Pandemic Pushes CRE's Transition Away From Libor To Back Burner, But Worries Remain
The scheduled expiration of the London Interbank Offered Rate, or Libor, in December 2021 is approaching without much fanfare, but don't let the lack of noise surrounding it fool you, real estate experts say.
"We are about 16 months away from Libor's demise as a benchmark rate, and the various participants in the market and parties to trillions of dollars of loans and financial products that reference Libor are by and large really underprepared," Paul Hastings Head of Global Derivatives Joyce Sophia Xu told Bisnow.
Libor, in essence the lending rate between banks, has served as the baseline for setting short-term interest rates since the 1980s, according to JPMorgan. The benchmark is used in many CRE adjustable-rate and floating-rate loans, with term sheets for bonds, construction loans and other CRE financial instruments setting a certain percentage above Libor.
More than $1 trillion of commercial real estate and multifamily debt was tied to Libor in 2019, according to data from the Mortgage Bankers Association. Looking beyond real estate, Morgan Stanley estimates $200 trillion to $300 trillion in mortgages, consumer loans, corporate debt, CMBS and other derivatives are tied to Libor benchmark interest rates.
The benchmark lost esteem several years ago when regulators began questioning the accuracy of bank borrowing rates used to set the Libor benchmark since the data came from a small group of surveyed financial institutions.
In 2017, U.K. banks decided they will no longer require the use of Libor after 2021 ends. Around the same time, regulators and financial agencies in the U.S. like the Federal Reserve decided the Fed's Secured Overnight Funding Rate, or SOFR, will replace Libor on the night of Dec. 31, 2021.
SOFR is established using the median rate paid by market players who borrow funds every night with Treasurys set as the collateral, according to a report by Morgan Stanley.
The move away from Libor is often lauded as much needed after the benchmark drew extensive criticism in the wake of the last recession for functioning as a type of arbitrary rate set by a handful of banks. Critics of the program say Libor is deficient in setting commercial real estate or other benchmark rates.
But there are definitely challenges and risks presented by Libor's end, including the uncertainties about what interest rates will be applied to legacy commercial real estate lending contracts when Libor evaporates, the possibility of litigation between borrowers and lenders, and concerns SOFR will have downfalls of its own as a benchmark.
"With more than $1 trillion in commercial and multifamily mortgage debt tied to adjustable rate indices, the LIBOR transition has the potential to create major disruptions for borrowers, lenders, investors, and everyone in-between," MBA Director of Commercial Real Estate Finance Andrew Foster said in a 2019 report.
The MBA found at the time that many lenders and borrowers were uncertain about their path forward in replacing Libor. Not everyone surveyed was on board with using SOFR instead — only 41% of the commercial and multifamily lenders the MBA surveyed said they anticipated using SOFR as the alternative, while 43% said they didn't know yet what benchmark they would use. Many said they were hoping more guidance would come from regulatory bodies, which hasn't materialized as hoped yet.
"Some types of instruments really require a forward-looking term rate, and SOFR by its definition is not that," Hogan Lovells partner Marc Gottridge told Bisnow.
Gottridge said there are ways to turn SOFR into a forward-looking term rate, but the Fed and regulators have yet to do that even with the countdown to Dec. 31, 2021, ticking away.
The most immediate concern will be what will happen to loans that were set based on Libor. Gottridge sees three possibilities, depending on loan documentation. Some existing contracts could turn from floating interest rates to fixed rates set by Libor's last benchmark on record. Some may have no backstop in existing documents that contemplates how to establish a new benchmark rate when Libor ends. Without a fallback provision that replaces Libor, the borrower and lender will have to work together to establish a new interest rate agreement.
Other contracts grant sole discretion to lenders in determining how to set new benchmark rates when Libor becomes unavailable, Gottridge noted. In these last two circumstances, borrowers, already struggling from a pandemic, may attempt to litigate if they feel replacement benchmark rates are less favorable to them than Libor's floating interest rates.
"If borrowers don't like the way a lender or trustee has imposed a new rate in place of Libor, they could very well say, 'You didn't act in good faith and actually stuck me with a worse rate than I would have gotten [with Libor]," Gottridge said.
Legislation proposed in New York that would have provided financial institutions with a safe harbor during the transition away from Libor by replacing Libor-based rates with rates set by SOFR with an added basis-point spread has yet to be passed to remedy these risks, Gottridge said.
Without such measures, a brewing litigation storm could erupt after Libor expires.
"The reason you would have litigation is if somebody is going to be disadvantaged by the change, or perceived to be significantly disadvantaged by it, and is going to say this is not what I bargained for," Gottridge said.
The coronavirus has distracted borrowers and lenders with legacy loans tied to Libor from aggressively tackling these issues, but it's time to do a deep dive into contracts and determine the best way for borrowers and lenders to prepare for December 2021, experts say.
"Right now, there are so many lenders dealing with defaults due to the recession that this is just one more layer that is going to overwhelm them," said Hart Advisors Group LLC founder and CEO Tanya Hart Little, who has extensive experience helping borrowers and lenders modify and renegotiate the terms of existing contracts.
The solution is to try to understand early on what lenders and borrowers need to create a best-case scenario for both parties when Libor finally expires, according to Hart Little.
"There are a lot of loan documents out there that I don't believe contemplated Libor going away," she said. "So that means it is going to be up to the financial institutions to restate what that is going to look like going forward for the borrowers."
Hart Little and Xu's advice is for borrowers and lenders to begin the process of talking it out now to ensure their contracts are ready for the transition late next year. The pandemic-driven recession in CRE puts added pressure on lenders and borrowers to get it right.
"In a time of crisis, especially when valuations of assets are under stress, you might see there is an increase in the motivation of parties to litigate," Gottridge said.