Commercial mortgage lenders are starting to move towards 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.
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, says. 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,” Pendergast says. “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.”
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] to think about SOFR,” Pendergast says. “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,” Pendergast says.
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 says. “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,” she says.
New benchmark, new loan documents
A new benchmark means 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,” says 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 adheres to the new standards in the coming years, says 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.”
“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”
Commercial Real Estate Finance Council
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, says 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
Ronen notes 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 says. “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 says.
KBS has seen its lending activity move to a more normal level as the US emerges from the covid-19 pandemic.
The Newport Beach, California-based real estate investment trust anticipates about $1.5 billion of loan transaction volume this year. “While this is about an average year for us, last year wasn’t too quiet – we completed about $1 billion of lending volume in 2020 despite the pandemic,” Rob Durand, executive vice-president of finance, tells Real Estate Capital USA.
The firm is having conversations with its lenders on the language around the transition to SOFR as the December 31 sunset for the use of LIBOR approaches, with Durand explaining that the firm has been scouring its portfolio to review any relevant language.
“We are seeing some lenders gravitate toward the Bloomberg BSBY index or SOFR, depending on the deal and the lender. There is some flexibility toward either,” Durand says. “Of late, we are seeing BSBY gain more acceptance.”
The question around BSBY is an interesting one, with Durand noting that the index might be a slightly more useful benchmark for commercial real estate loans as it more directly mirrors the attributes of LIBOR. That said, the BSBY rate is not managed by the Federal Reserve and doesn’t have the same current depth of use that SOFR does.
“There is a sense that BSBY more accurately reflects the banks’ cost of funds and, unlike SOFR, has a credit component to it,” Durand says. “BSBY’s one-month rate is more like the old LIBOR one-month rate and could fit more similarly into existing systems that use LIBOR.”
So, everything will be fine?
Probably. Still, converting trillions of dollars of loans is bound to cause some administrative headaches, market participants tell 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,” says 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.”