Item 3. Quantitative and Qualitative Disclosures About Market Risk
ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risk
Investment Portfolio Net Interest Income
Generally, our business model is such that rising interest rates will increase our net income (loss), while declining interest rates will decrease net income (loss). As of June 30, 2020, 97% of our investments by total investment exposure earned a floating rate of interest and were financed with liabilities that pay interest at floating rates, which resulted in an amount of net equity that is positively correlated to rising interest rates, subject to the impact of interest rate floors on certain of our floating rate loans. As of June 30, 2020, the remaining 3% of our investments by total investment exposure earned a fixed rate of interest, but are financed with liabilities that pay interest at floating rates, which resulted in a negative correlation to rising interest rates to the extent of our financing. In certain instances where we have financed fixed rate assets with floating rate liabilities, we have purchased interest rate swaps or caps to limit our exposure to increases in interest rates on such liabilities.
Certain jurisdictions are currently reforming or phasing out their Interbank Offered Rates, or IBORS, including, without limitation, the London Interbank Offered Rate, Euro Interbank Offered Rate, the Canadian Dollar Offered Rate and the Australian Bank Bill Swap Reference Rate. The timing of the anticipated reforms or phase-outs vary by jurisdiction, with most of the reforms or phase-outs currently scheduled to take effect at the end of calendar year 2021. We are evaluating the operational impact of such changes on existing transactions and contractual arrangements and managing transition efforts. Refer to “Part I. Item 1A. Risk Factors — Risks Related to Our Lending and Investment Activities — The expected discontinuation of currently used financial reference rates and use of alternative replacement reference rates may adversely affect interest expense related to our loans and investments or otherwise adversely affect our results of operations, cash flows and the market value of our investments.” of our Annual Report on Form 10-K for the year ended December 31, 2019.
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The following table projects the impact on our interest income and expense, net of incentive fees, for the twelve-month period following June 30, 2020, assuming an immediate increase or decrease of both 25 and 50 basis points in the applicable interest rate benchmark by currency ($ in thousands):
Assets (Liabilities)
Sensitive to Changes in
Interest Rates (1)(2)(3)
Interest Rate Sensitivity as of June 30, 2020
Increase in Rates
Decrease in Rates (4)
Currency
25 Basis
Points
50 Basis
Points
25 Basis
Points
50 Basis
Points
USD
$
12,520,462
Income
$
7,510
$
15,440
$
(4,652
)
$
(4,652
)
(10,440,646
)
Expense
(17,202
)
(34,851
)
11,164
11,164
$
2,079,816
Net interest
$
(9,692
)
$
(19,411
)
$
6,512
$
6,512
EUR
$
3,142,835
Income
$
—
$
1,350
$
—
$
—
(2,494,978
)
Expense
—
(1,068
)
—
—
$
647,857
Net interest
$
—
$
282
$
—
$
—
GBP
$
1,600,788
Income
$
1,853
$
4,028
$
(908
)
$
(908
)
(1,014,982
)
Expense
(2,030
)
(4,060
)
1,144
1,144
$
585,806
Net interest
$
(177
)
$
(32
)
$
236
$
236
AUD
$
233,425
Income
$
—
$
—
$
—
$
—
(169,299
)
Expense
(339
)
(677
)
202
202
$
64,126
Net interest
$
(339
)
$
(677
)
$
202
$
202
CAD (5)
$
41,188
Income
$
3
$
6
$
(3
)
$
(6
)
(45,384
)
Expense
(91
)
(182
)
91
182
$
(4,196
)
Net interest
$
(88
)
$
(176
)
$
88
$
176
Total net interest
$
(10,296
)
$
(20,014
)
$
7,038
$
7,126
(1)
Our floating rate loans and related liabilities are indexed to the various benchmark rates relevant in each case in terms of currency and payment frequency. Therefore the net exposure to each benchmark rate is in direct proportion to our net assets indexed to that rate. Increases (decreases) in interest income and expense are presented net of incentive fees. In addition, $13.0 billion of our loans earned interest based on floors that are above the applicable index as of June 30, 2020. Refer to Note 11 to our consolidated financial statements for additional details of our incentive fee calculation.
