Introduction
Will real estate loans using SOFR instead of Libor be more or less expensive in terms of interest payments?
What if real estate contracts call for interest payments to be calculated based on Libor after its cessation?
How do these changes affect real estate loans hedged by caps, swaps and other derivatives?
What are some practical recommendations for real estate practitioners?
Market participants, legislators and regulators are addressing questions arising out the cessation of the London interbank offered rate (Libor). Work to move away from the "world's most important number" is now in the final stages; the last settings of Libor are scheduled for discontinuation at the end of June 2023.
Libor replacement work continues to be underway in the commercial real estate industry. Chief financial officers responsible for borrowers are determining the all-in costs of loans using new benchmark rates instead of Libor.
New loans without fixed interest payment terms are being negotiated by lenders and borrowers without Libor terms and many of these loans are accompanied by financial derivatives to manage interest rate risk in a rising interest rate environment.
Lenders continue to reach out to borrowers to negotiate Libor replacement mechanics in signed loan documents that are hardwired for Libor only; existing loans that lack Libor replacement terms are today categorised as "legacy contracts". Legislators in many states and Congress have passed Libor replacement legislation that governors and the president have signed into law so that legacy contacts will by fiat adjust from Libor to the secured overnight financing rate (SOFR).
Caps, swaps and other over-the-counter derivatives accompanying commercial real estate loans may call for payments to be made based on Libor. If that is the case, it may be that the derivatives may not adjust in the same way that the loans adjust away from Libor.
This article:
- explores whether real estate loans using SOFR instead of Libor will be more or less expensive in terms of interest rates;
- sets out what to do if legacy real estate contracts call for interest payments to be calculated based on Libor after its cessation;
- looks at how these changes affect real estate loans hedged by caps, swaps and other derivatives; and
- provides some practical recommendations for real estate practitioners.
Will real estate loans using SOFR instead of Libor be more or less expensive in terms of interest payments?
In order to determine whether a post-Libor real estate contract is more costly, it is important to look at three component parts and how each work in practice:
- the benchmark rate used to calculate floating interest payments – including SOFR, there are nine primary benchmark rate replacements;
- a "spread adjustment" – this component is designed to minimise differences between SOFR, the most widely-used replacement rate in the United States, and Libor; and
- the basis points that a lender may add pursuant to the negotiated terms of the agreement.
Perhaps one of the most useful tools in calculating the all-in interest charges using SOFR and other Libor replacement reference rates is made available by the US-British financial services firm Refinitiv. Refinitiv has developed useful tools and, with an understanding of the three component parts in the analysis mentioned above, real estate practitioners can assess and determine the economics of the various new rates and run comparisons to determine how SOFR and other benchmarks will affect their bottom line over the term of their loan.
What if real estate contracts call for interest payments to be calculated based on Libor after its cessation?
Starting in early 2021, New York and other states began to enact legislation which would cause legacy contracts to, by legislative fiat, to self-amend to use SOFR as a replacement rate and otherwise use Libor replacement mechanics recommended by the Alternative Reference Rates Committee. In March 2022, Congress passed and President Biden signed legislation that included the Adjustable Interest Rate (LIBOR) Act. While these legislative solutions help the broader financial system from being threatened by mass defaults upon the cessation of Libor, many of the enacted laws permit parties to affirmatively "opt-out" by agreeing to a Libor substitute that may be different from the benchmark reference imposed on the parties to a legacy contract that does not call for a Libor substitute.
Legislative solutions appear at first glance to fix the legacy contract problem, but the legislation gives rise to a host of new questions, such as whether article 1(10) of the US Constitution,(1) as well as counterpart provisions in state constitutions, prohibits lawmakers from passing laws which interfere with private contractual relationships. None of these questions have been adequately tested and resolved by the courts and so this again points to the need for the two parties to a contract referencing Libor to privately and proactively negotiate amendments to replace Libor provisions on their own.
How do these changes affect real estate loans hedged by caps, swaps and other derivatives?
Commercial real estate borrowers may be obliged as a condition of the loan agreement to manage future interest rate risk or may voluntarily manage that risk by purchasing an over-the-counter (OTC) derivative such as a cap or swap. An interest rate cap typically calls for the cap purchaser to make an initial up-front payment in exchange for the cap provider making payments to the purchaser if interest rates exceed a certain threshold or "strike". This way, if interest rates exceed the strike, the cap provider makes the payments, which in essence gives the borrower insurance against rising interest rates. Borrowers that have a variable interest rate on their loan can also enter into a fixed-for-floating interest rate swap.
What challenges all of the financial modelling and legal work to put a hedge in place is the replacement of Libor in legacy real estate contracts and other agreements accompanied by caps, swaps or other hedges. If, on the one hand, a commercial loan agreement adjusts away from Libor (whether by the parties' amendment or by legislative fiat) to a benchmark rate that is not the same as that rate used in the accompanying hedge, the hedge may become "unmoored" from the loan – and not be a hedge at all.
Just as there are legacy real estate loan agreements with Libor-based payment provisions extending beyond June 2023 that must be amended, there are caps and swaps which were signed with Libor payment terms that need to be adjusted. Fortunately, the global trade association for OTC derivatives, the International Swaps and Derivatives Association, Inc (ISDA), through its working groups, have finalised and published "protocols" and definitions that make automatic the replacement of the Libor benchmark rate through a series of decision tree mechanics. While these mechanics will help keep the cap, swap or other hedge from going into default once Libor ceases, the operation of these mechanics may yield unintended economic results that may be contrary to the commercial real estate borrower's economic objectives; the hedge may not be a hedge at all.
What are some practical recommendations for real estate practitioners?
While each financing is unique and professional advice should be sought, borrowers may want to consider:
- asking lenders and hedge counterparties to run scenarios before (with Libor) and after (with Libor substitute(s)) to determine the all-in costs, and perhaps utilise additional market resources to model interest rate payments and the manner in which hedge payments may (or may not) help offset rising interest rates; and
- adjusting loan documentation in tandem with any accompanying hedge documentation with an eye towards synchronising the benchmark rates used in both sets of documentation.
It may be attractive for some lenders with sophisticated systems to offer borrowers in large credit facilities to "tranche" the loan proceeds and permit borrowers to select different benchmark rates and tenors for repayment on a tranche-by-tranche basis.
Instead of mandating the purchase of hedges by borrowers across the board, it may make sense for lenders to offer springing cap provisions which state that if the interest rates rise above a certain level, lenders will only then require the borrower to enter into a cap, interest rate swap or other hedge with a reputable hedge counterparty to help manage interest rate risk.
In any event, given all of the moving parts and considerations, many lenders continue today to provide resources for borrowers to understand how benchmark rates – coupled with lender conforming changes – operate as Libor is completely discontinued in the months ahead.
For further information on this topic, please contact Gordon F Peery at Seyfarth by telephone (+1 (213) 270-9607) or by email [email protected]). The Seyfarth website can be accessed at www.seyfarth.com.
Endnotes
(1) This constitutional provision, by its terms, bars state laws "impairing" the private obligations of contracts, and reads as follows:
No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.