Multifamily Industry Prepares for LIBOR Transition
- The London Interbank Offered Rate (LIBOR) has been the multifamily industry's benchmark for determining interest rates for adjustable-rate mortgages for decades.
- LIBOR's expiration in 2021 is leading multifamily lenders to prepare for a transition to an adjustable-rate alternative, which is likely to be the Secured Overnight Financing Rate (SOFR).
- The mortgage industry sees several benefits of using SOFR, which is based on actual transactions instead of self-reported data or estimates.
For decades, the multifamily industry has used the London Interbank Offered Rate (LIBOR) as the benchmark for determining interest rates for adjustable-rate mortgages. An estimated $1.1 trillion in outstanding commercial mortgage loans are tied to LIBOR.
With LIBOR set to expire at the end of 2021, multifamily lenders are preparing to transition to an adjustable-rate alternative. Replacing such a widely used benchmark of the financial industry is a significant undertaking. Although the mortgage industry has begun to prepare, there is still work to be done.
Issues Around the Use of LIBOR
The LIBOR index is an average of interest rates submitted by major banks across the globe. At the end of the financial crisis, there was controversy regarding market manipulation by participants. Several banks misrepresented their submissions to achieve better returns and to avoid signaling financial weakness. This exposed LIBOR’s major flaw: it relied on self-reported data, which did not always reflect actual transactions, and left it vulnerable to malfeasance.
Another flaw that has since been observed is the lack of meaningful data to ensure LIBOR’s reliability. The volume of transactions contributing to LIBOR has declined; the rate is now based on only a handful of transactions.
By 2017, as it had become clear that LIBOR was no longer a reliable index, financial regulators announced that they would not support LIBOR after 2021. The Alternative Reference Rates Committee (ARRC), a group of private-market participants convened by the Federal Reserve Board and the New York Fed, was established to explore reference rate alternatives as concerns grew over LIBOR. The Committee recommended the Secured Overnight Financing Rate (SOFR) as the preferred alternative to replace LIBOR.
SOFR as an Alternative to LIBOR
Several characteristics of SOFR differentiate it from LIBOR. SOFR is calculated based on actual transactions, not self-reports or speculative estimates. Additionally, the volume of transactions upon which SOFR is based is larger than that of any other U.S. money market. This ensures transparency and prevents manipulation. Furthermore, SOFR is not at risk of being discontinued, as it is derived from the U.S. Treasury market.
ARRC has recommended that the mortgage industry transition to SOFR, and Fannie Mae and Freddie Mac have started the process. However, representatives have stated that the transition could take 12 to 18 months. Additionally, several large institutions have already issued debt using SOFR, which reflects early confidence in the new benchmark. Fannie Mae issued three floating-rate notes valued at $6 billion in July 2018, which were the market’s first-ever securities priced to SOFR.
Although it’s yet to be specifically determined how rates on existing adjustable-rate mortgages tied to LIBOR will be calculated going forward, lenders are working to insure a smooth transition. A recent Mortgage Bankers Association (MBA) survey found that 92% of commercial and multifamily mortgage lenders are already planning for the LIBOR transition. Additionally, 77% responded that all their new loan documents contain fallback language addressing LIBOR alternatives.
The LIBOR transition will be an enormous, industry-wide undertaking. Although guidance has been given, there is still significant work to be done. In the meantime, lenders and borrowers should remain aware of any changes that could impact their investments. With communication and awareness, the industry should be positioned to successfully navigate the transition with little disruption.