LIBOR and Commercial Real Estate: What’s Next by Jillian Mariutti
As originally published in Commercial Observer on October 11, 2017.
Though hardly unexpected, the recent news that the London Interbank Offered Rate (LIBOR) will be phased out by 2021 is extremely significant. The standard international benchmark for floating-rate transactions, LIBOR was created to be a risk-free benchmark for variable-rate loans and derivatives. But while the index currently underpins approximately $350 trillion of financial instruments—including credit card debt and student loans in addition to commercial real estate—a series of scandals relating to LIBOR manipulation has discredited the index and spelled its subsequent demise.
Fortunately, the formal announcement about the LIBOR phase-out didn’t lead to any immediate market unrest, as liquidity has remained strong and market participants have seemed to take the news in stride (largely due to the news being widely anticipated following LIBOR’s well-publicized scandals). It is also important to note that many instruments—especially CRE bridge loans, which frequently have three-year terms—should not be affected, as they will reach maturity before the phase-out in 2021.
In the United States, LIBOR will be replaced by the Broad Treasury Financing Rate (BTFR), a transaction-based index overseen by the Alternative Reference Rate Committee that should be less prone to manipulation than LIBOR. BTFR will have the same stated goal as LIBOR—to serve as a benchmark representation of the risk-free borrowing rate—but as a transaction-based index, it may be somewhat prone to volatility. That said, BTFR will be rolled out in 2018, a full three years before LIBOR’s retirement, providing ample time for the Committee to monitor the inputs going into BTFR and fine-tune a formula that smooths extreme daily fluctuations. With the ability to refine BTFR from 2018 to 2021 while monitoring its spreads with LIBOR, we can expect the landscape for CRE borrowers in 2022 or 2023 to be quite similar to that of a decade earlier, albeit with a different benchmark for their loans.
The biggest challenge associated with the transition to LIBOR will be experienced by instruments originated with the LIBOR benchmark that extend beyond 2021. For commercial real estate investors, this includes not just loans but derivatives, as many borrowers with a floating-rate CRE loan are required to hedge their interest-rate risk with caps or swaps, generally based on LIBOR.
Hedge accounting is another area that may be caught in the crosshairs of the LIBOR-BTFR transition. Hedge accounting allows the mark to market of derivatives, which are extremely volatile, to sit in the “Other Comprehensive Income” section of the balance sheet, preventing major swings in present market value from impacting earnings figures. Regulations for this accounting method have changed several times over the past decade, and the LIBOR phase-out adds another confounding wrinkle to the process.
The saving grace for some real estate investors will be the terms laid out in loan documents, many of which included clauses that delineated what would occur in the event LIBOR didn’t exist for the entire term of the loan. However, alternatives such as replacing the index with the Fed funds rate plus a specified spread, will only go so far: By and large, these clauses were not heavily negotiated or even examined closely before being rubber-stamped, and some CRE investors are sure to be blindsided when they go into effect.
With LIBOR finally being terminated in 2021, it is certainly incumbent on any investors taking out loans with maturity dates beyond 2021 to examine terms closely and calculate what the transition to the new benchmark will mean for them. For some real estate investors, replacing LIBOR with another index could increase interest rate expenses and potentially require material modifications to their investment strategies. With floating-rate loans in this state of flux, prudent investors will seek the counsel of advisers before finalizing any loan terms that extend beyond 2021.
When LIBOR was developed in 1986, it brought uniformity to parties dealing in a range of financial instruments by providing institutions and borrowers with a negotiated index for floating-rate loans. While the LIBOR model has proved faulty, we can expect BTFR to be a worthy replacement once it incorporates enough transaction volume and has its kinks ironed out. The most important takeaways for the real estate investor, however, are to be cognizant of the significance of relevant loan terms and to ensure that they are fully prepared for what they are facing in this evolving landscape.