Understanding LIBOR alternatives in CRE loans
- November 12, 2021
Hedging and Capital Markets
Real Estate | Kennett Square, PA
Hedging and Capital Markets
Real Estate | Kennett Square, PA
Commercial real estate (CRE) lenders have begun to adopt SOFR and other LIBOR alternatives, presenting borrowers with different variations of these rates. This overview provides a summary of the common permutations of these rates and borrower considerations for each.
- The SOFR variations commonly seen in CRE loans and hedges include NY Fed 30-Day Average SOFR, Daily Simple SOFR, Term SOFR, and SOFR Compounded in Arrears.
- Some lenders (notably Bank of America) are also offering loans tied to the Bloomberg Short-Term Bank Yield Index, or BSBY.
- These indices have differences with respect to whether they are forward or backward looking, the availability of hedge products tied to the indices, and how they might behave in times of tight credit conditions.
As U.S. CRE lenders have begun to adopt SOFR and other LIBOR alternatives, borrowers have been faced with variations of these alternatives, each with its own calculation methodologies, hedge availability, and market dynamics. To provide further clarity into these alternates, we’ve prepared an overview of the permutations that CRE lenders are most commonly using. We highlight the leading SOFR calculation methods used in U.S. CRE loans, outline their relative economic impacts from a borrower’s perspective, and offer a summary of the current availability for hedges on associated loans.
New York Fed 30-Day Average SOFR
This SOFR variation is derived from spot SOFR and involves compounding this daily rate over a rolling 30-day period. It is calculated and published by the New York Fed, and its historical data may be found on FRED. When used in CRE loans, it is typically reset at the beginning of the interest period. This allows the borrower and lender to know their monthly interest expense at the start of the loan period, but this also implies that the current period’s interest expense is based on the prior month’s interest rates. In practice, this means a borrower would see a slight benefit in interest expense in a rising rate environment. Lenders, who want to match income on loans they make to their funding costs, tend to view this feature as a negative. Fannie Mae and Freddie Mac have been using this SOFR variation in their floating-rate ARMs for over a year, and hedges using this index are widely available and liquidly traded.
Daily Simple SOFR
This SOFR variation is also derived from spot SOFR and involves calculating interest expense over a given period using each day’s current spot SOFR rate. It is not a distinct rate itself but a methodology of averaging daily interest rates to determine a monthly interest expense. As this calculation occurs over the course of the interest period, it better matches the current period’s interest expense to the current period’s interest rate resets. This does preclude the interest expense for a period being known at the outset of that period, though a lag or cut-off is often applied so that the rate is known a few days prior to the end of the period (the ISDA standard is a five-day lookback for each daily reset). While it has only more recently started to appear in CRE loans, hedges indexed to Daily Simple SOFR are available in the market.
While 30-Day Average SOFR and Daily Simple SOFR are derived from actual spot SOFR settings, Term SOFR is a forward-looking rate designed to capture expectations of SOFR over a coming interest period. The CME Group began publishing different tenors of Term SOFR in April of 2021 and they are based on where SOFR futures contracts are trading. Like loans indexed to LIBOR, Term SOFR resets normally will be observed at the start of each loan interest period, allowing the borrower and lender to know the loan interest expense at the start of each interest period. The shape of the curve or the market’s expectation of rates over a given period will drive Term SOFR rather than where rates actually reset because it is a forward-looking rate. At the time of this writing, hedges indexed to Term SOFR are available from a handful of dealer banks, and the ARRC has acknowledged that other variations of SOFR may be more suitable for loans that are being hedged. Currently, there is at least one dealer bank that can provide Term SOFR interest rate caps acceptable to most CRE lenders and we expect greater hedge availability for Term SOFR caps in the coming months.
SOFR Compounded in Arrears
SOFR Compounded in Arrears, like New York Fed 30-Day Average SOFR, is a compounded rate derived from spot SOFR, with the distinction that it is calculated over the current interest period as opposed to the previous period. Like Daily Simple SOFR, it reflects the spot SOFR settings observed during the current interest period, with a period’s interest expense not known until the end of the period. While we’ve not observed this rate being used in CRE loans, it is the ISDA fallback rate for LIBOR-indexed derivatives. Borrowers with legacy LIBOR derivatives hedging LIBOR loans should be familiar with it as their LIBOR derivatives, if outstanding beyond June of 2023, will move to this rate if not otherwise amended or restructured beforehand. In practice, there likely will be a small mismatch between this rate and the rate used in the underlying hedged loan when that loan transitions to some form of SOFR.
Bloomberg Short-Term Bank Yield Index (BSBY)
Unlike the aforementioned rates, BSBY is not based on SOFR but is derived from bank funding transactions, particularly interbank deposit rates and commercial paper rates. It is similar in nature to LIBOR but is designed to rely less on bank “expert judgement” and more on third party verified transactions. As it is based on bank funding costs it includes a bank’s cost of funds component not captured in SOFR-based rates — making it appealing to many lenders. Bank of America is the most notable proponent of using this rate in CRE financings. Regulators have been very vocal about their dislike for this rate, as they view it as presenting the same “inverted pyramid” problem inherent in LIBOR, where the rate itself is derived from a very limited set of transactions that are orders of magnitude smaller than the contracts relying on the rate. BSBY-indexed hedges are not widely available or liquidly traded and many dealer banks do not seem to be prioritizing supporting them.
