The Concept:

The real estate sector has recently assumed considerable importance in Pakistan with the expectation that this could soon emerge as the critical catalyst for stimulating investment and industrial activity in the country. A number of factors including the high cost of inputs, declining productivity, reduced competitiveness of local industry in the post-WTO setting has discouraged industrial investment in the country. While the financial sector is sitting on a huge pile of funds and the borrowing cost has declined to historical lows, borrowers are few and far between. Under the circumstances, financing of housing projects offers promising prospects. Again, from the perspective of potential house owners, the financing option has become feasible only with the sharp decline in borrowing costs. The tax concessions in the recent budget have provided further incentives to finance house ownership through borrowing. Thus, all the necessary - and sufficient - conditions are in place for stimulating activity in the sector. However, there is one important factor which could discourage both lenders and investors (home owners). This concerns the credibility of developers and the reliability of completing housing projects on time and without cost overruns. This factor assumes greater significance in the backdrop of a number of scams in the recent past relating to property development and housing schemes. What could provide a degree of comfort to lenders and investors? In India, a mechanism which is being increasingly relied upon is the grading or rating of real estate developers and projects by recognized credit rating agencies. The real estate sector has traditionally been associated with inadequate information and lack of agreed standards. The PACRA grading, which will be an independent opinion on the relative performance capability of the relevant real estate entity, aims to serve as a tool for identifying and managing risks associated with the concerned entity.

Besides benefiting the sector participants and end users (investors/customers), the grading is designed to provide objective opinions as inputs in the pricing and credit decisions of banks/financial institutions. The grading will not be a recommendation to lend/do business with or not to lend/not to do business with a certain entity/project.

The Benefits:

The grading of the real estate developers is designed to make investors (end user/buyer of property) aware of the developer's relative capacity to deliver as per specified terms and quality parameters and transfer of ownership on time. The grading is also expected to facilitate the overall growth of the real estate sector by providing developers with incentives to conform to fair trade practices and legal requirements.

A scientifically graded project would lend itself to a more accurate and reliable estimation of risks associated with the real estate project/project promoter. This is expected to enhance the confidence of the end users and provide comfort to lenders of these projects, thereby facilitating the flow of institutional funds to the project/project owner.

The Grade Assessment Process:

The assessment process for the real estate developer or the real estate project commences at the request of the respective entity. Once the mandate letter is received, PACRA require, inter-alia, the developer's financial statements, organisational structure and project experience. On receipt of the information, a team of analysts takes up the task of preparing a report on that entity, highlighting its business and financial risks. During this process, support is drawn from the in-house research and database of PACRA. The report prepared by the analysts is presented to the Grading Committee for assessing the entity. The whole process is highly interactive and includes inputs from sector specialists, if and when required.

PACRA will ensure strict confidentiality of all information collected during the assessment process.
The methodology and definitions of the proposed rating/grading system are attached.

• Sector specific risk: Overview of the state of the economy and its near and medium term prospects. Sectoral presence of the developer/builder enterprise and revenue generation capacity.

• Market Position: The position of the developer vis-à-vis other players and the developer's general reputation in the market.

• Project Composition: Project mix in terms of the number and value of projects in hand.

• Adherence to project time schedules: Present state of all the projects undertaken by the developer and the extent of adherence to milestones indicates the chances of any time overruns.

• Project Quality track record: The quality of the completed projects has a vital bearing on the developer's business risk. The quality consciousness of the developer refers to the quality procedures adopted at the various project sites, material procurement and inspection systems adopted by the developer.

• Project Management and Systems for timely completion: The internal planning and project management systems adopted, extent of review meetings at the on going project sites, nature of construction agencies deployed and construction techniques adopted can significantly affect the progress at the worksites.

• Management Quality: Organisation structure, commitment of the management, management policies and human resources deployed.

• Extent of legal compliance and documentation: Conformity with building byelaws and regulations and trade practices followed. Extent of documentation also has an important bearing.

• Contract Composition: Indicates the nature of contracts entered into by the developer with the construction agencies which influences the risk sharing in case of any delay or deviation.

• Past projects track record: Track record of the developer in terms of quality, timely completion and transfer of ownership to the customers.

• Dispute and litigation track record: Nature and extent of litigation against the developer by government/semi government/public sector agencies and the general public.

• Customer satisfaction: Extent of satisfaction of the customers/investors and redressal of grievances of the purchaser/investor; specifically, the system and timeliness of handling queries and complaints.

• Profitability: Important indicator of developer's financial strength.

• Leverage: Developers that are highly leveraged face bigger problems during economic downturns.

• Financial Flexibility: Financial flexibility refers to the company's ability to arrange funds in case of a liquidity crunch and erratic cash inflows.

• Working Capital Management: Control of receivables and advances from customers and working capital management thereby requiring less interest-bearing working capital support from external sources.

• Insurance Cover: Insurance cover taken by the developer for its various projects reduces the risk in case of any contingencies.

• Accounting Quality: Includes accounting practices and standards followed.

• Contingent Liability: Any contingent liability that may significantly affect the risk profile of the developer.

• Completion risk: This is the risk that the project may not be completed in time or at all due to faulty planning, cost overruns, wrong choice of construction agencies.

• Price risk: Price quoted should be reasonable and any risk of volatile prices due to supply-demand factors increases the price risk.

• Resource risk: The risk includes the non-availability or a possibility of an adverse price movement in construction inputs.

• Quality and non-conformance risk: This is the risk of non-conformance of laid down quality standards for construction processes and raw materials.

• Policy risk: This risk relates to consistency in government policies that could have a material impact on the project.

• Project development risk: This is a risk that the project development may not take place in an orderly manner if the agreement between the landowner and developer contains certain ambiguities.

• Permission Risk: This is the risk that official clearances like approved building plans, licences from competent authorities may not be forthcoming or subject to expensive conditions.

• Interest Rate Risk: This is the risk that the floating interest rate of the project, if any, would increase beyond the levels assumed for preparing projected cash flows.

• Insolvency Risk: This is the risk of insolvency of the Developer.

• Site Risk: This is the risk that the project site might have legal encumbrances.

• Transfer of ownership risk: This is the risk that the ownership title may not be transferred effectively.

• Penalty clause: Presence of a penalty clause in case of delay in handing over possession in time can act as a source of comfort to the investor.

• In addition to the project specific risks the past track record of the developer and its financial position have an important bearing on the grading of the project.