On 15 July, at an event hosted by the US Securities Industry and Financial Markets Association in New York, the chief executive of the UK’s Financial Conduct Authority, Andrew Bailey, said the transition from the London Interbank Offered Rate was happening.
LIBOR, which is used as the reference rate in debt markets across the world, could be phased out as early as 1 January 2022. In his speech, Bailey said there had been good progress in the transition to alternative benchmarks across the derivatives and securities markets. The market in which the transition is least advanced, he added, was lending.
How to replace LIBOR is the great unanswered question across many financial markets, including real estate debt. The uncertainty began in 2017, when the FCA announced that LIBOR would be phased out. This followed a series of scandals which revealed that the benchmark had been manipulated throughout much of its life.
It has also become clear that LIBOR, which is now independently managed by the ICE Benchmark Administration, is simply not relevant to the way modern credit markets work. When Bailey sounded its death knell in 2017, he said the underlying markets it sought to measure – unsecured wholesale term lending to banks – were no longer sufficiently active. If the benchmark is not reflective of real movements in interest rates, lenders are basing their contracts on unrepresentative data.
There is much discussion, but little certainty, about what will replace LIBOR. In the corporate loans market, the first loan pegged to the Sterling Overnight Index Average, known as SONIA, was written this month. In commercial real estate, the presale document for the latest securitisation of the Westfield Stratford City shopping centre in west London indicated that the floating rate element would be linked to SONIA, rather than LIBOR, though we understand the deal will now be struck at a fixed rate.
Sources say LIBOR’s eventual replacement will need to retain the current benchmark’s benefits, including its forward-looking capability and its incorporation of credit risk. Some suggest that compounded overnight lending rates would be the best alternative benchmark for debt markets. Until SONIA or some other replacement rate catches on, real estate lenders are unclear as to what their future industry standard benchmark will be.
Sources within the real estate lending market tell us loans are still being written across the sector using LIBOR, even though the benchmark is unlikely to exist by the time many of the facilities mature. In the absence of a clear alternative, it is understandable that lenders are continuing to base their floating-rate deals on LIBOR. However, it is crucial that they prepare for life after LIBOR as best they can.
This means ensuring loan documentation includes a methodology that enables lenders to make the transition to an alternative benchmark when LIBOR becomes obsolete. Some contractual documents already offer lenders the provision to replace LIBOR in circumstances where it is unavailable. However, lawyers consulted by our sister title, Private Debt Investor, believe such provisions are unlikely to consider the possibility of LIBOR ceasing to exist.
Work is ongoing to devise standard documentation in this area: the Loan Market Association, for example, is developing boilerplate language for syndicated loans that use overnight risk-free rates as a benchmark.
It is also important that real estate lenders audit their loan portfolios to ensure that existing loans include the necessary amendments to documentation. These lenders should also be aware of the LIBOR-based loans that are set to mature after the benchmark’s demise.
Furthermore, lenders should remain aware of the benchmarks that might replace LIBOR and consider the best options for their loans. Until further progress has been made across the financial world, the end of LIBOR will be a difficult issue to get ahead of. But being armed with foreknowledge of the options, and documentation that could help to smooth the transition, can only be a good thing.
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