Insights

What's On the Horizon for Commercial Loan Interest Rates?

January 28, 2019

By Serafino Tobia, Head of CMBS Trading, Greystone

Commercial borrowers could find themselves in the midst of a sea change in 2021, when variable-rate loans that are typically tied to the LIBOR index may be benchmarked by another index. However, time will tell if the anticipated impact turns out to be a non-event comparable to the hyped-up “Y2K" concern about the impact of the turn of the 20th century on the world's technology or a major disruption:

LIBOR's role in commercial lending

The LIBOR index, which refers to the London Interbank Offered Rate, serves as the benchmark interest rate for an estimated $350 trillion dollars' worth of commercial loans, financial derivative contracts and consumer loans. The use of LIBOR has been widespread since 1986, but in 2012 government investigators found that several banks had manipulated their overnight rates during the financial crisis. In 2014, the Federal Reserve asked a special committee to identify a replacement for LIBOR.

Only borrowers with variable rate loans would be impacted by a shift away from LIBOR. Approximately one-third of Greystone's commercial loans have a floating rate or are a hybrid loan with a fixed-rate period followed by a period with adjustable rates. For example, Greystone's Multifamily Bridge Loan Program*, designed for short-term financing of up to three years while a property undergoes renovations or seeks permanent financing, has a rate tied to the 30-day LIBOR rate.

Greystone's Freddie Mac Small Balance Loans, which are generally between $1 million and $7.5 million depending on the market, are 20-year hybrid ARMs with a five-, seven- or 10-year fixed period. Once the loan begins to adjust, the interest rate charged is 6-month LIBOR plus a 275 or 325 margin.

What's next for commercial loans

The preferred replacement for LIBOR, chosen by the Alternative Reference Rates Committee (ARRC), which includes 27 financial organizations and is backed by 10 financial regulators, is the Secured Overnight Financing Rate (SOFR). The main benefit of SOFR is that it's a market-driven index of actual transactions, rather than rates set by banks. That means that SOFR can't be subject to manipulation by banks as LIBOR has been in the past. SOFR's interest rates are based on short-term, collateralized loans.

Currently, approximately $800 billion transactions are used to set the overnight SOFR rate, compared to approximately $500 million transactions used to set the three-month LIBOR rate.

However, SOFR is only an overnight rate, rather than one based on multiple maturities. Most debt tied to LIBOR is linked with a one-month or three-month LIBOR rate, not an overnight rate. SOFR would need to be expanded to function in the same way as LIBOR. The more SOFR is used, the more accepted it will become by lenders. Part of the transition plan by the Federal Reserve is the development of a term reference rate based on SOFR derivatives.

What Will Happen in 2021?

For commercial loans based on LIBOR rates, Fannie Mae recently initiated guidance to lenders that allows for substitution for LIBOR. Earlier this year, Fannie Mae issued the market's first-ever SOFR securities. But there's no firm indication of what will happen by 2021, when LIBOR is meant to be completely phased out.

Nothing dictates that banks must stop using LIBOR and it could be used beyond 2021 by some financial institutions. In the meantime, adoption of a new index, mostly likely SOFR, will slowly take place. Eventually, SOFR rates are likely to mirror LIBOR, with the added benefit of SOFR being a market-driven index with less potential for manipulation.

Since $350 trillion in loans is currently tied to LIBOR, it's in everyone's best interests to come up with a solution that will improve—rather than disrupt—the market. For commercial borrowers, as well as other borrowers, there's nothing to be done at the moment but watch and wait.

The information provided on this website, including, without limitation, any opinions, predictions, forecasts, commentaries or suggestions, is for informational purposes only and should not be construed to be professional or personal investment, financial, legal, tax or other advice.