The London Interbank Offered Rate (LIBOR) was, for decades, one of the most critical reference rates globally, underpinning trillions of pounds worth of financial products, including commercial mortgages. A LIBOR-based commercial mortgage used this rate as its foundational benchmark, upon which a lender’s specific margin was added to determine the borrower’s interest rate.

What is a LIBOR-based commercial mortgage, and how does it work?

A commercial mortgage is a type of secured loan specifically designed to finance business assets, such as commercial property acquisition, development projects, or portfolio expansion. Unlike residential mortgages, commercial mortgages are typically structured with complex terms, higher loan amounts, and often rely on variable interest rates.

When a mortgage rate is variable, it means the interest you pay adjusts periodically based on changes in a predetermined economic index. For a significant period up until the early 2020s, that index was LIBOR.

The Mechanics of a LIBOR-Based Mortgage Rate

For a borrower with a LIBOR-linked commercial mortgage, the rate they paid was calculated using a simple formula:

• Benchmark Rate (LIBOR): This represented the theoretical cost for banks to borrow from each other in the unsecured interbank market for a specific currency (e.g., Sterling, USD, Yen) and tenor (e.g., one month, three months, six months).
• Lender’s Margin (Spread): This is a fixed percentage added to the benchmark rate. It covers the lender’s operational costs, profit margin, and the risk associated with lending to that specific borrower or project.

For example, if the three-month Sterling LIBOR rate was 1.5%, and the lender applied a margin of 3.5%, the borrower’s effective rate for that three-month period would be 5.0%.

Because LIBOR was a floating rate, the interest amount paid by the borrower would adjust every three or six months based on the new published LIBOR rate, introducing volatility but also allowing the borrower to benefit if market rates fell.

Understanding the End of LIBOR

LIBOR was used as the anchor for an estimated $200 trillion globally. However, after the 2008 financial crisis and subsequent investigations revealing instances of manipulation and misrepresentation by submitting banks, regulators deemed the rate unsustainable and lacking robustness. The market volume of unsecured interbank lending, upon which LIBOR was based, had significantly diminished, meaning the rate relied heavily on expert judgment rather than actual transactions.

In response, international regulators mandated a shift away from LIBOR to new, more reliable, transaction-based benchmarks, often referred to as Risk-Free Rates (RFRs).

Key Transition Dates and Deadlines

The transition timetable was overseen in the UK by the Financial Conduct Authority (FCA) and the Bank of England (BoE). The key deadlines were:

• End of 2021: Cessation of all new lending referencing LIBOR. Most key LIBOR settings (including all Sterling tenors) ceased being published or became non-representative.
• Mid-2023: The remaining USD LIBOR settings ceased publication, marking the official end of LIBOR use across the globe for financial contracts.

This means that any commercial mortgage referencing LIBOR today is a legacy product, and its terms must have already been transitioned to a replacement rate or are in the final stages of doing so, depending on the contract’s maturity.

If you are a commercial property owner or developer in the UK, understanding the replacement rate is critical to managing your financial liabilities. The FCA provides comprehensive guidance on the transition process, which is essential reading for owners of legacy contracts. You can review the latest guidance on the LIBOR transition on the FCA website.

The Replacement Rate: Introducing SONIA

In the UK, the agreed primary replacement for Sterling LIBOR (GBP LIBOR) is SONIA, the Sterling Overnight Index Average.

How SONIA Differs from LIBOR

While both are benchmark rates, they differ fundamentally in calculation and risk profile:

1. Transaction Basis

• LIBOR: Based on quotes, estimates, or expert judgment of the theoretical rate banks could borrow at.
• SONIA: Based purely on actual, executed, verifiable overnight transactions in the Sterling market. This makes it far more robust and less susceptible to manipulation.

2. Credit Risk

• LIBOR: Contained an inherent bank credit risk component (the risk that a bank borrowing money might default).
• SONIA: Is considered a near Risk-Free Rate (RFR) as it reflects risk-free overnight lending and does not incorporate the same level of bank credit risk.

3. Calculation Period (Forward vs. Backward Looking)

• LIBOR: Was a forward-looking rate, typically published for future tenors (3 months, 6 months). You knew your rate at the start of the interest period.
• SONIA: Is an overnight rate (backward-looking). To create a mortgage rate for a 3-month period, the lender must compound the daily SONIA rates over that 3-month period. This means the borrower typically does not know their exact interest payment until the end of the interest period, or shortly before.

The Impact of Transition on Existing Commercial Mortgages

The shift from a forward-looking, credit-risk-inclusive rate (LIBOR) to a backward-looking, near risk-free rate (SONIA) could not be done by simply swapping one rate for the other. This process involved careful renegotiation, contractual amendments, and the application of a “spread adjustment.”

The Spread Adjustment

Since LIBOR inherently included an element of bank credit risk that SONIA does not, SONIA rates are typically lower than comparable LIBOR rates. If a lender simply replaced a 3% LIBOR with a 2% SONIA, the borrower would gain an immediate, unfair advantage, and the lender would suffer a loss of expected revenue.

To ensure “fair value transfer,” a permanent margin—known as the Spread Adjustment—was added to the replacement rate (SONIA). This adjustment was calculated based on the historic difference between the two rates over a defined period (usually a five-year median difference, calculated by the International Swaps and Derivatives Association or ISDA).

