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Unraveling the Maze of Real Estate Investment Due Diligence:
A Primer for Trustees

By Stanley L. Iezman

A version of this article was published in Probate & Property May/June/2000 by the American Bar Association
Copyright © Stanley L. Iezman
Revised: January 15, 2007

Anyone who has ever participated in acquisition due diligence knows from hard won experience that it is a costly, time consuming and complex process. If this weren’t enough, due diligence invariably takes place under the gun of an approaching deadline. Conducting it properly requires a large and closely coordinated team of specialists and real estate investment professionals with the ability to get a highly technical job done yesterday.

More than one investor has asked him or herself if due diligence was really worth the effort. It is an important question… and one we are going to address in detail in this article.

The short answer is an unequivocal yes. Due diligence is an essential component of the acquisition process, and by extension, of the entire investment process. The devil is in the details, for both the investment and the trustee.

Most basically, due diligence is the only accurate way to develop a realistic and achievable investment strategy. There is no substitute for crawling inside the details of the investment (literally and figuratively) to find the hidden risks and opportunities that will determine if a property is a good investment.

For a trustee, there is an additional reason to embrace due diligence. It is the single most important step you can take to protect yourself and your fund against regulatory liability. In today’s environment, trustees of pension plans must be sensitive to the fact that hiring an investment manager is only one part of the creation of a sound real estate investment program. The investment manager must also know how to perform, evaluate, articulate, and integrate a high-quality, comprehensive due diligence process into the investment decision and into the investment strategy. Why? Having a detailed, and documented due diligence process that quantifies the findings is a very important part of the process that the Department of Labor has established as a hurdle that all trustees must meet in order to satisfy their fiduciary responsibilities.

Given the fiduciary and regulatory mandates the due diligence process must satisfy, the technical complexity of the process is largely inevitable. But, having said this, understanding the process does not require you to become a due diligence expert. That’s the investment manager’s responsibility. Instead, the most productive role of a trustee is as a sophisticated evaluator of due diligence.

To help you in this process, this article will delve beneath the language you see in due diligence reports to explain the reasoning for key due diligence areas and to identify the essential "wheat" you should be searching for in the "chaff."*

Due Diligence Defined

Due diligence may seem like a precise term, but in practice it can be vague, with little objective definition. As a result of differing focuses, there is a wide variation in the scope of due diligence work among investment managers.

The simple sound–bite is that "everyone does due diligence," but the fact is that due diligence is too often seen as a process of compiling the requisite reports. Adding to the complexity, there is no single "right" due diligence approach. Procedures must be customized for each potential investment by defining and prioritizing the analyses that are most likely to affect the investment decision for the particular property.

As a consequence, your evaluation of the efficacy of a due diligence process must begin with ensuring that the investment manager’s understanding matches your own (and those of staff and consultants).

While it may not be possible to establish a universal "checklist," the broad elements of due diligence are clear. To provide a shared basis for evaluating the process; let’s take a moment to establish a rigorous definition of due diligence — that is, due diligence as it should be done.

Fundamentally, acquisition due diligence is the process through which the investment manager confirms and supports the selection of the property to be acquired, develops the investment strategy for the property and, thus, begins to add value through active management.

The process requires a diverse team of technical experts, including real estate professionals, engineers, attorneys, accountants, environmental specialists and others. The real estate investment manager coordinates the due diligence process, integrates data from specialists, evaluates the data, reviews the property firsthand and develops an achievable strategy for the investment that supports the final decision to acquire the property.

The due diligence process is intended to quantify the knowledge gained about the asset and integrate that knowledge into the financial and business underwriting of the investment. For example, a property may be in poor condition, but may still be a good investment if the costs necessary to bring it up to market standards are reflected in the calculation of the return on investment, and if that return on investment (given the risk of investment) is within the guidelines of the pension plan.

