The London interbank offered rate’s (LIBOR’s) role as a base rate in business loans is living on borrowed time.
It will disappear at the end of 2021 and lenders are transitioning to a new ‘risk free’ rate, known as SONIA. Banks are just starting to offer loans based on the new SONIA rate and most lenders will stop offering LIBOR-based loans by Q3 2020. But what does this mean for real estate?
Put simply, the reasons for the change are threefold: banks do not lend to each other so much; LIBOR now has a small sample size; and there was evidence of manipulation by insiders. By contrast, SONIA, which stands for ‘sterling overnight index average’, is robust and less volatile as it is based on actual overnight interest rates in active and liquid wholesale cash and derivative markets. It is also virtually risk free as it does not incorporate any credit risk/liquidity premium like LIBOR, which was calculated on banks lending to each other over longer time periods.
The key difference for borrowers is that LIBOR is forward looking – agreed at the start of the interest period – whereas SONIA is backward looking and cannot be determined until the end of the agreed interest period. Borrowers will therefore no longer have upfront certainty about the amount of their interest payments. However, they can draw comfort from SONIA historically being less volatile and usually lower than LIBOR and tracking the Bank of England base rate very closely.
Existing loans running beyond 2021 are likely to be required to change. There may be a market-wide protocol adopted or lenders may develop their own protocols to apply to all LIBOR-based loans in their books. Break costs, currently charged when borrowers repay during an interest period, will in theory no longer be required if loans are no longer priced against a forward-looking rate. Instead, borrowers may see lenders seeking additional pre-payment fees to compensate.
Many real estate finance term loans are hedged by interest rate swaps. Changing the benchmark rate is likely to cause a mismatch in payments within the related hedging documents, and so borrowers should remind lenders that changes will be required across their hedging products as part of the transition.
For older readers who remember Sonia, our second-placed Eurovision contestant back in 1993, is it a case of “better the devil you know”? We think not. There will of course be issues arising as we make the change but in time, SONIA will be a fairer and more robust system.
Jonathan Porteous and Andrew Dodds are partners in the real estate finance team at Stevens & Bolton