Contractual Fallout and Fallback Language

For existing LIBOR-based commercial mortgages, the process followed one of two paths:

1. Renegotiation: The lender and borrower agreed and executed an amendment to the mortgage contract, explicitly naming SONIA plus the new margin (including the spread adjustment) as the reference rate going forward.
2. Fallback Activation: If renegotiation was not possible or timely, the contract’s original “fallback language” would be triggered. This language outlined what rate should be used if the benchmark ceased to exist. Because many older contracts had insufficient fallback language (e.g., defaulting to the Bank of England base rate, which could introduce enormous volatility), regulatory bodies had to step in with statutory replacement mechanisms for tough legacy contracts.

Borrowers who failed to engage with their lenders risked having a statutory rate applied to their contract, potentially leading to operational complexity and unexpected changes in financing costs. Lenders must undertake due diligence during this process, reviewing the borrower’s financial capacity under the new benchmark structure.

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Risks and Considerations for Legacy LIBOR Mortgage Holders

While the risk of the LIBOR rate becoming unusable has passed, owners of transitioned commercial mortgages face ongoing considerations:

1. Basis Risk

Even post-transition, many financial instruments associated with the commercial property (such as hedging swaps or underlying debt arrangements) might reference different benchmarks (e.g., some overseas jurisdictions may use SOFR or TONA). If the rate used in your loan contract (SONIA) differs from the rate used in your hedging instrument, you face a potential mismatch, known as Basis Risk, which can increase volatility.

2. Operational Complexity

The calculation of SONIA is inherently more complex than LIBOR. Borrowers need to understand that their interest is calculated based on an average of daily rates, possibly using different methodologies (e.g., compounded in advance, compounded in arrears). This requires sophisticated accounting systems and clear communication from the lender.

3. Contractual Documentation

It is essential to retain copies of all documents relating to the transition, including the formal contractual amendment (the deed of variation). This ensures that the applied margin, the spread adjustment, and the methodology for calculating SONIA are clearly understood and legally binding.

Failure to meet the repayments as scheduled under the new interest rate regime can lead to serious consequences. Your property may be at risk if repayments are not made. Possible consequences include legal action, increased interest rates, additional administrative charges, and ultimately, repossession of the commercial property that secures the loan.

Alternatives to SONIA in Commercial Lending

While SONIA is the dominant replacement for Sterling LIBOR, commercial lenders sometimes offer alternative benchmarks, particularly for specific types of debt or cross-currency deals:

• Bank of England Base Rate (BBR): This is the primary tool used by the Monetary Policy Committee (MPC) to manage inflation. It is a simpler rate to track and often used for straightforward commercial variable-rate loans.
• Term SONIA Reference Rate (TSRR): To address the issue of SONIA being backward-looking, some markets are developing ‘forward-looking’ term rates based on SONIA derivatives (futures and swaps). These rates would allow borrowers to know their rate at the start of the interest period, much like LIBOR, improving operational predictability.
• Fixed Rates: Many businesses prefer the stability of fixed-rate commercial mortgages, where the interest rate is locked in for a set period (often 2, 3, or 5 years), regardless of changes to SONIA or BBR.

People also asked

What happens if I still have a LIBOR-based contract?

If you still hold a legacy contract that has not formally transitioned, the lender must have applied the regulatory-mandated replacement rate (typically SONIA plus a spread adjustment) by law. You should immediately contact your lender to confirm the terms of the substituted rate and ensure all documentation is up to date.

Is SONIA the only replacement for LIBOR?

No, SONIA is the main replacement for Sterling (GBP) LIBOR. However, other global currencies have their own RFRs, such as SOFR (Secured Overnight Financing Rate) for USD, EURIBOR (reformed) for the Eurozone, and TONA (Tokyo Overnight Average Rate) for the Japanese Yen.

What is the difference between a variable rate commercial mortgage and a fixed rate?

A variable rate mortgage, like one based on SONIA, means the rate changes periodically, reflecting market movements. A fixed rate mortgage locks in the interest rate for a specific duration, providing cost certainty regardless of market fluctuations.

Do LIBOR commercial mortgages still exist for new borrowing?

No. Lenders in the UK ceased offering new loans tied to LIBOR settings by the end of 2021. Any new commercial mortgage will reference an RFR (like SONIA) or the Bank of England Base Rate, or be fixed for a defined term.

Did the end of LIBOR affect the margin on my commercial loan?

Yes, the change of benchmark often required the lender to adjust the margin to account for the risk difference between LIBOR (which included credit risk) and SONIA (which does not). This adjustment, known as the spread adjustment, was typically small but crucial for maintaining economic neutrality.

Conclusion

The transition away from LIBOR represents one of the largest regulatory shifts in modern financial history. While the era of LIBOR-based commercial mortgages is over, understanding the legacy contracts and the mechanics of the replacement rate—SONIA—remains critical for UK commercial property owners.

For borrowers, the focus must shift from merely tracking a published index to understanding the complexities of compounded daily rates and ensuring that the contractual transition was executed correctly. By maintaining transparent communication with lenders and fully grasping the implications of the SONIA methodology, commercial property investors can continue to manage their financing costs effectively in the post-LIBOR environment.