Determining this must begin with the manager’s in-depth evaluation of both the asset and the market to identify the risks and opportunities presented by the investment that may impact its value. We will review the tactical areas of due-diligence in more detail in another section of this article. At the strategic level, however, due diligence adds value to the real estate investment by:

• Identifying the specific opportunities and risks of the investment, including market factors
• Quantifying and reducing the risks of the investment
• Providing support for the underwriting assumptions
• Acquiring the documents, data and knowledge that will be required to manage the asset
• Confirming that the investment meets the investment criteria of the pension plan
  

The knowledge gained from this aspect of the due diligence process provides a thorough understanding of the property and the factors that can potentially influence the value and operations of the property. From this understanding, the due diligence team can identify the opportunities and constraints presented by the property and formulate a realistic strategy to maximize the value of the investment. The more comprehensive the due diligence process, and the higher the investment manager’s degree of expertise, the greater the potential to maximize the value of the investment.

As we discussed at the beginning of this article, there is no substitute for firsthand knowledge of the property. A thorough due diligence process must include a proactive effort by the manager to identify the areas of property level risk for the investment. Several examples of how due-diligence can reduce property–related risk include:

• Identifying and quantifying deferred maintenance costs at the property
• Identifying additions of new buildings to the existing inventory of buildings in the competitive market
• Identifying financially troubled tenants at the property
• Determining if the property is a non-conforming use that cannot be rebuilt if damaged or destroyed
• Identifying obsolete factors (such as low ceiling heights in an industrial building)
  

As crucial as determining risk may be, the due diligence process must go beyond this to uncover hidden opportunity. Examples of opportunities include:

• Governmental development constraints that will restrict future competitive supply
• Leases that are below market rents
• Identification of unused space within the property that can be converted to rentable space
• Plans to significantly improve the transportation infrastructure near the property
  

Another critical role of the due diligence process is to provide support for the financial analysis, or underwriting, of the investment. Underwriting assumptions include projected revenues, operating expenses, capital expenditures, and proceeds from disposition.

The underwriting analysis includes an analysis of the expected return on the investment given the perceived risk of the investment and the proposed investment strategy. The more realistic these assumptions are, the more reliable the underwriting becomes for the investment decision. Therefore, the investment manager can add value during the underwriting analysis by refining the assumptions and developing an achievable financial projection that reflects the investment strategy for the property.

The data acquired during the due diligence process are also essential for management of the asset after acquisition. It is important to recognize that a real estate investment is not a static or passive investment. Monitoring and updating an investment strategy by continually updating the initial due diligence data throughout the holding period is essential to maximizing the return on the investment.

It is the investment manager’s responsibility to develop, implement, monitor, and revise the investment strategy for the property — all of which are grounded in the due diligence process. Going forward, the manager will help determine whether to continue to hold the investment or to sell it. The decision not to sell the investment is, in essence, a decision to acquire the property at its current value. A pragmatic way to think of it is that a hold decision is a purchase decision. Reliable information and depth in the due diligence process is essential to make these decisions.

For all of the above reasons, acquisition and loan due diligence must be proactive and must supply the data needed to provide the basis for the final decision to acquire, or not to acquire, the property or to make the loan.

Deficiencies in the due diligence process may force the investment manager into reactive, rather than proactive, management of the asset after acquisition and will generally reduce the return on the investment. It is the investment manager’s responsibility, therefore, to integrate all of the factors that are uncovered during the due diligence process into the decision matrix, the investment strategy and the underwriting.

Due-Diligence Implementation & Timing

Purchase decisions seem to wait for no man. Too often, the momentum of an acquisition can take on a life of its own. As understandable as this may be, letting an acquisition move forward before due diligence is complete is an extremely risky gamble.