Having established a baseline understanding of each of these rates, its logical to next examine how each “performs” relative to one another over time, to help better understand how each might drive interest expense on a loan. In doing this it’s helpful to look at both recent historical performance and expected future rates as implied by forward curves.
Comparing recent historical data on different rates provides good insight into how a borrower might expect the different rates to behave under different rate environments. The graph below looks at Daily Simple SOFR, 30-Day Average SOFR, Term SOFR, and BSBY back to the beginning of 2020. Each rate trended similarly — they fell as the Fed cut rates — but each exhibited some nuanced movements distinct from the others. Daily Simple SOFR and Term SOFR fell the most quickly as they immediately reflected the actual rate cuts occurring in the market. 30-Day Average SOFR fell, but with a lag, as it reflected the average spot SOFR rates from the previous month. BSBY fell gradually and exhibited a period in April when it increased even as the SOFR-based rates were falling –exemplifying the potential impact of the credit component inherent in BSBY but not in the SOFR variations.
Historical base rates
While forward curves historically are not very accurate predictors of future rates, the relative difference between forward curves can provide insight into how a borrower might expect two different rates to behave on a relative basis in the future. The graph below shows forward curves for each of Daily Simple SOFR, 30-Day Average SOFR, and Term SOFR, for the coming five years. (We’ve excluded the BSBY forward curve because the transaction data from which it is derived very thin, and a forward curve for that index out five years is not meaningful). Over this period, the forward curves imply that each rate will average 1.092%, 1.079%, and 1.106%, respectively. The curves all track each other very closely, but 30-Day Average SOFR is slightly less (on an expected basis) than Daily Simple SOFR and Term SOFR, reflecting its “one month in advance” calculation and the impact of that in an environment with an upward sloping forward curve.
With these facts and data in mind, we suggest the following considerations for borrowers confronted with LIBOR alternatives for the first time.
- SOFR looks like a safe bet. While it’s impossible to predict the future (particularly as it pertains to LIBOR transition), it seems likely that some form of SOFR will be in use for CRE loans going forward. Each of the major SOFR variants outlined here are reasonable for use in CRE loans, though some variations may benefit borrowers more than others on the margins.
- BSBY less so. Over the past few months, the regulators have become increasingly strident in their opposition to BSBY, in large part because it has some of the same flaws as LIBOR. With a few exceptions, most major CRE lenders don’t seem to be embracing it and derivatives dealers don’t seem to be prioritizing support for BSBY hedges. While it would surprise us to not see SOFR-indexed loans being closed in two years, it would not surprise us if BSBY loan originations have ceased by then. We encourage borrowers making use of BSBY in loan agreements to make sure they are comfortable with the fallback language in the loan agreement governing a discontinuation of BSBY.
- Hedge availability is still in flux. Caps and swaps, common hedges for CRE loans, are available now on both NY Fed 30-Day Average SOFR, SOFR Compounded in Arrears, and Daily Simple SOFR. Hedges for Term SOFR are just becoming available and in recent trades, we’ve seen Term SOFR swaps trade with a small premium for liquidity and basis risk, though it’s unclear if that premium will persist or exist for Term SOFR caps. For that reason, we encourage borrowers closing Term SOFR loans with required hedges to ask their lenders for flexibility to hedge with different variations of SOFR. BSBY hedges seem to be available from banks that are lending over BSBY but not from other dealer banks, and don’t seem to price as efficiently.
- Rate variations will behave differently. New York Fed 30-Day Average SOFR “precedes” Daily Simple SOFR and Term SOFR by an interest period based on its calculation. This will benefit a borrower in a rising rate environment and harm a borrower in a falling rate environment, though likely only on the margins over the life of a loan. BSBY incorporates a bank’s cost of funds component and may spike or remain elevated in times of reduced credit liquidity even as SOFR-based rates are falling. This cost of funds component should make BSBY higher than SOFR-based rates (on the order of 10 bps) over the life of a loan, a fact which borrowers should consider in conjunction with the loan spread. The current spread between BSBY and SOFR is about one basis point.
- Borrowers should be aware of language permitting a lender to switch rates after close. Some lenders originating loans indexed to NY Fed 30-Day Average SOFR or Daily Simple SOFR include language in the loan agreement permitting them to switch the index to Term SOFR after close if the CRE lending market comes to predominantly use Term SOFR. While this may be reasonable from the lenders’ perspective, borrowers should be thoughtful about 1) how this could impact their rate (a change from NY Fed 30-Day Average SOFR to Term SOFR could impact the effective coupon by 1–3 bps over the life of the loan); 2) legal and hedge restructuring costs associated with this change, and, 3) for clients sensitive to accounting treatment of hedges like public REITs, how such a change might impact hedge accounting effectiveness.
If you’d like to better understand these considerations, or have a specific loan you’d like to discuss, please reach out to your Chatham representative to discuss in more detail.
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Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.21-0316
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