Impact of transition from LIBOR to SOFR for multifamily industry

The index used by the multifamily housing industry for adjustable-rate loans and other financial transactions is gradually being phased out.

After June 30, 2023, financial institutions will use SOFR as the benchmark to price loans, replacing LIBOR. SOFR, being based on various market segments, is a stronger, more accurate, and secure indicator than LIBOR. The transition to SOFR provides an additional avenue to optimize investment opportunities.

What is LIBOR?

For many years, the London Interbank Offered Rate (LIBOR) has been the fundamental basis for determining interest rates on loans, particularly for commercial real estate loans. Essentially, LIBOR represents the interest rate at which banks lend to each other over the short term. However, the Secured Overnight Financing Rate (SOFR) is fast replacing LIBOR. By 2022, major banks will no longer be submitting rates for LIBOR, leading to its complete replacement. The floating interest rates in commercial real estate are frequently linked to LIBOR. Nevertheless, LIBOR serves as a benchmark for a broad range of financial products, including government bonds, corporate loans, swaps, credit cards, and numerous other financial instruments.

The LIBOR is a mean value of interest rates that are reported by significant financial institutions, but some of these banks have faced allegations of manipulating their figures to attain higher profits. On the other hand, SOFR is a comprehensive gauge of the borrowing of money overnight that is secured by Treasury securities and is grounded in genuine transactions instead of a survey.

What is SOFR?

SOFR is the top contender to replace USD LIBOR, recommended by the ARRC due to its reliability in various market conditions. The main difference between SOFR and LIBOR is that SOFR is based on the cost of borrowing cash overnight in the repo market, while LIBOR is based on panel bank input.

LIBOR vs. SOFR, which one to use for Multifamily Financing Modelling

SOFR's adoption is expected to positively impact the commercial and multifamily lending industry in the long term, but there may be some challenges in the short term. One such challenge arose in April 2018, when the Federal Reserve Bank of New York disclosed that it had included erroneous data in its calculation of SOFR, causing a loss of confidence in the new index.

Moreover, many real estate loans, including commercial, single-family residential, and multifamily loans, that are linked to LIBOR have maturities extending beyond 2021, making it unclear what will happen to these loans once LIBOR is no longer reported. Additionally, the current trend of SOFR being slightly higher than LIBOR adds to the uncertainty, compounded by the fact that the two indices are not directly linked.

It is worth noting that the move to SOFR will primarily affect loans with variable interest rates, such as a significant portion of bank apartment loans, as well as Freddie Mac® and Fannie Mae® multifamily loans. Conversely, fixed-rate loans, such as most CMBS loans, all HUD/FHA multifamily loans, and a considerable number of life company loans, are not expected to be significantly impacted by the shift to SOFR, unless the transition were to cause significant fluctuations in interest rates, which is unlikely.

The impacts on lending business is still being evaluated. You can read more about these changes on housing agency websites and other sources. The choice of whether to use LIBOR or SOFR for commercial real estate financing depends on various factors, such as the loan type, the lender's preference, and the borrower's needs.

Traditionally, LIBOR (London Interbank Offered Rate) has been the benchmark interest rate for commercial real estate loans. However, LIBOR is being phased out, and lenders are transitioning to alternative reference rates such as SOFR (Secured Overnight Financing Rate).

SOFR is a more robust benchmark rate because it is based on the actual overnight repurchase agreements backed by US Treasury securities, while LIBOR is based on estimates provided by banks. However, SOFR can be more volatile than LIBOR because it is a short-term rate.

If you are considering commercial real estate financing, you should consult with your lender to determine which reference rate they prefer and whether they are offering loans based on LIBOR or SOFR. You should also consider your risk tolerance and the potential impact of the interest rate on your loan payments before deciding which benchmark rate to use.

SOFR implications on commercial real estate financing

The adoption of the Secured Overnight Financing Rate (SOFR) as the replacement for LIBOR in 2021 will have a significant impact on commercial real estate financing. Specifically, floating-rate CMBS financing and variable rate Fannie Mae® and Freddie Mac® Multifamily loans will be particularly affected. In the event that SOFR is not widely adopted due to inaccuracies in its calculations, most adjustable commercial real estate loans will automatically switch to a spread based on the prime rate, which is the lowest bank interest rate available to consumers. However, this automatic switch is not ideal and could lead to various issues and inconsistencies.

According to the Federal Reserve, contracts valued at over $200 trillion worldwide were tied to LIBOR as of late 2021. If you have a variable-rate loan that is linked to LIBOR and matures after June 2023, it is advisable to contact your lender to discuss any transition plans that are not clearly stated in your financing package. Many loans include fallback language that gives lenders some flexibility in determining how to transition from LIBOR.

SOFR is a reference rate that is determined by analyzing the interest rates at which banks engage in short-term, unsecured lending with each other. This rate is slated to replace LIBOR by the close of 2021 and is anticipated to offer superior accuracy and dependability in comparison to LIBOR. Due to its reliance on actual transactions, rather than estimations, SOFR is also predicted to provide a more consistent and transparent metric for evaluating lending rates. Additionally, since it is derived from a more extensive and varied dataset, SOFR is expected to offer a more reliable and accurate benchmark for determining commercial real estate financing rates.

Some source worth reading about the impact of SOFR on apartment loans:

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