The Pakistan Credit Rating Agency Limited

Rental Real Estate Investment Trust

(REIT) Fund Rating Criteria
Assessment Framework
Table of Contents Summary

Introduction ........................................ 2 This methodology outlines PACRA’s approach to assigning

Rental REIT Fund Rating, an independent opinion on the
Profile .................................................. 4 capacity of a Rental REIT Fund to maintain stable rental
Economic & Industry Risk ................ 4 income, and risk factors impacting value of REIT assets
over the foreseeable future.
Asset Quality Risk .............................. 5
Financial Risk ..................................... 7 It is important to understand that Rental REIT Fund Rating
Management Review .......................... 7 differs fundamentally from the traditional credit rating,
which reflects an entity/issuer’s ability to meet its financial
obligations. PACRA’s opinion is based on evaluation of the
following factors: i) Profile, ii) Economic and Industry Risk,
iii) Asset Quality Risk, iv) Financial Risk, and v)
Management Review.

Analyst Contacts The Pakistan Credit Rating Agency Limited

Nusrat Abeer Hyder Head Office
+92-42-3586 9504 FB1 Awami Complex
[email protected] Usman Block, New Garden Town
Lahore
Phone +92 42 3586 9504
Karachi Office
PNSC Building,3rd Floor
M.T. Khan Road, Lalazar
Karachi
Phone +92 21 35632601

Disclaimer: PACRA has used due care in preparation of this document. Our information has been obtained from sources we
consider to be reliable but its accuracy or completeness is not guaranteed. PACRA shall owe no liability whatsoever to any loss
or damage caused by or resulting from any error in such information. Contents of PACRA documents may be used, with due care
and in the right context, with credit to PACRA. Our reports and ratings constitute opinions, not recommendations to buy or to
sell.
 Rental REIT Fund Rating
Assessment Framework

1. Introduction
• Overview: Pooled 1.1 Overview: Real Estate Investment Trusts (REITs) are investment vehicles designed to
investment, Close-end mobilize resources from a large pool of investors and, in turn, provide them access to income-
funds generating real estate assets. A REIT is structured like a traditional closed-end mutual fund,
• REIT Industry however, instead of stocks and bonds, a REIT investor owns real estate backed units that sell
Structure: Distinction like any other units/listed security, enabling the unit holder to invest directly in real estate.
between Direct
Returns for the investors are in the form of either rental income distributed through dividends
Investment and SPV
structure
or capital gains through price appreciation of the underlying assets reflected in the unit price.
• Scope: Opinion on a REITs generally distribute majority of their profits (over 90% in Pakistan) to their unit holders
Rental REIT fund’s to receive favorable tax treatment under Pakistan’s tax laws. REITs enable investors to have a
capacity to maintain direct exposure with low individual investments to a relatively illiquid asset class with sizeable
stable rental income, initial capital requirement.
and risk factors
impacting value of 1.2 REIT Industry Structure: REITs fall under two structures:
REIT assets over the
foreseeable future. i. Direct Investment Structure – REIT Scheme directly invests in the REIT project.
• Regulatory ii. Special Purpose Vehicle (SPV) Structure – REIT Scheme invests in SPV for execution
Framework: Real
of REIT Project. Following conditions should be met:
Estate Investment Trust
Regulations, 2022 and a) With the consent of Trustee, RMC shall appoint SPV through SPV Management
Listing on PSX Services Agreement to set the terms
• Rating Framework: b) If there is any change in structure of REIT, RMC shall get approval of Unit Holders
Qualitative and through Special Resolution
quantitative factors, all
c) REIT Scheme shall own at least 75% share capital of SPV
factors assessed on
standalone and relative d) No change can be made in SPV Management Services Agreement without consent of
basis Trustee and a prior notice of at least seven days to Unit Holders
• Rating Scale: AAA(rr)
to B(rr) 1.3 Types of REITs: The REIT industry has two distinct elements: REIT Management
Company (RMC) and REIT funds. REIT funds can be structured as three different models –
Rental, Developmental or Hybrid REIT funds. These are briefly described below:

i. RMC – a public limited company licensed to undertake REIT management services

ii. Rental REIT funds – established with the objective of making investment in industrial,
commercial or residential real estate for generating rental income
iii. Developmental REIT funds – established with the objective of development,
construction, refurbishment, rehabilitation, management and/or operation of real estate
for industrial, commercial, residential purpose or a combination of these
iv. Hybrid REIT funds – comprising developmental component as well as rental
component

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 Rental REIT Fund Rating
Assessment Framework

1.4 Scope: PACRA has developed separate methodologies to capture the distinct rating
considerations attached to these elements of the REIT industry, depicted in the following
diagram. This methodology outlines PACRA’s rating considerations for Rental REIT Fund
Rating.

