The End of LIBOR

At the end of 2021, LIBOR is ending and SOFR will take its place. LIBOR, or the London InterBank Offered Rate, is a benchmark representation of the interest rate that banks use when loaning to one another. This has been a long time coming, since 2012 when whistleblowers announced that banks had been manipulating LIBOR for profit. By falsely reporting the interest rates, banks were impacting the LIBOR benchmark. This resulted in borrowers overpaying on interest. As a result, federal financial institutions collaborated to create a replacement: SOFR (Secured Overnight Financing Rate).

The transition from LIBOR to SOFR presents new challenges and expectations for commercial appraisers. Here is what you need to know to seamlessly transition into serving your clients under SOFR in 2021 and beyond.

Lower Rates with SOFR

For appraisers who are accustomed to calculating interest rates with LIBOR, the SOFR rates may take some getting used to. Because SOFR is quoted at a lower rate due to its overnight rate, this means that a direct transition from LIBOR to SOFR points to a lower interest rate. This change affects approximately $1.2 trillion in American adjustable-rate mortgages. Previously, the LIBOR benchmark was calculated based on unsecured transactions. It included a bank funding risk. Going forward, appraisers will need to make adjustments on SOFR to ensure compatibility. The good news is that this lower rate is based on more accurate calculations. A major complaint about LIBOR is that the benchmark was based on a declining sample size, as panel banks were reporting fewer transactions. In 2022, SOFR is expected to become the dominating benchmark rate globally.

Backward-Looking Rates vs. Forward-Looking

Most contracts are founded on a forward-looking index, such as mortgage loans. For instance, one-year LIBOR represented the average of rates anticipated in the future year (calculated on a yield curve). This forward-looking calculation is very different from SOFR. The new benchmark is an overnight rate, with a forward looking term still under development to be released at the end of 2021.

The ARRC, or Alternative Reference Rates Committee, is now promoting SOFR on a voluntary basis. If you’d like to stay ahead of the game, start learning about SOFR now before LIBOR officially enters retirement. The new benchmark is calculated entirely on transaction data. It’s also a purely daily rate. Given this, appraisers need to understand that LIBOR cannot simply be swapped out for SOFR. The new type of rate calculation will require adjustments to contracts.

Contracts May Need Rewriting

If you plan to commit to any new contracts that will extend past 2021, experts recommend using another benchmark or including fallback language. This ensures the legitimacy and enforceability of your contracts past the retirement of LIBOR. For existing contracts, review the language closely to understand how LIBOR’s retirement will affect you. What is your contract exposure? Is the fallback a fixed rate, prime rate, or something else?

It’s wise to complete this now and amend the contracts as soon as possible. This can help you reduce costly litigation with borrowers who disagree on the new terms of the arrangement. Spend time reviewing individual contracts with a fine-tooth comb. Make sure the provisions are clear and straightforward. Lenders should contact borrowers as early as possible.

Update LIBOR-Reliant Appraisal Software

Commercial appraisers who utilize valuation software should research its compliance with new regulations. If your software’s existing algorithms rely on LIBOR as the benchmark, it’s possible you may need to transition to a new appraisal software that is capable of calculating based on SOFR. Keep in mind that your appraisal software needs to incorporate SOFR’s effect on risk assessment and reporting.

There is plenty of time to prepare your seamless transition. The ARRC is publishing toolkits for SOFR adoption that can help you adapt your business well in advance of the transition. You’re not alone, as commercial appraisers everywhere attempt to recalibrate their valuation process before LIBOR retires.

Start the adjustment process now and take advantage of the period to look for appraisal software that is committed to becoming SOFR-compliant. Valcre is a leading valuation tool for commercial appraisers with a smart database, cloud storage, with quick and easy reporting. Work with Valcre to make sure your clients don’t feel any speed bumps on the road from LIBOR to SOFR.

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This article first appeared on the Valcre blog at valcre.com/the-end-of-libor.