Rating Methodology. Alternative Investment Funds Open-Ended Real Estate Funds. June Contact

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1 Alternative Investment Funds Open-Ended Real Estate Funds June 2016 Contact Sonja Knorr Director +49 (0)

2 Purpose of Document This document explains the methodology used by Scope to rate Alternative Investment Funds () of the openended real estate fund variety. It covers the analytical framework in detail and the primary drivers in the rating process. The rating process and methodology for open-ended real estate funds rest on principles that are valid for all ratings carried out by Scope. They can be viewed online at Scope Ratings.com Code of Conduct Conflict of Interest Management Disclosure Requirements Scope of Application and Rating Opinions The methodology described here is applied to all open-ended real estate funds that make equity investments and whose individual investors do not have a fixed investment horizon, in particular German open-ended real estate mutual funds for retail investors (offene Immobilienpublikumsfonds) as well as institutional investors (Immobilien-Spezialfonds). In these ratings, Scope gives an opinion on the open-ended real estate fund s risk/return profile based on its investment portfolio and investment strategy, and thus provides a ranking of various funds against these parameters. Overview The rating process takes into account both qualitative and quantitative criteria, which allows for a high degree of objective comparability across the open-ended real estate fund segment. The methodology used has three components: Portfolio analysis & risk/return relationship. Portfolio analysis involves performing quantitative analysis to determine the risk of the underlying real estate portfolio. Both property and lease data are thoroughly examined for specific risks, for example those arising on the age or size of the properties, occupancy rates, lease structure, or real estate market fundamentals. At the same time, risk factors related to sustainability and capital structure are assessed. These risk factors are weighted and used to calculate a risk premium representing the expected loss that is added on to the risk-free interest rate. Scope uses the interest rate in the relevant country on a (virtually) riskfree investment in capital market instruments to determine the risk-free rate. In accordance with the IDW 1 Standard (IDW ES 10), the return on government bonds with the same maturity is considered a good proxy for the risk-free interest rate. Asset management analysis. In asset management analysis, Scope assesses the management performance at both the investment management company (now referred to in Germany as a Kapitalverwaltungsgesellschaft, or KVG) and with respect to the individual funds it manages. Entity and sector analysis. The third component involves a qualitative assessment of what are known as specific factors, for example market influences, the performance of individual funds, or how they manage their liquidity. 1 The German Institute of Public Auditors (Institut der Wirtschaftsprüfer). June / 11

3 Graph 1 - Diagram of the Rating Methodology for Open-Ended Real Estate Funds Source Scope Analysis June / 11

4 Rating Methodology for Open-Ended Real Estate Funds Level 1: Real Estate Portfolio, Capital Structure, and Sustainability Analysis Risk/Return Relationship Real Estate Portfolio Analysis In portfolio analysis the largest analytical component key risk indicators are identified for the portfolio and then aggregated to obtain the value of the portfolio. National and Local Market Parameters In assessing national market parameters, Scope uses the Deka Immobilien Real Estate Country Score published each year. The risk level, which is weighted to reflect the market value of the assets, is calculated at fund level. In rating investment diversification, Scope examines the distribution among geographies and markets as well as by the types of use to which properties are put. The breakdown covers the division by continent, national market, and investment market. Urban investment markets are divided into Classes A, B, C and lower, based on criteria like the size of the local real estate market and the office space turnover rate. Designation A locations B locations C locations General considerations Metropolises with a degree of international importance Big cities of national and sub-national importance Cities of predominantly subnational importance Stock of office space Turnover rate Prime rents Over 7m sq. m. Over 150,000 sq. m. Over EUR 16/sq. m. Over 2m sq. m. Over 35,000 sq. m. Over EUR 12/sq. m. Under 2m sq. m. Under 35,000 sq. m. Under EUR 12/sq. m. Scope s analysis of distribution by property type focuses not only on the division of assets into several basic property types, but also on the specific features of each property type. For example, Scope distinguishes between sectors that are cyclical, non-cyclical or lag behind the economic cycle. Structural Parameters The guiding principle underlying the assessment of the property age is that the older an asset is, the greater the risk. In terms of property size, Scope examines the percentage of properties similar in size and of the same type in a given market, drawing on market data from the Investment Property Databank (IPD). The more liquid the market in which properties are traded, the lower the risk for the fund. Leasing Parameters Scope assesses leasing parameters using four sub-criteria: lease terms, single tenant risk, over-rent risk, and occupancy rate. Over-rent risk is calculated as the share of leases due to expire in a property s main lease category on which the rents currently exceed average market rents by more than 10%. A tenant that generates more than 95% of gross potential rental income from a given property is classified as a single tenant. In assessing both single tenant and over-rent risk, Scope only considers leases that are due to expire within the next three years. June / 11