1.5 Regulatory Framework: REITs are regulated by the Securities and Exchange Commission
of Pakistan (SECP), which has issued a comprehensive set of regulations (REIT Regulations
2022, hereon referred to as “the Regulations”). Recently introduced amendments in the
regulations are aimed at introducing new REIT products and decomplicating the registration
and approval processes to encourage new entrants and improve industry competitiveness.
Following are some of the key amendments:
i) Enhanced scope of REIT Assets through addition of following real estate
segments: agriculture, healthcare, transport, power, energy, telecommunication,
water & sanitation, social, cultural & commercial segment.
ii) Addition of new types of REIT Scheme: “Investment based REIT scheme” which
can invest in multiple completed real estate units e.g. shops, hotel rooms, offices
etc. where source of return for unit holders would be revenues generated from rental
income.
iii) Reduction of total number of approvals required by REIT from 7 to 4, with more
responsibility placed with RMC and trustee for various steps.
iv) Valuer given liberty to decide valuation methodology, while following
requirements specified in relevant annexure of Regulations and
industry/international best practices.

1.6 The Regulations address all aspects of REIT registration, operations, and roles and
responsibilities of all parties including the RMC. REITs can be formed under Public and Private
Partnership model (referred to as PPP REIT schemes) or otherwise directly or through Special

•REIT Manager •Rental REIT Fund •REIT Fund

Rating is an Rating is an Rating is an
independent independent independent
opinion on the opinion on the opinion on the
quality and capacity of a likelihood of
expertise Rental REIT Fund successful
deployed by an to maintain stable implementation
RMC and rental income, of a REIT
potential and risk factors project, and risk
vulnerability to impacting value factors impacting
investment of REIT assets value of REIT
management and over the assets over the
operational foreseeable foreseeable
challenges. future. future.

Purpose Vehicles (referred to as non-PPP REIT schemes). As per the Regulations, a non-PPP
REIT scheme must be listed on the PSX within three years after its first financial close while in
case of PPP REITs, it should be listed no later than after the first year of its commercial
operations date. Some salient features of the Regulations are listed in the table below:

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 Rental REIT Fund Rating
Assessment Framework

Minimum ownership requirement by accredited investor/RMC:

In case of single strategic investor 25% of fund size
In case of multiple strategic investors 5% of fund size
Permitted borrowing without approval of unit holders 25% of fund size
Application for permission to form an RMC PKR 0.25 million
Application for license to undertake or carry out REIT Management PKR 1 million
Services.
Application for the renewal of license to carry out an activity or Nill
function.
Launch REIT scheme PKR 0.5 million
Annual Monitoring Fee to SECP (Rental REIT) 0.1% of fund size
Annual Monitoring Fee to SECP (Developmental REIT) 0.2% of fund size
Annual Monitoring Fee to SECP (Hybrid REIT) 0.15% of fund size
1.7 Rental REIT Fund Rating Framework: PACRA follows a comprehensive framework
when assigning Rental REIT Fund Rating, comprising both qualitative and quantitative
analyses. The factors considered during evaluation include: i) Profile, ii) Economic & Industry
Risk, iii) Asset Quality Risk, iv) Financial Risk, and v) Management Review. PACRA attempts
to analyze a REIT not only on a standalone basis but also in the relative universe, where
applicable.

1.8 Rating Scale: Rental REIT Fund Rating scale ranges from AAA (rr) (fund having
exceptionally strong capacity to maintain stable rental income, and risk factors impacting value
of REIT assets are negligible over the foreseeable future) to B (rr) (fund having weak capacity
to maintain stable rental income, and risk factors impacting value of REIT assets are very high).
The scale is appended with “+” and “-” signs to denote relative status within each category
except “AAA (rr)” and B (rr)”.