We have talked about risk in a general way. Let’s get specific. The following are actual examples of risk we have uncovered during past due diligence:

• An office building with a poorly designed structural foundation that would require extensive repair in the future.
• A seller who "hid" the fact that market absorption for a housing tract was created through "sham" sales.
• A major tenant in an industrial building had a side letter with the existing owner giving it the right to terminate its lease early.
• A shopping center located on a former toxic waste facility that created legal and financial obligations for the buyer to remediate the site in the future.
• An office project located next to a vacant lot where a meat rendering plant that would create foul odors, was being developed.
• A shopping center which did not have sufficient parking to meet current zoning requirements.
• An industrial building with a major leak in the roof which could not be seen.
• A shopping center with a major tenant who was going to be declaring bankruptcy.
• An industrial building had 100% occupancy and strong demand; however, a large new project was being built in the same market area that would cannibalize the tenant base in the market.
• A seller who "mis-categorized" operating expenses to increase apparent income and thus, increase the apparent value of the building.
• A borrower on a loan who had an improperly designed building to be secured by a job generating loan, which, would not capture the highest rent in the market, resulting in the security for the loan being in jeopardy.
  

It is sobering that this is the very short list. A complete listing of even the most common hidden risks that managers have found would fill a volume.

As a practical consideration, risk is never obvious. Acquisitions always look good on paper. It is only through the due diligence process that risk is uncovered and quantified. This is why you should have one inviolate rule for your fund’s acquisition due diligence: The process must be finalized prior to a purchase decision.

It is equally crucial to ensure that it is finalized by the end of the due diligence period provided for in the purchase and sale contract. The initial decision to pursue the acquisition must be decided or refined as early as possible, since as the process proceeds, internal costs and costs for consultants and other service providers increase. The amount of money required to be deposited by the Purchase and Sale Agreement also generally increases and eventually becomes non-refundable after the due diligence period expires.

Ensuring that the process moves forward expeditiously is one of the chief responsibilities of the investment manager. There are several critical deadlines during the due diligence process that the investment manager must carefully monitor, including the following:

• The bid date, or the date when an initial offer on the property must be made.
• The execution of Letter of Intent and the timeframes specified in the Letter of Intent for due diligence process.
• The dates specified for deposit of the earnest money funds into the escrow account, title company or neutral depository.
• The due diligence period specified in the Purchase and Sale Agreement and/or the Letter of Intent.
• The date when the earnest money becomes non-refundable (a final decision must be made prior to this date to either move forward and close the transaction or terminate the acquisition).
• The date of the closing, when the implementation of the investment plan for the asset begins.
  

The bottom line is that when the due diligence period ends, and the buyer of the property is required to "go hard" on the contract, the investment manager must have completed the due diligence process. Therefore, it is crucial for the investor to ensure that the investment manager has completed a thorough and comprehensive evaluation of all the aspects of the property, as well as integrated the findings into the underwriting and into the investment strategy for the property.

Unfortunately, many investment managers do not necessarily conclude their due diligence at this time and may move forward with the acquisition, even though, critical areas of inquiry have not been completed. This oversight may result in the investment not performing within the investment guidelines created by the trustees of the pension plan.

An investment manager who understands the due diligence process will terminate a transaction, notwithstanding the fact that it may have incurred significant cost on behalf of the pension plan during the due diligence process, if the underwriting or the investment criteria cannot be supported due to issues uncovered during the due diligence process.

Areas of Due Diligence

We have discussed the fact that acquisition due diligence is complex and time consuming, but at a practical level what does this mean? As a reference, and to give you a feel for the true scope of the process, this section breaks down the due diligence process into its component areas of investigation.

Acquisition due diligence is focused in the following nine interrelated areas:

• Market analysis
• Physical/property analysis
• Regulatory/compliance analysis
• Tenant analysis
• Financial analysis
• Risk analysis
• Transaction analysis
• ERISA analysis
• UBTI analysis
  

Market Analysis

Analyses of market factors are used to define the supply and demand characteristics of the competitive real estate market, and to develop appropriate market driven underwriting assumptions for rental rates, rent growth, vacancy rates and other lease terms. There are two main areas of market analysis: economic factors and real estate factors.

Economic: The performance of a real estate market is dependent on the performance of the national, regional and local economies. Generally, the expected rate of employment growth (job creation) in a market is an indicator of the future demand in the market for office and industrial space. Closely related to the expected employment growth is the expected rate of population growth, which is generally an indicator of the future demand for housing and retail development in the market. The market’s primary industries, and the diversification of those industries within the local and regional economies, will also affect the amount of risk in the market and, therefore, the risk of the investment.

