The LIBOR/SOFR Transition: What Multifamily Borrowers Need to Know
- SOFR will replace LIBOR as the benchmark that financial institutions use to price loans after June 30, 2023.
- SOFR, which is based on multiple market segments, is more robust, representative, and secure than LIBOR.
- The switch to SOFR presents another opportunity to maximize investment potential.
The highly anticipated transition from LIBOR® to SOFR, which goes into effect after June 30, 2023, will make SOFR the standard benchmark rate across a wide range of financial products. Although the financial community is expecting a smooth transition, there are notable differences between the two rates that will influence multifamily lending.
What is SOFR?
SOFR (Secured Overnight Financing Rate) is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. Next year, it will permanently replace LIBOR (London Interbank Offered Rate), which has been in use since 1986.
What Prompted the Switch?
The move to SOFR has been about a decade in the making. Following widespread rate collusion between several major financial institutions, a need emerged for a more secure benchmark reference rate.
Less Susceptible to Manipulation
SOFR is more transparent and secure because it is based on observable transactions, not estimated borrowing rates. The transactions underlying SOFR involve collateral, specifically U.S. Treasurys, eliminating opportunities for credit risk premiums effect its rates.
More Representative and Robust
Reflecting roughly $1 trillion in daily transactions, SOFR has a significantly higher volume than LIBOR. This larger underlying market — based on a more diverse set of borrowers and lenders from multiple market segments — makes SOFR a more representative and robust rate.
Less Uncertainty in the Rate
SOFR adds a level of credibility to its rate missing from the previous benchmark. Its spread adjustments for derivatives are determined based on the five-year historical mean difference between SOFR and the relevant term LIBOR rate. Even with overnight variability, the average daily SOFR is considered less volatile than the 3-month LIBOR.
More Reflective of Market Expectations
Term SOFR, a forwarding-looking rate based on SOFR futures, is another option now available for use in floating-rate commercial real estate and corporate financings. This proactive rate moves on implied market expectations, such as the Federal Reserve’s interest rate hikes, which can benefit investors in volatile market conditions.
Limits the Influence of Interest Rate Changes
Like other adjustable-rate mortgages (ARMs), SOFR ARMs have initial, periodic, and lifetime limiters. By placing a cap on the amount an interest rate can change at its first adjustment, at each subsequent adjustment, and over a loan’s life, SOFR ARMs offer borrower protection in a rising interest rate environment.
How the New Rate is Calculated
To move from one rate to another, a spread adjustment is necessary to account for the differential between the two rates. After June 30, 2033, any term LIBOR rate will be replaced by the daily compounded SOFR plus this spread adjustment:
LIBOR + [Credit Spread] = SOFR + Spread Adjustment + [Credit Spread]
Contact Us to Learn More
SOFR, LIBOR, and other intricate financial topics can be challenging for any multifamily borrower to master. If you have any questions, an Arbor originator is available to guide you through what the changes in the marketplace mean for multifamily lending.
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