2. Profile
• Portfolio Mix: 2.1 Portfolio Mix: Rental REITs hold completed, rent generating assets in industrial,
Property, segmental commercial or residential real estate segments. PACRA looks at composition of the REIT fund’s
and geographic portfolio and degree of diversification in terms of the number of properties and underlying real
diversification in estate segments. A fund with a single underlying property or multiple properties within a single
portfolio real estate segment would generally be considered riskier due to higher risk of disruption. This
does not entail that a fund specializing in a certain real estate segment would necessarily be at a
disadvantage. Nor does it imply that simply higher number of properties would assure high
stability in rental income and appreciation in asset value. In case of multiple properties, PACRA
would assess diversification at segment and geographic level. Meanwhile, individual asset
quality of each property would be assessed as per the criteria outlined in Section 3 of this
methodology, and will be factored accordingly into the rating opinion.

3. Economic & Industry Risk

• Economic Overview: 3.1 Economic Overview: The real estate industry is strongly correlated with overall economic
Linkage of real estate conditions. Macroeconomic indicators like GDP, manufacturing activity, interest rate
industry with environment and favorable policies exhibit a favorable correlation with the real estate demand
macroeconomy and, in turn, prices. It is also viewed by investors as a viable investment venue. In a growing
• Industry Dynamics: economy, with low interest rates, capital availability becomes high, resulting in higher
Systemic risks and
purchasing power and creates interest for investors. Therefore, more commercial real estate
operating environment

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 Rental REIT Fund Rating
Assessment Framework

projects are likely to be initiated. Interest rates can have a dual impact. In addition to capital
access, high interest rates may end up negatively impacting demand for REITs as investors opt
for safer investment options such as bank deposits or government securities. Meanwhile,
population demographics, urbanization rate and political stability are other important factors
when analyzing real estate trends. Budgetary allocation by the government for infrastructure
development also plays an important role in the development and growth of the industry as
investors are attracted and encouraged to invest through various schemes and incentives.

3.2 Conversely, in times of low economic growth, REIT returns may suffer as property prices
stagnate and the market becomes illiquid. Rental income may also get impacted due to
likelihood of low occupancy and inability to increase or recover full rental payments. In such
conditions, negotiating power of property owners over tenants is also likely to be compromised.
PACRA closely monitors economic conditions for indicators of negative movement in the
economy and factors the same in its rating assessment.

3.3 Industry Dynamics: PACRA analyzes the real estate industry in context of the local
economy and regulatory environment. REITs are a relatively new entrant in Pakistan’s market.
However, progressive regulatory reforms in recent years have encouraged several new entrants.
At the time of this document’s publication, 22 RMCs have obtained licenses to provide REIT
management services. These numbers reflect the addition of 7 RMCs in the past year, reflecting
the improvement in the sector’s attractiveness for investors. REITs remain a tax friendly
investment avenue, given 90% of its profits are distributed.

3.4 The COVID-19 pandemic had a negative impact on commercial properties, especially retail
and office buildings. With lower footfall and consumer shift to online shopping and work from
home protocols, several malls and commercial buildings faced pressure on tenancy and had to
restructure rental agreements. Government’s focus on the real estate and construction sector,
including several incentive packages for the construction industry, ignited strong growth in
recent years. However, a fast-rising interest rate environment and policy uncertainty with the
incumbent government has impacted the sector. PACRA follows prevailing economic,
regulatory and industry events and trends and duly incorporates it in its analysis and opinion
formation.