Real Estate: The analyses of the real estate factors include the analyses of the market as a whole, the sub-markets and the property’s neighborhood. The due diligence process attempts to define the expectations for the market and sub-markets and the competitiveness of the property within these markets. Expectations for the performance of the real estate market are impacted by the economic expectations for the area. Real estate factors analyzed as part of the acquisition due diligence process include (but are not limited to) the following:

• Comparable sales
• Comparable leases
• Competitive properties
• Appropriate discount rates, capitalization rates and other underwriting assumptions for comparable investments
• Under-construction, planned or potential new development in the market
  

Understanding the amount of the supply in the market is equally as important as understanding the expected demand to be derived in the market. Anticipating and evaluating where demand is going to come from is an extremely difficult issue. Demand is really created from population and job growth, and the overall impact of a positive economy. Any impact on one of these factors, can cause demand to be reduced and would have a deleterious effect on real estate returns. While supply may be constrained in various markets, the sources and drivers of demand must be equally understood. This requires a great deal of understanding of the market, and a focus on what the drivers of real estate demand really are and where they are going to come from.

All of these factors must be carefully evaluated and included in the financial model used to evaluate the investment. A sound, financial model requires the ability to use "real" operational and market information to create a valid model that is substantially grounded in fact, and which the investment strategy accurately reflects.

Physical/Property Analysis

The area of greatest importance to the creation of a successful investment program is the proper and thorough due diligence of the physical aspects of a real estate asset. The failure of most real estate investment managers to perform this very necessary step at a detailed rather than a superficial level is all too often the foundation of a failed investment.

The due diligence of physical and property factors is used to define the condition of the property. This provides the basis for the development of the capital budget, which is used to estimate the costs to cure deferred maintenance, to estimate the costs of the on-going maintenance of the property, and to quantify the impact of these costs on the expected return on investment of the property. Physical and property factors analyzed as part of the acquisition due diligence process include (but are not limited to) the following:

• Inspections of the plans, site, structure, mechanical systems, parking lot and other improvements
• Environmental inspections
• Determination of compliance with the Americans with Disabilities Act (ADA)
• Review and approval of the title commitment and title insurance policy
• Review and approval of an ALTA survey
• Inspection and inventory review of personal property

Regulatory and Compliance Analysis

The due diligence of regulatory and compliance factors is used to determine the compliance of the property with regulations governing the development and operation of commercial real estate. These factors can significantly impact the value of the property. Ongoing compliance, or upgrading the physical aspects of the property to be in compliance, can have significant costs.

For example, if the property is a non-conforming use that cannot be rebuilt to the same density if destroyed, then the risk of the investment is significantly greater than the risk for a similar, conforming property. Regulatory and compliance factors analyzed as part of the acquisition due diligence process include (but are not limited to) the following:

• Review of zoning regulations and compliance
• Confirmation of the issuance of building and occupancy permits
• Review of required licenses
• Review of rent control regulations and compliance
• Review of growth and development controls
• Review of flood zone designation
• Review of earthquake zone designation
• Review of compliance with the Americans with Disabilities Act (ADA)

Tenant Analysis

With all of the focus on dot.com and e-commerce companies today, owners of real estate must be much more mindful of how they underwrite tenants and their businesses. The following questions should be considered:

• Is the business growing or declining?
• How diversified do you want your tenant base to be?
• Is the tenant in an expanding or declining business/sector?

