SS104: What is SOFR?

SS104 What is SOFR

The Secured Overnight Financing Rate (SOFR) is an alternative to the London Interbank Offered Rate (LIBOR). In this episode, Charles breaks down what is SOFR and why is it replacing LIBOR.

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Talking Points:

  • In Episode SS51; I discussed the London Interbank Offered Rate (LIBOR), its history, and how it is used. In this episode, we are going to talk about the Secured Overnight Financing Rate (SOFR). SOFR was established as an alternative to LIBOR.
    • SOFR is a benchmark that lenders utilize to price loans for consumers and businesses. As the name states are based on the rates that large financial institutions pay each other for overnight loans. SOFR is the average rate at which financial institutions can borrow US dollars overnight while posting US Treasury bonds as collateral.
    • SOFR takes into consideration actual lending transactions between institutions, unlike LIBOR which was based on rates that financial institutions SAID they would offer; done via a survey.
    • SOFR is a more accurate indicator of borrowing costs.
  • Why is SOFR important to real estate investors?
    • Real estate investors who are considering adjustable-rate mortgages, floating-rate bridge loans, etc. should be aware and familiar with SOFR.
    • These loan products will be based on SOFR; with a spread above SOFR of typically 1.25%-4%; depending on the strength of the collateral and the borrower. For example; if SOFR is 3% and the spread is 2%; your interest rate will be 5%. Like with any loan; there are a number of one-time fees that can vary per lender.
  • How to protect yourself when utilizing floating debt?
    • Get a rate cap; interest-rate caps are contracts that firms buy to protect themselves from sharp increases in rate benchmarks. Some floating-rate lenders require their borrowers to purchase them; which will greatly reduce the chance of customers defaulting on their loans.
    • Get fixed-rate debt instead of a floating rate. Fixed-rate mortgages are the most risk-averse, but if you are anticipating a short hold period; fixed-rate prepayment penalties can be expensive. There is however the ability with most commercial mortgages to have the new buyer assume the mortgage. However, if interest rates have fallen during the time you have owned your property; your buyer will most likely not want to assume it, and if your mortgage has yield maintenance; a pre-payment penalty that gets more expensive if interest rates drop; your pre-payment penalty will be larger.
    • The main benefits of variable debt are that it is able to be paid back early without any type of penalty and during short hold periods; variable debt costs less.
    • Floating-rate mortgages were maligned in the past with irresponsible borrowing; but when you calculate the risks alongside your business plan; it may be the best choice. Not all real estate investors are long-term investors and floating-rate debt provides more flexibility. You can always refinance into fixed-rate debt after you have completed repositioning the property.
    • Don’t just look at the rate when you are getting a commercial mortgage; also review and take into consideration the other fees; especially the pre-payment penalty.
    • Floating rate debt is not for new investors; make sure to weigh all of the pros and cons prior to entering into any lending contract.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing what is SOFR.

Charles:
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Charles:
An episode SS51, I discussed London Interbank, offered rate LIBOR in the history and how it’s used. In this episode, we’re gonna talk about the secured overnight financing rate. SOFR. SOFR was established as an alternative to LIBOR. SOFR is a benchmark that lenders utilized the price loans for consumers and businesses. As the name states, it’s based on the rates that large financial institutions pay each other for overnight loans. So FFR is the average rate at which financial institutions can borrow US dollars overnight while posting US treasury bonds as collateral. SOFR takes into consideration actual lending transactions between institutions, unlike LIBOR, that was based on rates that financial institutions said they would offer done via a survey. SOFR is a more accurate indicator of borrowing costs. So why is SOFR important to real estate investors? Well, real estate investors who are considering adjustable rate mortgages, floating rate bridge loans should be aware and familiar with.

Charles:
So firm these loan products will be based off of, SOFR, with a, with a spread above. SOFR of typically one in a quarter to 4%, depending on the strength of the collateral and the borrower. For example, if SOFR is 3% and the spread is 2%, your interest rate will be 5%. Like with any other loan, there are a number of onetime fees that can vary per lender. So how do you protect yourself when utilizing floating debt? First is get a rate cap. Interest rate, rate caps or contracts that firms buy to protect themselves from sharp increases in rate benchmarks like so. R some floating rate lenders require their borrowers to purchase them, which will greatly reduce the chance of customers defaulting under loans. Next is get fixed rate debt instead of floating rate debt. Fixed rate mortgages are the most risk averse, but if you’re anticipating a short holded period, fixed rate prepayment penalties can be expensive.

Charles:
There is, however, the ability with most commercial mortgages to have the new buyer assume the mortgage. However, if interest rates have fallen during the time you’ve owned your property, your buyer will most likely not want to assume it. And if your mortgage has yield maintenance, a prepayment penalty that gets more expensive. If interest rates drop, your prepayment penalty will be larger. The main benefits of variable debt are that it’s able to be paid back early without any type of penalty. And during short hold periods, variable debt costs less. Now, floating rate mortgages were maligned in the past with irresponsible borrowing, but when you calculate the risks alongside your business plan, it may be the best choice. Not all real estate investors are long-term investors, and floating rate debt provides more flexibility. You can always refinance into fixed rate debt after you’ve completed repositioning the property. Don’t just look for the rate when you’re getting a commercial mortgage. Also take into consideration the other fees, especially the prepayment penalty. Now, floating rate debt is not for new investors. Make sure to always weigh all the pros and cons prior to entering into any lending contract. So I hope you enjoyed. Please remember to rate for you subscribe, submit comments and potential show topics at globalinvestorspodcast.com. Look forward to two episodes next week. See you then.

Announcer:
Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure, subscription documentation, and are subject to all applicable laws. Please consult an appropriate tax legal, real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstar, LLC, exclusively.

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