4. Asset Quality Risk

• Market Position: 4.1 Market Position: Market position is determined with the perspective of customer interest
Relative standing for a particular property and is driven by a variety of factors including property type, location,
among peers in terms infrastructure dynamics and physical state. Market position ultimately drives the occupancy of a
of property type,
location, infrastructure,
property across changing market dynamics and economic shocks.
physical state • Type of Property: Different types of properties exhibit varying degrees of business risk.
• Tenancy Risk: PACRA considers demand for shopping malls and hotels to be highly sensitive to
Tenancy contracts, economic cycles while demand for schools, hospitals, residential and office space, is
rates and trends, expected to remain more stable even in an economic downturn, hence providing more
concentration in tenant comfort to the rating. PACRA recognizes that such relationships may not always hold or
base be as straightforward. For example, demand for industrial properties like factories and
• Legal Risk: Legal title, manufacturing plants may show a mixed trend, depending on the demand-supply
documentation, dynamics of the particular industry and its sensitivity to economic conditions.
transferability,
disputes, approvals Investors and customers are becoming increasingly conscious about Environmental,
• Third-Party Service
Social and Governance (ESG) risks pertaining to Real Estate sector and projects. E&S risk
Provider Risk:
Servicing agreements,
become more important for rental REIT perspective as preference for “Green” buildings
onboarding, is gaining traction. These could impact the demand and eventual returns of the project.
performance PACRA considers these risks in its evaluation to assess their impact on the final rating.

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 Rental REIT Fund Rating
Assessment Framework

monitoring and • Geographic Location: Strategically located properties with close proximity to residential
controls and commercial areas are viewed positively. PACRA analyzes the ongoing and planned
• Event Risk: development in the area to form a view on demand prospects. Presence of substitute
Incorporating risk of properties or threat of new entrants can impact market position.
unforeseen events
• Infrastructural Dynamics: Connectivity to well-developed transportation networks for
accessibility and availability of utilities (power, gas, water etc.) and parking space is
considered favorable.
• Physical State: PACRS assesses the age, physical state, amenities and maintenance of the
properties to estimate its useful life and prospects to maintain or improve income
generation as well as remain competitive. A well-maintained property is more likely to
result in long-term occupancy and ability to attract new tenants.

4.2 Tenancy Risk: To determine tenancy risk, PACRA looks at the underlying tenancy
agreements, vacancy rates, and profile and diversity of tenant base.
• Tenancy Agreements: Longer term tenancy agreements, with prescribed rental increment
clauses are viewed favorably since they mitigate the risk of unexpected vacancies and
provide stable cashflows. PACRA examines average tenure of the agreements, expiry and
opt out clauses, and backup plans if a major tenant leaves unexpectedly.
• Vacancy Rates: Higher vacancy rates relative to the industry can be an important indicator
of troubles in property management or marketing. PACRA opines whether this is a
temporary or one-off occurrence or whether a trend is developing.
• Tenant Base: Concentration of revenue among top 5 and top 10 tenants is considered.
Less than 10% exposure to the top tenant is considered desirable. High-profile tenants,
evergreen tenants or tenants with good credit ratings generally offer more comfort to the
rating due to their financial strength and ability to honor contractual tenancy terms.

4.3 Legal Risk: PACRA evaluates the protocols in place for evaluation of legal risk as legal
disputes pertaining to property can potentially cause huge losses or even lead to closure of
projects or suspension of income. PACRA expects due diligence to be conducted pertaining to
the legal status of the property, including ensuring the property is clear from any lien mark, stay
orders against the transfer of the legal title, availability of complete documentation and approvals
obtained from relevant authorities for real estate development and factors the same in its rating
assessment accordingly.

4.4 Third Party Service Provider Risk: As per the REIT Regulations, third parties are
required to be appointed by an RMC to provide certain services through Service Level
Agreements (SLAs). PACRA considers the quality and terms of engagement for these parties
while control mechanisms to monitor their performance and comprehensiveness of related
contingency planning are also evaluated. This is important to prevent potential disruption in
operations due to negligence or underperformance by service providers which can end up
impacting property quality and tenant satisfaction. Some key parties which are scrutinized
during this analysis include: Valuer, Development Advisor/Property Manager and External
Auditor.
• Valuer: The Valuer is appointed with by the RMC (with consent of trustee) for valuation
of REIT assets. PACRA assesses the independence of the Valuer, its listing position on
the panel of valuers maintained by Pakistan Banks’ Association (PBA), and experience in
the field since it directly impacts the value of the REIT assets.
• Property Manager: Smoothly run daily operations are essential for tenant satisfaction
and property preservation. The Property Manager is responsible for managing and
maintaining the property on a daily basis. Here, PACRA reviews the experience, track
record and market reputation of the designated personnel/entities to determine their ability
to ensure maintenance and upkeep. SOPs outlining regular maintenance and support

