SOFR, so good...
If you have been borrowing for real estate on a short-term basis, say a Construction or Bridge Loan, you will no doubt be familiar with Libor (London Interbank Offered Rate). It has been one of the main interest rate benchmarks used in short-term real estate loans for the past fifty years.
Now Libor is being transitioned out in favor of a new benchmark called SOFR (Secured Overnight Financing Rate). Most lenders have transitioned away from Libor since December 31st, 2021, however there are many loans still being priced in Libor. It is likely that there will be no further use of Libor from June 30th, 2023 onwards, as the banks reporting that produce the Libor benchmark will no longer be required to do so.
Libor’s reputation as a reliable benchmark was impacted by a rate fixing scandal in 2012, whereby participating banks fixed the rates they reported in order to bolster their profitability. At the same time, the volume of loans between banks had fallen substantially and was no longer representative of the total market for loans. In 2017 the UK regulator, the Financial Conduct Agency (FCA), which oversees Libor, concluded that Libor should be wound down as a benchmark rate.
In 2017 the US Federal Reserve formed the Alternative Reference Rates Committee (ARRC) to come up with an alternative benchmark interest rate. ARRC is a group of private-market participants and it recommended an alternative benchmark, the Secured Overnight Financing Rate (SOFR).
Libor is calculated daily by reference to a small group of banks and the interest rates they would charge each other overnight (interbank rate). As their interbank lending has gotten smaller over the years, the daily survey of these lenders interbank rates was based more and more on rates they would charge each other on hypothetical loans rather than actual loans.
On the other hand, SOFR is based on a very large liquid market of overnight loans. It is based off the cost of borrowing cash overnight collateralized by US Treasuries, known as the Repo market (or repurchase agreement market). The average daily volume in this market is $1 trillion, making it a better representation of current market interest rates.
As SOFR is based off borrowing against US Treasuries as collateral, it is considered a “risk-free” rate. Therefore when lenders use SOFR to quote loan terms to their real estate borrowers, they will add a spread, or risk premium, to generate the interest rate being offered to the borrower.
Another benchmark used by lenders to lend on short-term loans is the Prime interest rate. A lender will usually quote the Wall Street Journal (WSJ) Prime Rate. The Prime rate is the interest rate that commercial banks charge to their most creditworthy customers. The WSJ Prime rate is based off polling the 10 largest U.S. banks to see what their Prime lending rate is.
Just as with Libor and SOFR, a lender using any benchmark like Prime to price their interest rate to borrowers will add a spread to the benchmark in quoting their lending rate.
For reference, the benchmarks mentioned are listed below with their rates as of January 31st, 2023 / 2022 / 2021 :
- Prime: 7.50% / 3.25% / 3.25%
- SOFR: 4.31% / 0.05% / 0.06%
- Libor: 4.30% / 0.07% / 0.07%
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