5 Special Cases and Departures from the Established Portfolio Assessment Procedure Scope analysts may depart from the established procedure for weighting the various criteria, and particularly sub-criteria, when a fund exhibits special characteristics. This applies in particular to the question of diversification. In the case of smaller funds, diversification risk takes on greater significance and may therefore be given greater weight. The methodology covers both mixed commercial real estate portfolios and homogeneous portfolios, such as those composed solely of residential properties. However, in the case of residential property portfolios, the residual lease terms may be treated somewhat differently. Sustainability Property sustainability takes on particular relevance for both the investment and the portfolio management process. To reflect that relevance in its analyses of open-ended real estate funds, Scope has created a separate rating component for sustainability. A sustainability assessment has three elements: the fund manager s sustainability strategy, the sustainability organization, and the sustainability of the portfolio. Sustainability Strategy To start with, Scope checks whether the management company has an actual sustainability strategy, how that strategy is laid down and documented and whether an annual sustainability report is issued. Scope then determines whether the sustainability strategy seems plausible, both in general terms and in relation to the specific portfolios being considered. Special emphasis is placed on the extent to which the strategy is put into practice and affects the real estate portfolios under management. Scope specifically assesses the type and scope of the certification obtained by the portfolios and what requirements the management company sets for both acquisitions and its existing portfolio. Sustainability Organization How consistently sustainability is incorporated into the various processes along the real estate value creation chain is a decisive criterion for evaluating the organization structure responsible for ensuring sustainability. Significant focus areas here include acquisition and disposal planning, technical due diligence, and risk control. To evaluate the degree to which the sustainability strategy is actually implemented, Scope analyses the sustainability organization and the size of its staff against the number of portfolios under management and their geographic and sectoral breakdown. Of particular importance in this connection is whether the organization has a sustainability budget, and if so, how large it is and whether there is a system for comparing properties (e.g., with respect to carbon emissions) to evaluate the effectiveness of the strategy. Sustainability of the Property Portfolio In rating portfolios, Scope tracks 20 indicators applied to individual properties: 13 indicators for property maintenance and value preservation, and 7 predominantly use-based indicators for sustainable resource management. With regard to property maintenance, indicators like rainwater harvesting, the use of renewable energy, and main entrance accessibility are tracked and evaluated. In the areas of sustainable resource management, Scope examines such indicators as CO 2 kg per square meter per year and individual tenant usage data (water and electric power). June / 11

