LIBOR - What is it and How is it Used in Real Estate?
What is LIBOR?
LIBOR or London Interbank Offered Rate is a benchmark interest rate index used to make adjustments to variable rate loans. It is used as a reference rate for mortgages, construction loans, permanent loans, as well as derivatives, and other financial products. It is usually determined by using LIBOR + a spread based on the borrower’s credit rating or risk profile of the loan.
How is it Calculated?
The Intercontinental Exchange Benchmark Administration (IBA) determines the LIBOR rate daily to reflect the rate that banks would charge one another for large loans of varying maturities, from one day to one year. The IBA publishes 35 rates and the interest rates are compiled for loans with seven different maturities for each of the 5 major currencies: the Swiss Franc, the Euro, the Pound Sterling, the Japanese Yen, and the U.S. dollar.
At Top Shelf Models, we download the LIBOR rates published by the IBA and use them in our assumptions. The 1-month LIBOR rate is the most commonly used in financial modeling for private equity investments.
LIBOR Curve
The LIBOR curve is a graphical representation of the interest rate term structure of various maturities of LIBOR.
LIBOR Cap
An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. The LIBOR cap is a type of interest rate cap wherein the buyer would receive payment for each month that the LIBOR rate exceeds a certain %. This is a way for the borrower to limit interest rate exposure. Most lenders require the borrower to enter into a LIBOR Cap that is determined based on coverage ratios.
LIBOR Floor
An interest rate floor is a series of put options on a specified reference rate, usually LIBOR. In the case of a LIBOR floor, the buyer of the floor receives money if, on the maturity of the put option, the reference rate is below the agreed strike price of the floor. Lenders may include a LIBOR Floor in the loan agreement. For example, the interest rate might be LIBOR + 2.00% with a LIBOR Floor of 0.50%. So, if LIBOR is below 0.50%, then the borrower would be charged at the floor and not at the rate which is less than the floor.
How is LIBOR used in Real Estate?
In real estate, when lenders want to charge a floating interest rate, they use LIBOR + x%, where x equals the margin that the lender determines necessary to account for factors such as the duration of the loan, the borrower’s creditworthiness, and the quality and value of the collateral.
We will use this Multifamily Development model template from Top Shelf Models to demonstrate how we use it:
In this example, we adjust cell N32 with Y or N if it is a fixed interest rate or not. The inputs are the Fixed/spread over LIBOR, LIBOR Cap, and LIBOR Floor
If Y, then input the fixed rate into cell N33
If N, enter the spread over LIBOR (usually a few basis points)
These inputs then flow to monthly cashflows rows 172-176 as pictured above.
If Y, it takes the inputted fixed rate
If N, it takes the projected LIBOR Curve in row 172 and adds the spread in row 175 unless Caps or Floors kick in
