The New Risk-Free Rate: Understanding why SOFR is replacing LIBOR

Chris Peters

Receiving a lender’s term sheet or LOI is always a great feeling, as that means there’s a lender interested in financing the property and the deal is that much closer to closing. Real estate investors typically scan the offer for the leverage, term length, amortization, interest rate and fees among several other items, however, when reviewing interest rate investors may be wondering what this new “SOFR” acronym is that’s starting to pop up.
SOFR — the Secured Overnight Financing Rate — has started to replace LIBOR (London Interbank Offered Rate) as the base index rate used some lenders calculate their interest rates.

What is LIBOR?

We typically see LIBOR used in short-term or construction loans where the interest rate is floating and can move higher or lower depending on where, and by how much, LIBOR moves. Investors should be used to LIBOR as it has been a base index rate for several decades, however, investors have kept a close watch on the turmoil in the LIBOR market over the past several years punctuated by high-profile pricing scandals involving the largest banks in the world.

For decades, LIBOR was a major benchmark rate that was used by financial institutions around the world to calculate interest on a multitude of financial and investment contracts. LIBOR has been used by government institutions, financial institutions, specialty finance companies, private capital sources, etc. to structure financial contracts including mortgages, derivative contracts, and business/consumer loans to name a few. LIBOR is just one of several index rates out there alongside Prime, Fed Funds, Treasuries, Swaps, etc.

LIBOR is administered by the Intercontinental Exchange (ICE), which asks major global banks how much they would charge other major global banks for short-term loans (i.e. overnight). This rate is “risk-free” meaning there is essentially zero risk the short-term loan will not be repaid. I bolded “asks” and “would” as those words tend to be subjective and vague which can lead to, you guessed it, manipulation!

When these major banks and other financial institutions make loans to risky borrowers (i.e. non-major banks), these lenders typically add a spread to LIBOR depending on the risk level of the loan, collateral and borrower. These borrowers include everyday consumers, students, corporations and even real estate investors.
As an example a bank might lend to a real estate investor at 30-day LIBOR plus 2.50%, meaning the rate will be calculated as the 30-day LIBOR plus 2.50%. As of this writing, 30-day LIBOR is 0.11% so the rate would be 0.11% + 2.50% = 2.66%. The 2.50% spread reflects the risky nature of lending to a non-major bank borrower. The higher the spread, the riskier the loan and the higher the interest rate to the borrower.

Why is the market moving away from LIBOR?

So, now that we understand how LIBOR works, let’s dig into why we are shifting away.
Over the years, LIBOR lost its reliability and transparency as there have been several pricing scandals involving these very banks that are considered “risk-free”. It was discovered that banks were falsely deflating and inflating their rate submissions so that they could profit from trades and/or enhance their creditworthiness. Banks are supposed to submit the actual rates they are paying, or would expect to pay, however, that’s not what was always happening.

It had been rumored that LIBOR manipulation was prevalent as far back as the early ’90s and in the late 2000s and early 2010s, the scandal became public and after several years of investigation, many large banks including JP Morgan, Citibank, UBS, Deutsche Bank, Barclays, Rabobank and RBS received fines and several employees and even CEOs lost their jobs.

Enter SOFR

In order to reduce the potential for further manipulation, SOFR was identified as the best possible replacement as it better reflects the way financial institutions fund themselves, and it is based on actual transactions whereas LIBOR was based on would-be transactions.

According to the Federal Reserve Bank of New York, SOFR “is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.”
Simply put, SOFR is based on actual risk-free transactions collateralized by essential risk-free Treasury securities whereas LIBOR is based on hypothetical risk free transactions backed by the bank’s word. Just as lenders moved away from stated income towards verified income after the Great Recession, SOFR is a logical move towards verified transactions.

What can real estate investors expect? Well, for starters, SOFR offers a more secure and trustworthy index that is less prone to manipulation. This alone should make everyone feel a little more secure. Secondly, the current SOFR rate of 0.05% is lower than the 30-day LIBOR rate of 0.11%, so investors should reap the benefits of a slightly lower overall borrowing rate.

Investors may continue to see LIBOR as the rate won’t fully cease to be published until June 30, 2023, however, we at StackSource are already seeing an increasing number of lenders start to transition towards LIBOR.

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