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 Rental REIT Fund Rating
Assessment Framework

services, along with systems in place to document and address tenant complaints and
grievances are analyzed. Easy and efficient complaint systems with short resolution
timelines are considered positively. The degree of oversight and supervision and sharing
of related MIS is also considered.
• REIT Auditor: Assessing the quality of the REIT auditor is crucial to establish the
integrity of its financial statements and reporting. PACRA reviews whether the external
auditor is on the panel of approved auditors maintained by the State Bank of Pakistan
and/or has a satisfactory QCR rating to form its opinion.

4.5 Event Risk: Incorporating the risk of unforeseen events that can cause a disaster, into a
rating opinion is challenging, given their unpredictable nature. However, their potential impact
makes them a consideration. These events may be external (economic changes, regulatory
changes, litigations, or natural disasters such as earthquakes, landslides or flooding) or internally
driven (unrelated diversification or strategic restructuring) and can lead to sudden and material
shocks to rental income. PACRA evaluates any third-party guarantees or insurance arrangements
in place to mitigate such risks. PACRA also applies its analytical judgment in assessing the
likelihood of such occurrences and potential impact, insofar as may be possible, and assesses the
REIT fund’s track record, expertise of RMC and level of financial discipline to incorporate the
same into its ratings.

5. Financial Risk
• Cashflows: Ability to 5.1 Cashflows: Properties with strong market position (in terms of location, amenities, and
raise cash, strategic physical state) and financially strong, diversified tenant profiles are generally likely to generate
investors’ financial more stable cash flows. Longer tenure of rent agreements and regular rent renewal clauses
profile, liquid assets, would also favorably impact stability of cash flows. Given the liquidity constraints posed by
borrowing lines high dividend distribution requirement to maintain tax free status, it is crucial for PACRA to
• Coverages: Quantum
assess the REIT’s ability to raise cash, internally or through the strategic investor. Herein,
and stability of
cashflows, coverage of
special consideration would be given to existence of liquid assets, available borrowing lines and
costs access to capital markets to sustain ongoing operations including proper maintenance and
• Capital Structure: upkeep of the properties and all related services and amenities, and cover incurrence of
Leveraging, financial unexpected costs (e.g., financial penalties or fines from legal authorities or third parties). The
flexibility quality and market position of properties in the REIT’s portfolio factor in here as important
determinants of occupancy and, hence, rental income and value of REIT assets.

5.2 Coverages: Key cash flow measures used by PACRA include a REIT’s Funds from
Operations (FFO) and Adjusted Funds from Operations (AFFO) where AFFO accounts for the
impact of ongoing maintenance expenses, capital expenditure and impact of any rent increases
and advances received from tenants PACRA analyzes the adequacy of coverage provided by
cash flows to outstanding costs, including debt principal and interest payments.

5.3 Capital Structure: PACRA analyzes capital structure to determine a REIT’s reliance on
external financing. While there is no absolute ceiling for borrowing stipulated by the
Regulations, from a rating perspective, REITs with conservative leveraging are viewed
favorably. This is because higher borrowing and debt repayment leads to drain of cash resources
and limited financial flexibility which impacts the REIT’s ability to adapt to changing economic
conditions or sustain shocks in business.

6. Management Review
• RMC Rating: Quality 6.1 The ability of a REIT fund to meet its investment objectives and adhere to stated policies
of REIT manager is depends on the RMC’s expertise and quality of support systems. Therefore, an assessment of
determined under the RMC’s qualification, experience, capabilities and track record are an integral part of the

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 Rental REIT Fund Rating
Assessment Framework

PACRA’s REIT rating process. The assessment of management quality may also provide a basis of how the fund
Manager Rating might respond to future opportunities or stress situations under different market conditions.
methodology
6.2 RMC Rating: Opinion on quality of the RMC is directly derived from the RMC Rating, the
criteria for which is detailed in PACRA’s REIT Manager Rating methodology. During the
evaluation process, PACRA reviews the policies and procedures developed by the management
to meet its investment objectives and assesses the efficacy of the investment management
process, the supporting organizational structure, internal controls, risk management, and
reporting systems.

