SOFR: What Is It and Its Implications to Commercial Real Estate?
December 8th, 2022 · 5 min read
The Federal Reserve determined that American lending and financial derivatives had to be benchmarked with a more trustworthy index following the LIBOR manipulation incident of 2012. Something published frequently and difficult to manipulate. They established the Alternative Reference Rate Committee (ARRC) in 2014 to accomplish this.
By the middle of 2017, the Committee had suggested switching to the SOFR through a progressive phase-in period that would start on January 1, 2022, and conclude on June 30, 2023. SOFR monitors the overnight market rate for repurchases (repos) of U.S. Treasury bonds, as opposed to LIBOR, which examines interbank lending. The ARRC considered this a more reliable source of market interest-rate data because U.S. Treasury Bonds trading is not expected to end soon.
To boost accuracy, SOFR integrates repo transactions from 3 major sources while excluding the bottom 25% of trading quotes. Compared to the EFFR, which gauges uncontrolled borrowing (also in dollars) between other parties, usually government-sponsored firms, along with bankers.
How are SOFR Rate Calculations Done?
In recent years, LIBOR has fallen under scrutiny, especially when many major banks faced conspiracy allegations to raise (and lower) the rates by reporting fictitious interest rates. SOFR is based on completed transactions unlike LIBOR, which relies on self-reported quotations by financial firms, among the key variations of its use. As a result, it is determined by previous activities and is much less prone to manipulation.
The SOFR computations are as a volume-weighted median of the repo transactions, which entail overnight cash loans secured by US treasuries. For SOFR contracts, interest may be due for durations longer than overnight. Calculating the applicable cost of borrowing applicable for the pertinent interest period is by averaging the daily SOFR rate. The interest payable for the relevant period is unknown until the conclusion of the interest period.
Incorporating Treasury repurchases, a far more large-scale dataset than LIBOR is yet another essential aspect of SOFR calculations. It is a secured rate; therefore, its credit risk premium is not a factor during its computation. According to many experts, lending rates will incorporate credit spreads to reflect this development.
SOFR vs. LIBOR: What’s the Difference?
- Whereas US Treasuries protect SOFR, LIBOR is a market-transaction based
- LIBOR has a bank-to-bank lending rate that involves credit risk while SOFR has risk-free scores
- LIBOR encompasses $500 million USD of daily trading in transactions within a three-month external financing market, while SOFR has over $1 trillion of daily trading in transactions.
- LIBOR currency options include USD, GBP, EUR, JPY, and CHF while SOFR is only USD
Advantages of SOFR
Because of the manner of development, SOFR is more stable and sturdier than LIBOR. The foundation of SOFR is an extremely extensive market of real repurchases operations. Nearly $1 trillion in daily transactions underpin the SOFR rate, as opposed to the approximately $500 million for the three-month USD LIBOR.
SOFR is more market-representative. The ARRC claims that Compounded SOFR is a solid approximation of the cost of managing deposit accounts. The price to hold risk-free resources is also precisely reflected by SOFR. Since LIBOR is determined using the costs associated with banks to provide loans to other banks, LIBOR is less reflective of the markets. The projected rates for LIBOR that LIBOR panel banks report ahead do not derive from actual trades.
Among the drawbacks of LIBOR was its propensity to manipulate, whereas SOFR is less prone to it. Unlike approximated borrowing rates, SOFR is associated with observed operations. Because of a strong underlying market and compliance with international guiding principles for interest rates, SOFR is not vulnerable to ceasing. At Terrydale Capital, we’re here to help you every step of the way. If you need assistance with anything, don’t hesitate to contact us!
Disadvantages of SOFR
SOFR exhibits more volatility as every day SOFR may fluctuate. The ARRC has stated that several financial products rely on an aggregate of daily rates rather than a particular day’s reporting of SOFR, which reduces volatility.
SOFR is not credit-sensitive. Since it is a secured rate, it correlates the credit risk with that of US Treasury securities. Besides, several of the SOFR rates that are currently offered are backward-looking and not prospective values, although, this is not a concern for Term SOFR.
How Does The LIBOR to SOFR Transition Affect Commercial Real Estate?
Several CRE loans include interest rates that depend on LIBOR. This shift impacts commercial real estate and commercial real estate financing. To guarantee a seamless transition for the cost of borrowing after LIBOR discontinuation, each LIBOR loan must have the language in the loan documentation.
Each loan agreement is unique. There is no one-size-fits-all, and the protocols are typically custom drafted. It is ultimately the responsibility of every borrower to contact their lenders, review their loan agreements, consult an attorney, and analyze the content of the contracts.
A significant number of lenders have probably already explicitly contacted borrowers to add transitional phrases and inform them of the developments. However, if this is not the case, contact your lender.
Are you a CRE Investor?
This is the perfect opportunity to review your loan. Ensure your LIBOR-based adjustable-rate credit isn’t flipping over if you have one. But if you can refinance, consider both fixed-rate and floating choices.
Since there are many lenders offering better terms, it is crucial for investors to comprehend the comprehensive set of loan choices accessible and to compare them. Assess whether and how LIBOR affects an existing loan, look at other alternatives, and examine different loan arrangements.
LIBOR may not go as quickly as expected, but even then, banks and other lenders may explore alternative methods of determining market rates. Be careful before signing anything new or revising existing agreements to guarantee a seamless transition, because a change may lead to higher base rates in the future.
Investors can note a statement on their loan rates suggesting calculations based on SOFR instead of LIBOR, even though the changeover from LIBOR will largely affect lenders. The architecture of the world’s financial system has significantly changed because of this revolution. Although LIBOR is not extinct yet, it will vanish over the coming months and years.
At Terrydale Capital, we are experts in financing commercial real estate. We maintain close ties with the leading banks, financiers, and family offices, which enable us to offer competitive financing options. We leverage our extensive knowledge, background, and professional network as an independent financing firm to proactively keep you abreast of the market. Get in touch with us today to begin your commercial real estate investing success journey.
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