What is SOFR (Secured Overnight Financing Rate)?
- MREI Official
- 2 days ago
- 3 min read
SOFR, or the Secured Overnight Financing Rate, is a benchmark interest rate that reflects the cost of borrowing cash overnight using U.S. Treasury securities as collateral. It is based on actual transactions in the U.S. Treasury repurchase (repo) market, making it a transparent and reliable measure of short-term borrowing costs.
SOFR was introduced by the Federal Reserve in 2018 and has gained global prominence as the official replacement for LIBOR (London Interbank Offered Rate) a long-standing but increasingly unreliable benchmark previously used to price trillions of dollars in financial contracts.
Why SOFR Replaced LIBOR
LIBOR, once the dominant global benchmark rate, was phased out due to widespread manipulation scandals and the shrinking volume of real interbank loans underpinning it. Regulators sought an alternative based on observable market data rather than bank estimates.
SOFR emerged as the preferred alternative because it is grounded in actual repo market transactions, averaging over a trillion dollars daily. This volume ensures accuracy, credibility, and resistance to manipulation—key reasons regulators have mandated its adoption for U.S. dollar-based contracts.
How SOFR Is Used in Lending
SOFR now serves as a benchmark for a wide range of financial instruments, including:
Adjustable-rate mortgages (ARMs)
Commercial real estate loans
Corporate debt
Derivatives and interest rate swaps
In most loan structures, SOFR is combined with a spread or adjustment to reflect credit risk and term premiums, since SOFR is a risk-free overnight rate. For example, a loan may be priced as “SOFR + 2.5%” to approximate the lender's required return.
Impact on Real Estate and Commercial Lending
The adoption of SOFR has had a significant impact on real estate financing, particularly in the commercial sector. Many lenders now structure floating-rate commercial mortgage loans using Term SOFR as the base rate, combined with a credit spread. Borrowers benefit from increased transparency, but may also experience greater short-term rate volatility, especially if their loan adjusts daily or monthly. Developers, investors, and property managers must now monitor SOFR trends just as closely as they once tracked LIBOR, particularly when budgeting for interest payments or refinancing risk.
Transition Challenges for Legacy Contracts
For legacy financial contracts still tied to LIBOR, the transition to SOFR has not been without complications. Many older agreements lacked clear fallback language clauses detailing what to do if LIBOR ceased to exist. As a result, lenders and borrowers have had to renegotiate terms, often replacing LIBOR with SOFR equivalents and adjusting spreads to maintain economic parity. The financial industry has largely adopted fallback protocols from organizations like ISDA (International Swaps and Derivatives Association) to smooth this process, but it remains crucial for all parties to review their documents and understand how SOFR is implemented in their existing and future contracts.
Limitations and Considerations
While SOFR offers transparency and stability, it has some limitations. Because it is an overnight rate, it lacks a built-in term structure like LIBOR, which offered 1-month, 3-month, or 6-month rates. To address this, new alternatives such as Term SOFR have been developed to better match the needs of lenders and borrowers who prefer forward-looking rates.
Additionally, because SOFR is collateralized by Treasuries, it reflects lower credit risk than what many banks actually face—so a spread is typically added to make it a practical benchmark for real-world lending.
Real-World Example
Imagine a commercial real estate loan previously priced at “LIBOR + 2.75%.” With the transition to SOFR, that same loan may now be priced at “Term SOFR + 2.85%” to reflect a similar risk-adjusted return. The lender uses Term SOFR to provide rate predictability for the borrower, while still anchoring it to a transparent and regulated benchmark.
Final Thoughts
The shift from LIBOR to SOFR marks a major evolution in the financial system. While SOFR lacks some of LIBOR’s convenience, it brings a much-needed level of accuracy, transparency, and integrity to global finance. Whether you're a borrower with an adjustable-rate loan, a commercial investor, or managing corporate debt, understanding SOFR is essential for navigating modern interest rate structures and anticipating how rates might affect your financing over time.
