Why real estate needs to prepare for Sonia

COMMENT: If it’s not already firmly on the radar, the time has come for borrowers and lenders to take heed of the planned 2021 transition from London Inter-Bank Offer Rate (Libor) to Sterling Over Night Index Average (Sonia) reference rates. What sounds like a technicality firmly in the domain of lenders and derivatives providers also has inherent risks for real estate and infrastructure owners. Libor is inextricably linked to all aspects of commercial finance but none more than commercial real estate, with its heavy reliance on term debt with periodic interest payments, fixed-rate lending through interest rate derivatives and covenant calculations heavily based on interest cover. Sonia, an overnight rate, provides nothing like the upfront certainty of future interest costs that the market is used to through Term Libor. The Bank of England currently has a live consultation seeking feedback as it grapples with how (and if) Term Sonia rates can be derived, the outcome of which will be key. Against this backdrop, how many borrowers and, with an ever-growing multitude of UK debt providers, lenders have fully woken up to all the risks enshrined in this rate change? Large lenders have been heavily involved in consultations for these changes since first mooted, borrowers less so. Yet the impact of the change is vast when you include debt and derivatives and cash products. It even requires amendments to software infrastructures. The work required to deliver the latter should not be underestimated, with estimated infrastructure build times varying across providers from 6 to 18 months. Borrowers risk being caught on the hoof, both in terms of the inherent risks in existing debt and derivative documentation, and also all new documentation executed prior to clarity on how Sonia will be implemented. How practical is it to ignore the risks when documents being executed now are known to no longer be fit for purpose? What are the current key risks of the rate switch? Without a solution for Term Sonia rates, accurate cashflow forecasting of interest, along with calculation of early redemption or prepayment break costs, becomes challenging. While average Sonia rates have tracked closely to Libor, there have been some meaningful overnight variances. The change could result in covenant breaches and cashflow issues, along with mismatched hedges. Such a rate transition is not provided for under-existing documentation. Amendments to reflect Sonia will be under lenders’ control, requiring either all or majority lender consent, which may not be practical for CMBS and securitisation issuances. Further provisions in some floating rate bonds could see them become fixed rate at the last prevailing Libor rate. How can borrowers protect themselves and prepare for this change? Map out existing exposures – ensure clear visibility over all Libor exposures – whether through term debt, bonds, derivatives etc. Review documentation provisions for clarity over what happens when Libor is unavailable. Assess whether the risks of waiting for the market to determine how the transition will take place are acceptable or take the front foot and engage with lenders early. Consider risks being taken in all documentation executed before new standards emerge and engage with lawyers and lenders to seek protections for an orderly transition. There are currently no timescales to resolve the transition from Libor to Sonia from either a term rate or documentation perspective. Is this a risk that you can afford to ignore? Fiona Freeman is a managing director at FTI Consulting Corporate Finance specialising in real estate and project finance