6 Financial Structure Scope uses four key metrics to rate the capital structure of an open-ended real estate fund: the level of liquidity and its composition, the debt financing structure, and open foreign exchange positions. Level and Structure of Liquidity Adequate liquidity is extremely important for open-ended real estate funds and will remain so with the new KAGB (the German Capital Investment Code). In this panel, Scope examines a fund s liquidity ratio and available credit facilities as a possible liquidity management instrument. In assessing liquidity structure, Scope examines the extent to which a fund has cash or assets readily convertible into cash, along with the associated investment risk. Bank credit balances generally rank highest among assets readily convertible into cash, but Scope analysts also consider whether the fund s overnight and time deposits are divided up among different banks. They base their evaluation of money market instruments and securities held by a fund on the available external ratings for those investments. The higher they are rated, the lower the risk is. Debt Financing Structure In this panel, two basic points are examined: loan amounts and terms to maturity. Scope s analysis of loan amounts is based on the general principle that the lower the debt ratio, the lower the risk. In assessing term to maturity and fixed interest-rate periods on loans, Scope places major emphasis on how the interest rates will evolve over the life of the loans. Open Foreign Exchange Positions Open i.e., unhedged foreign exchange positions are assessed according to the principle that the smaller the open positions, the lower the exposure to adverse movements in exchange rates. Risk/Return Relationship To determine the risk/return relationship, Scope uses the historical returns over the minimum period that investors are typically required to stay invested (currently two years for German mutual funds) as a basis. The risk factors related to the areas referenced above are weighted and then translated into a risk premium equal to the expected loss that is added on to the risk-free interest rate. Scope uses the interest rate in the relevant country on a (virtually) risk-free investment in government bonds to determine the risk-free rate. In accordance with the IDW Standard (IDW ES 10), the return on government bonds with the same maturity is considered a good proxy for the risk-free interest rate. Of decisive importance for Scope s assessment is the comparison between the risk-adjusted return and the actual performance of the fund. If the two figures are roughly commensurate, Scope assigns a BBB rating. A fund that outperforms the riskadjusted return gets an A rating or higher, whereas a fund that underperforms it is rated BB or lower, depending on how large the gap is between the two returns. If no complete history of returns is available for the minimum holding period, Scope determines the risk/return relationship based on the returns recorded to date and the return forecasts for the portfolio under consideration. In such cases, the rating will be marked (P) for preliminary. June / 11

7 Level 2: Asset Management and Fund Management Scope firmly believes that good management is a major driver of successful investment. High-quality management can reduce risk and increase opportunity. In rating open-ended real estate funds, Scope examines management from two standpoints. Asset management ratings involve looking closely at the management company as a whole, whereas fund management ratings deal solely with specific individual funds. In analysing open-ended real estate funds, Scope draws explicitly on its own published asset management ratings. For companies with no separate asset management rating assigned to them, Scope carries out a structured rating process that may be adjusted in special cases at the Rating Committee s request. Asset Management Ratings Scope s asset management ratings (AMR) evaluate the quality of asset managers and thereby provide an informational edge for making investment decisions. Its AMRs apply a top-down, bottom-up approach that analyses both qualitative and quantitative factors in a panel-based structure to ensure maximum comparability between asset management companies. The top-down approach examines each company s corporate and capital structure, strategy, management expertise, processes, regulatory compliance, and risk management policies at a macro level. The bottom-up approach examines such metrics as quality, track record, and the performance of investment products and the properties in the portfolio. Historical and current data are used to arrive at a meaningful assessment of the prospects for both the asset manager and the managed portfolio. Please see for a copy of the detailed methodology. Fund Management Ratings Scope s fund management ratings consider the following metrics: real estate experience, the structure and continuity of fund management. In addition, the fund strategy and the historic performance of the portfolio are taken into account. Further relevant points include management costs, transactions, and rental performance in the preceding fiscal year, the trend in occupancy rates, and the proportion of properties with vacancy rates exceeding 25%. This metric determines whether a fund gets notched above or below the Level 1 asset management rating. June / 11