(2)
Includes investment exposure to the 2018 Single Asset Securitization. Refer to Notes 4 and 15 to our consolidated financial statements for details of the subordinate position we own in the 2018 Single Asset Securitization.
(3)
Includes amounts outstanding under secured debt agreements, non-consolidated senior interests, securitized debt obligations, non-consolidated securitized debt obligations, and secured term loans.
(4)
Decrease in rates assumes the applicable benchmark rate for each currency does not decrease below 0%.
(5)
Liabilities balance includes two interest rate swaps totaling C$17.3 million ($12.7 million as of June 30, 2020) that are used to hedge a portion of our fixed rate debt.
Investment Portfolio Value
As of June 30, 2020, 3% of our investments by investment exposure earned a fixed rate of interest and as such, the values of such loans are sensitive to changes in interest rates. We generally hold all of our investments to maturity and so do not expect to realize gains or losses on our fixed rate investment portfolio as a result of movements in market interest rates.
Risk of Non-Performance
In addition to the risks related to fluctuations in cash flows and asset values associated with movements in interest rates, there is also the risk of non-performance on floating rate assets. In the case of a significant increase in interest rates, the additional debt service payments due from our borrowers may strain the operating cash flows of the collateral real estate assets and, potentially, contribute to non-performance or, in severe cases, default. This risk is partially mitigated by various facts we consider during our underwriting process, which in certain cases include a requirement for our borrower to purchase an interest rate cap contract.
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Credit Risks
Our loans and investments are also subject to credit risk. The performance and value of our loans and investments depend upon the sponsors’ ability to operate the properties that serve as our collateral so that they produce cash flows adequate to pay interest and principal due to us. To monitor this risk, our Manager’s asset management team reviews our investment portfolios and in certain instances is in regular contact with our borrowers, monitoring performance of the collateral and enforcing our rights as necessary.
In addition, we are exposed to the risks generally associated with the commercial real estate market, including variances in occupancy rates, capitalization rates, absorption rates, and other macroeconomic factors beyond our control. We seek to manage these risks through our underwriting and asset management processes.
The COVID-19 pandemic has significantly impacted the commercial real estate markets, causing reduced occupancy, requests from tenants for rent deferral or abatement, and delays in construction and development projects currently planned or underway. These negative conditions have persisted, and in the future may continue to persist and impair our borrowers’ ability to pay principal and interest due to us under our loan agreements. We maintain a robust asset management relationship with our borrowers and have utilized these relationships to address the potential impacts of the COVID-19 pandemic on our loans secured by properties experiencing cash flow pressure, most significantly hospitality assets. Some of our borrowers have indicated that due to the impact of the COVID-19 pandemic, they will be unable to timely execute their business plans, have had to temporarily close their businesses, or have experienced other negative business consequences and have requested temporary interest deferral or forbearance, or other modifications of their loans. During the three months ended June 30, 2020, we closed 13 loan modifications, representing an aggregate principal balance of $2.4 billion. The loan modifications included term extensions, interest rate changes, repurposing of reserves, temporary deferrals of interest, and performance test or covenant waivers, many of which were coupled with additional equity commitments from sponsors.
We are generally encouraged by our borrowers’ initial response to the COVID-19 pandemic’s impacts on their properties. With limited exceptions, we believe our loan sponsors are committed to supporting assets collateralizing our loans through additional equity investments, and that we will benefit from our long-standing core business model of originating senior loans collateralized by large assets in major markets with experienced, well-capitalized institutional sponsors. Our investment portfolio’s low origination weighted-average LTV of 63.6% as of June 30, 2020, reflects significant equity value that our sponsors are motivated to protect through periods of cyclical disruption. While we believe the principal amounts of our loans are generally adequately protected by underlying collateral value, there is a risk that we will not realize the entire principal value of certain investments.