6.3 Analysis of arrangements with and quality of third-party services providers is conducted.
Adequacy of the resources and appropriate segregation of duties to prevent conflict of interest
is considered positively. Further, the profile of the RMC management team is assessed in terms
of relevant experience and track record. A key measure of management effectiveness is its track
record of delivering on past projections and sticking to strategies defined in its business plan.
Investment process and quality of underlying research are also key considerations.

6.4 To determine the REIT fund’s level of risk tolerance and confirming harmony in fund’s
stated objectives and the REIT manager’s investment philosophy in future course of action,
discussions with the RMC regarding investment strategy and outlook on business and industry
are a vital part of the rating process. The framework deployed to ensure compliance with
regulatory requirements and its actual effectiveness would likewise be an important
consideration.

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 Rental REIT Fund Rating
Scale – Rental REIT Fund Rating
Scale

Rental REIT Fund Rating - Current

Opinion on the relative capacity of a Rental REIT fund to maintain stable rental income and risk factors impacting value of REIT
assets.

Scale Definition
Exceptionally Strong capacity to maintain stable rental income. Risk factors impacting value of REIT assets are
AAA (rr)
considered negligible over the forseeable future.
AA+ (rr)
Very Strong capacity to maintain stable rental income. Risk factors impacting value of REIT assets are modest over
AA (rr)
the foreseeable future.
AA- (rr)
A+ (rr)
Strong capacity to maintain stable rental income. Risk factors impacting value of REIT assets may be vulnerable to
A (rr)
changes in the economy over the foreseeable future.
A- (rr)
BBB+ (rr)
Adequate capacity to maintain stable rental income. Risk factors impacting value of REIT assets may be impacted by
BBB (rr)
changes in the economy over the foreseeable future.
BBB- (rr)
BB+ (rr)
BB (rr) Inadequate capacity to maintain stable rental income. Risk factors impacting value of REIT assets are high.
BB- (rr)

B (rr) Weak capacity to maintain stable rental income. Risk factors impacting value of REIT assets are very high.

Outlook (Stable, Positive, Rating Watch Alerts to the Suspension It is Withdrawn A rating is Harmonization A
Negative, Developing) Indicates possibility of a rating change not possible to withdrawn on a) change in rating due
the potential and direction of a subsequent to, or, in update an opinion termination of rating to revision in
rating over the intermediate term in anticipation of some material due to lack of mandate, b) cessation applicable
response to trends in economic identifiable event with requisite of underlying entity, c) methodology or
and/or fundamental indeterminable rating information. the debt instrument is underlying scale.
business/financial conditions. It is implications. But it does not Opinion should be redeemed, d) the rating
not necessarily a precursor to a mean that a rating change is resumed in remains suspended for
rating change. ‘Stable’ outlook inevitable. A watch should be foreseeable future. six months, e) the
means a rating is not likely to resolved within foreseeable However, if this entity/issuer defaults.,
change. ‘Positive’ means it may be future, but may continue if does not happen or/and f) PACRA finds
raised. ‘Negative’ means it may be underlying circumstances are within six (6) it impractical to surveill
lowered. Where the trends have not settled. Rating watch may months, the rating the opinion due to lack
conflicting elements, the outlook accompany rating outlook of should be of requisite information
may be described as ‘Developing’. the respective opinion. considered
withdrawn.

Surveillance. Surveillance on a publicly disseminated rating opinion is carried out on an ongoing basis till it is formally suspended or withdrawn. A
comprehensive surveillance of rating opinion is carried out at least once every six months. However, a rating opinion may be reviewed in the
intervening period if it is necessitated by any material happening.

Disclaimer: PACRA has used due care in preparation of this document. Our information has been obtained from sources we consider to be reliable but
its accuracy or completeness is not guaranteed. PACRA shall owe no liability whatsoever to any loss or damage caused by or resulting from any error
in such information. Contents of PACRA documents may be used, with due care and in the right context, with credit to PACRA. Our reports and
ratings constitute opinions, not recommendations to buy or to sell.