about and quote SOFR-based loans. But it’s been a kicking and screaming exercise because there are so many parties involved,” said Pendergast. “My concerns over the transition are also operational – operational issues can blow you up just as much as credit issues. We’re hoping for a smooth transition.”
2 – By December 31, all LIBOR-based CMBS and CRE CLO loans should be securitized
Fixed-rate US commercial real estate loans tend to be priced off of US treasuries, with floating-rate loans typically priced at a spread over LIBOR. Within the securitization markets, single-asset/single borrower commercial mortgage-backed securities deals and commercial real estate collateralized loan obligations are typically floaters that are priced over LIBOR.
“I think we are hitting the point where we are getting down to brass tacks. If you’re writing loans for LIBOR and securitizing those loans, you need to [start] think about SOFR,” Pendergast said. “You will have to finish 2021 having securitized all LIBOR loans and what we do know is that SASB and CRE CLOs will be impacted.”
Finally, the benchmark for conduit loans will also change. Conduits have been priced off the swap rate – the cost to convert a fixed interest rate to a floating interest rate – since the 1998 Russian debt crisis. “This will need to be converted to SOFR or CMBS will simply have to be priced over Treasuries, like the corporate bond market,” Penderfast said.
3 – SOFR isn’t LIBOR
SOFR, which tracks the overnight borrowing costs of loans collateralized by US treasuries, is a different beast than LIBOR. Quite simply, LIBOR is a forward-looking survey of projected borrowing costs while SOFR is a backward-looking analysis of what borrowing costs were.
“One concern that borrowers have raised is that SOFR is a treasury rate, rather than a credit-sensitive rate like the Bank Yield Index, Ameribor or Bloomberg’s BSBY rate,” Pendergast said. “The concern as a lender is that in 2009 or 2020, the treasury rate plummeted because of a flight to quality.”
This means that in situations where the treasury rate drops, a borrower’s rate will decline while a lender’s financing costs could go through the roof. “There are concerns that there is somewhat of a mismatch,” Pendergast said.
4 – New benchmark, new loan documents
A new benchmark means that lenders are writing new language around SOFR into loan documents. CMBS fund managers are already looking at that when evaluating new bonds.
“All of our loan documents have provisions for alternative benchmarks other than LIBOR,” said Ed Shugrue, a portfolio manager for the CMBS-focused RiverPark fund. “I’ve got zero concern for our portfolio right now.”
Borrowers and lenders will have to do their due diligence to make sure all of their debt confirms to the new standards in the coming years, Karen Schenone, a fixed-income product strategist at BlackRock.
“I think the markets are in good shape, but I still think we’re going to get to the summer of 2023 and people are definitely gonna have to check documents and see what their actual bonds are saying the rates will be,” she said.
5 – SOFR… or maybe prime?
Although SOFR is widely expected to take LIBOR’s place, there are still some other possibilities.
Shlomi Ronen, managing principal of Los Angeles-based investment management and advisory Dekel Capital, said the firm is in the process of closing a construction loan that is being priced over prime. The loan is being funded by a regional bank with a national presence.
Ronen noted that lenders are still adapting to the change – and that borrowers are taking it all in stride.
“It feels like for existing loans, banks are waiting until the last minute to make changes. Many of these loans are short-term in duration, there is always a chance that the loan will get paid off,” he said. “From the borrower standpoint, as long as the index that the bank changes to doesn’t impact the overall rate on the loan, for the most part they’re not going to care.”
The impact will be seen however on loans with caps, with borrowers likely having to go and purchase new interest rate caps. “There will be a conversation about the index and what the right strike point is on the caps and costs,” Ronen said.
So everything will be fine?
Probably. Still, converting trillions of dollars of loans is bound to cause some administrative headaches, market participants told Real Estate Capital USA.
“I think it’s a very much wait-and-see [situation] and everyone is taking a very casual approach to it,” said Alan Todd, a managing director and head of CMBS strategy at Bank of America. “Everyone knows that it has to get done, and I think it’s one of those things that I think people will finalize where they’ll come to some kind of consensus as it gets closer. It’s almost like when you hear about the deficit talks about a debt ceiling – there’s talk and talk but they don’t come up with a solution until two minutes to midnight.”