Our Manager’s portfolio monitoring and asset management operations benefit from the deep knowledge, experience, and information advantages derived from its position as part of Blackstone’s real estate platform. Blackstone Real Estate is one of the largest owners and operators of real estate in the world, with a proven track record of successfully navigating market cycles and emerging stronger through periods of volatility. The market-leading real estate expertise derived from the strength of the Blackstone platform deeply informs our credit and underwriting process, and gives us the tools to expertly asset manage our portfolio and work with our borrowers throughout periods of economic stress and uncertainty.
Capital Market Risks
We are exposed to risks related to the equity capital markets, and our related ability to raise capital through the issuance of our class A common stock or other equity instruments. We are also exposed to risks related to the debt capital markets, and our related ability to finance our business through borrowings under credit facilities or other debt instruments. As a REIT, we are required to distribute a significant portion of our taxable income annually, which constrains our ability to accumulate operating cash flow and therefore requires us to utilize debt or equity capital to finance our business. We seek to mitigate these risks by monitoring the debt and equity capital markets to inform our decisions on the amount, timing, and terms of capital we raise.
The COVID-19 pandemic has resulted in extreme volatility in a variety of global markets, including the real estate-related debt markets. U.S. financial markets, in particular, are experiencing limited liquidity and forced selling by certain market participants with insufficient liquidity available to meet current obligations has put further downward pressure on asset prices. In reaction to these tumultuous and unpredictable market conditions, banks and other lenders have generally restricted lending activity and requested margin posting or repayments where applicable for secured loans collateralized by assets with depressed valuations.
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Margin call provisions under our credit facilities do not permit valuation adjustments based on capital markets events, and are limited to collateral-specific credit marks generally determined on a commercially reasonable basis. During the three months ended June 30, 2020, we entered into agreements with seven of our secured credit facility lenders, representing an aggregate $7.9 billion of our secured credit facilities, to temporarily suspend credit mark provisions on certain of their portfolio assets in exchange for: (i) cash repayments; (ii) pledges of additional collateral; and (iii) reductions of available borrowings.
Counterparty Risk
The nature of our business requires us to hold our cash and cash equivalents and obtain financing from various financial institutions. This exposes us to the risk that these financial institutions may not fulfill their obligations to us under these various contractual arrangements. We mitigate this exposure by depositing our cash and cash equivalents and entering into financing agreements with high credit-quality institutions.
The nature of our loans and investments also exposes us to the risk that our counterparties do not make required interest and principal payments on scheduled due dates. We seek to manage this risk through a comprehensive credit analysis prior to making an investment and active monitoring of the asset portfolios that serve as our collateral.
Currency Risk
Our loans and investments that are denominated in a foreign currency are also subject to risks related to fluctuations in currency rates. We generally mitigate this exposure by matching the currency of our foreign currency assets to the currency of the borrowings that finance those assets. As a result, we substantially reduce our exposure to changes in portfolio value related to changes in foreign currency rates.
The following table outlines our assets and liabilities that are denominated in a foreign currency (€/£/A$/C$ in thousands):
June 30, 2020
Foreign currency assets (1)
€
2,849,505
£
1,654,698
A$
344,002
C$
108,478
Foreign currency liabilities (1)
(2,220,577
)
(1,123,093
)
(245,982
)
(78,943
)
Foreign currency contracts - notional
(620,400
)
(530,200
)
(92,800
)
(24,400
)
Net exposure to exchange rate fluctuations
€
8,528
£
1,405
A$
5,220
C$
5,135
____________
(1)
Balances include non-consolidated senior interests of £302.0 million
Substantially all of our net asset exposure to the Euro, the British Pound Sterling, the Australian Dollar, and the Canadian Dollar has been hedged with foreign currency forward contracts.