Keep Calm and Transfer  

Considerations Ahead of the LIBOR Index Transfer

By Cindy Barreda and Trey Smith

LIBOR has been the market standard for adjustable-rate mortgages for as long as most of us can remember.  Consequently, transitioning to the new SOFR index in the United States, and to SONIA in the UK and Europe, is forcing many CRE players to exercise muscles that haven’t been used lately, and is dragging many more into completely uncharted waters. While providers of capital prepare for the eventual shift away from LIBOR, many are feeling relief in light of the recently announced extension of several US LIBOR tenors. Others, by contrast, would have rather seen things move forward as scheduled. Either way, this transition will require extensive coordination, planning and communication.

Late last year, when the official phase out of LIBOR was announced, it was unclear who would move first or what the incentives would be to do so as an early adopter. Concerningly, as of mid-Q2 2021, deals are still being priced to LIBOR indexes and, while some corners of the market have changed or have made provisions for the future, present day approaches are neither universal nor consistent.

Let’s unpack some of the key challenges and strategies of the upcoming transfer form LIBOR to SOFR.

What are some of the key challenges facing SOFR adoption? Changing the benchmark interest rate was always going to be difficult. Initially, it was not clear who would lead the way to transition the industry away from LIBOR and, while we knew the deadline for cessation, we were unsure about roadmap it would take to effectually make the changes over time. Today, it is still a challenge to understand how each LIBOR-based loan and any  associated interest rate cap agreement will ultimately convert, and what additional complexities may exist if a loan is pledged to a warehouse line or is part of a securitization.   Lenders, their attorneys, and other service providers of capital should continue to do their part to prepare. The same goes for investors, borrowers, servicers and anyone else that will be impacted by this change as the industry continues to work through significant complexities to the conversion. If you haven’t prepared yet, a deep dive into your loan documents is critical and may reveal required language modifications to prepare for the impending changes. In addition, any automated systems or reporting should be reviewed to make sure it, and any downstream uses of that information, will be ready for the  LIBOR replacement.

What are some strategies we’ve seen implemented ahead of the LIBOR phase out? At the time of  writing, the transition date for most sits roughly 12 to 18 months away.

Lenders, now working feverishly on COVID-related forbearance agreements and loan modifications, have also been taking the opportunity to discuss with their borrowers and counterparties hurdles and triggers to better optimize future deal structures that will better accommodate the LIBOR-SOFR transition. Industry trade groups have also been influential in guiding prudent and practical solutions for the challenges presented through the conversion. The Alternative Reference Rates Committee (ARRC) has published several white papers on best practices including a USERs guide to SOFR, recommending hard-wired fallback language and released conventions for using SOFR.

We are both encouraging and guiding our clients with a refresh on the capital structures for their assets and portfolios in relation to their exposure to this question – now is the time, and even clients who may elect to take no action should do so intentionally and, on a case-by-case basis. Some lenders are looking at the SOFR question differently, depending upon whether loans are made at the portfolio or asset level.

Heightened focus is also being placed on maturity dates, extension options and covenant compliance. For deals that are less defined, lenders may work alongside their borrowers to examine, inform and determine these variables, and how they might affect their loan or broader leverage strategies.

With the ICE Benchmark Administration announcing the extension of Overnight, 1-month, 3month, 6-month and 12-month US LIBOR Index, what are the consequences of such?

This extension will allow many more legacy loans to be retired and, therefore, not require the complexities and work associated with a replacement index, thereby lessening transaction loads, disputes and opportunities for mistakes in the earlier stages of conversion. For those early transactions that are converted to SOFR, this extension also arguably provides breathing room for the market to mature under SOFR and for iteration to a more uniformly adopted best-practices standard.

One concern is that extensions just prolong required actions and could increase market/ benchmark volatility, particularly if there’s a last-minute scramble.  Borrowers and lenders do themselves a favor by avoiding this outcome through a more thoughtful, proactive approach.