Almost all real estate loans that involve periodic draws (like construction loans), or periodic draws and repayments (like revolving credit facilities), are floating rate loans invariably based on the "London Inter-Bank Offered Rate," or "LIBOR," as the benchmark rate. The beauty, at least theoretically, of LIBOR is that it reflects the actual interest rate market and provides advantages to parties on each side of the loan: Borrowers reap the benefits in a falling rate market and lenders have protection in a rising rate market. A few years ago, however, financial markets were roiled by scandal when it was brought to light that LIBOR rates were being manipulated – and it has since become clear that the vision of LIBOR as a true reflection of the market may have been more aspirational than factual.

The rates scandal resulted in not only increased regulatory scrutiny, but also a determination within the industry that a better index was needed. Since 2014, a working group known as the "Alternative Reference Rates Committee (ARRC)," convened by the Federal Reserve and comprised of representatives of major banks throughout the United States, has been meeting to develop an alternative reference rate for floating rate loans. The ARRC's work became more urgent in August when Andrew Bailey, the Chief Executive of the UK Financial Conduct Authority, gave a speech indicating that LIBOR was unlikely to be published as a benchmark rate beyond 2021. There is speculation in the market that LIBOR might cease to be published as early as 2020.

The immediate concern for real estate borrowers who currently hold LIBOR-based floating rate loans is obvious: if LIBOR is no longer available as the benchmark rate, what will take its place? Most loan documents address this scenario via boilerplate provisions that receive little attention or fanfare, but which are taking on new significance as LIBOR's extinction becomes inevitable.

In many instances, boilerplate provisions provide that if LIBOR is no longer published, its replacement will be an equivalent rate mutually agreed to by the parties, or another rate selected by the lender that the lender considers to provide it an equivalent yield. In all likelihood, in order to remain competitive, lenders will substitute a rate that will not result in materially different rates to the borrowers than their previous LIBOR-based rates.

A potentially bigger problem is that the boilerplate in some loan documents provides that if LIBOR is no longer available as the benchmark rate, the index becomes the lender's announced "prime rate" (often adjusted downward). Currently announced prime rates are roughly 300 basis points higher than current LIBOR rates. If LIBOR is replaced by a lender's prime rate, and the downward adjustment is not at least 300 basis points, the borrower will suffer a rate increase.

Any real estate borrower with a LIBOR-based floating rate loan that will not be repaid before the end of 2019 should review its loan documents carefully to determine what the LIBOR alternative is. If the alternative is based on the prime rate, then borrowers should assess whether the alternative will result in a higher rate, and if it would, they should consider negotiating a modification now. If the alternative rate is a rate determined from rates selected by the lender, it would be appropriate to ask the lender how it intends to compute new interest rates based on that language and review them to see if those results roughly track today's LIBOR.

For borrowers who are currently negotiating term sheets and loan agreements providing LIBOR-based floating rate loans that extend beyond 2019, it is prudent now to consider what the appropriate alternative rate should be. It is likely that prior to the time LIBOR vanishes, the AARC will agree on a new benchmark which will become the standard. An alternative for new loans might be to reference whatever standard rate the AARC comes up with and then, as a failsafe (in the event the AARC does not come up with the benchmark), fall back to the standard language used by lenders now, so long as that standard language if it is based on announced prime rates is set at roughly 300 basis points below the prime rate.

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