8 Overview of Fund Management Metrics and Ratings The asset management ratings (inflected by means of notching) incorporated into Level 2 are shown in the table below. Below-investment-grade ratings are extremely unusual (such low-quality asset managers are unlikely to opt for an external asset management rating), but do have a negative effect on fund ratings. AAA AMR AA AMR A AMR BBB AMR BB AMR B AMR The asset managers rated at this level exhibit excellent asset management (AM) qualities and state of the art operational structures and processes. The asset managers rated at this level exhibit very good AM qualities and operational structures and processes. The asset managers rated at this level exhibit good AM qualities and operational structures and processes. The asset managers rated at this level exhibit satisfactory AM qualities and operational structures and processes. The asset managers rated at this level exhibit weak AM qualities and operational structures and processes. The asset managers rated at this level exhibit very weak AM qualities and operational structures and processes. Table: AMR Rating-Skala Level 3: Analysis of Entity- and Sector-Specific Factors At Level 3, Scope examines qualitative factors that can sometimes have a substantial impact on open-ended real estate funds. They are reflected in a uniform notching process that covers the entire industry. Liquidation Risk A major factor dealt with at Level 3 is liquidity management by investment management companies. This includes how the distribution network is structured and managed and the composition of the investor base (institutional vs. individual investors, clusters of large investors and those investing less than EUR 30,000). Any liquidity risk for the fund identified in the course of Scope s analysis will adversely affect the rating outcome. Structural and Legal Risks Scope also evaluates risks related to the regulatory environment for open-ended real estate funds (depending on the jurisdiction). For example, funds with a high proportion of long-standing investors (from before the German Capital Investment Code KAGB ) are rated higher risk than funds that were designed with the new rules in mind. Risks Specific to the Fund or Sector Scope uses this rating metric to identify possible risks that may result from shifts in the market. Examples include the risks arising for newly created funds in overheated markets, or changes in property taxation that can create investment/divestment barriers for funds June / 11

9 Rating Definition and Rating Scale for Open-Ended Real Estate Funds Rating-Definition An investment rating is an assessment of a fund s ability to generate risk-adjusted returns. A rating becomes effective as soon as the rating report is issued and remains valid until a rating update comes out (usually a year later). During this period, the relevant factors are monitored on a regular basis. Scope reserves the right to withdraw or adjust ratings in response to critical changes. All rating reports are posted on the Scope Information Platform once the rating process has been completed. Please see for a copy of the methodology used and the rating outcomes. Rating Scale for Open-Ended Real Estate Funds can be assigned ratings from aaa to d, with notch-specific adjustments being applied for ratings from aa to b. The suffix highlights the applicability of such ratings to as defined in EU directive 2011/61/EU. The following definitions apply to the different ratings: aaa aa a bbb bb b ccc cc c d produce an excellent risk-adjusted return produce a very good risk-adjusted return produce a good risk-adjusted return produce a balanced risk-adjusted return produce a modest risk-adjusted return produce a very modest risk-adjusted return produce a poor risk-adjusted return produce a poor risk-adjusted return combined with a very likely risk of a capital loss produce a poor risk-adjusted return combined with a high risk of a substantial capital loss Funds rated in this category are expected to produce a negative return Table: rating scale June / 11

10 Rating Changes and Reviews Scope s ratings on open-ended real estate funds are regularly updated, usually once a year. Unless otherwise indicated, Scope monitors such funds in the interim. If specific events detected in the monitoring process suggest that a rating change may be appropriate, Scope places the rating on review while it evaluates the impact of these events. When such events occur, Scope publicly announces that it is putting the fund on review, with an indication of the possible rating change (to positive, negative, or stable). The process may, in some cases, result in the initial rating being confirmed without a change. Note The following symbols may be appended to a rating: a. (NM) indicates a non-monitored rating. b. (P) indicates a preliminary rating. Risk classification Some jurisdictions require the fund s distribution agent to classify investment products into various risk categories. 2 As guidance, for each it rates, Scope will suggest a classification for the fund into one of five risk categories for financial investments, with 1 being the least and 5 being the most risky category. Scope has found this classification to be a commonly accepted standard. The risk classification is based on each fund s risk score which is determined within the scope of the rating. Risk category Risk characteristics 1 Low risk 2 Moderate risk 3 Increased risk 4 High risk Table: Scope risk classes 5 Very high risk 2 For instance para 31 of the German Securities Trading Act. June / 11

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