The due diligence of tenant factors comprises legal, economic, operational and functional analysis and is used to confirm current lease terms and to ensure that the terms are accurately reflected in the underwriting. It is also important to identify leasing trends at the property to determine the tenants’ credit ratings, areas of satisfaction and dissatisfaction, and plans to expand or contract. A review of the laws that affect landlord/tenant relations must also be included. Tenant factors analyzed as part of the acquisition due diligence process include (but are not limited to) the following:

• Review of tenant leases
• Review of the property manager’s tenant files, especially correspondence files
• Interviews of all tenants
• Tenant credit analysis
• Review of state and local laws that affect landlord/tenant relations

Financial Analysis

The due diligence of financial factors includes developing an operating budget for the property, reviewing historical collection trends (including rent collection), service contract obligations, utility rates, real property, personal property, corporate and other taxes, and tax exemptions that affect the property, and confirming current loan terms, if applicable. This analysis directly affects the underwriting assumptions. Therefore, a thorough analysis of these factors is necessary to confirm the feasibility of the returns projected in the underwriting. Financial factors analyzed as part of the acquisition due diligence process include (but are not limited to) the following:

• Review of the books and records for the property, including aging reports and operating statements
• Review and approval or disapproval of service contracts
• Investigation of utility rate structures, availability and transfer requirements
• Determination of prudent insurance coverage
• Review of historical and/or ongoing insurance claims
• Investigation of tax laws affecting the property
• Review of Unrelated Business Taxable Income ("UBTI") issues
• Review of loan documents and loan payment history

It is important to understand that the creation of a financial model is crucial to the investment decision-making process. The model must include realistic expectations of both market and property performance, and reflect the overall investment strategy. Part of the creation of the investment model is the definition and input of all the various cash flow items, such as rental and expense recovery income, and the following expenses:

• Operating expenses recoverable from tenants
• Non-recoverable operating expenses
• Capital expenditures
• Vacancy and credit losses
• Other third party costs associated with the operation of the asset

A financial model must be generated from specific and realistic data derived from an understanding of the asset’s position within the market, and other factors, such as the economy, population growth, changes in taxation policy, will have on the market. All too often, financial models are based on industry standards and norms taken from publications with little or no direction or modification to reflect specific market factors or the asset’s market position. This usually results in lower performance returns. Further, there is little consistency in the categories of budget line-items, and the investment manager must understand how to burrow through the minutiae to get to those underwriting factors that will significantly impact the investment and that are important to the decision making process. The use of a discounted cash flow analysis is crucial to this process.

Understanding the strengths and weaknesses of financial modeling is very important. The use of an internal rate of return, modified internal rate of return, or net present value model in underwriting real estate investments is fairly standard in today’s investment world. What is important, however, is to understand each of the assumptions used and the strengths and weaknesses of each of them.

Furthermore, understanding risk is equally as important to the process. It is crucial that the investment manager understand how to create an investment model that reflects the investment strategy and the knowledge derived in the due diligence process with realistic inputs that reflect the property’s and the market’s past performance — superimposed with strategic considerations of where the property and the market are going. It is from these considerations that the investment manager will be able to create an investment strategy with an appropriate hold period for the asset that will maximize the return on the investment.

It is important to understand that the investment management process must include regular hold-sell analysis on at least a quarterly basis. The competent investment manager, who has had extensive experience in understanding how to create institutional investment portfolios, will integrate this process into the investment decision-making analysis every step of the way during the hold period.

Understanding how the capital markets will impact the property is also very important. The capital markets will dictate whether the property can be financed where there is an advantage to the pension plan, or alternatively, whether the capital markets may negatively impact the property in the near future and whether the property should be held for a longer period of time or sold.

Each of these considerations must be evaluated by the investment manager regularly as he monitors the asset and the market and adjusts the investment strategy appropriately.

Risk Analysis

Institutional real estate investors are faced with a series of risks involved in the ownership of real estate. These risks include:

• Leverage risk
• Operational risk
• Leasing risk
• Market risk
• Tax policy risk
• Political risk
• Interest rate risk
• Capital market risk
• Property market risk
• Management risk
• Ownership’s structure risk
• Technology risk
• Functionality and use risk
• Tenant risk
• Other systemic and non systemic factors

There are, no doubt, numerous other risks that must be considered. The astute real estate manager should develop an investment "hurdle" rate, above which each investment must perform, based upon the analysis of these risks.

The following chart is designed to help trustees of pension plans determine what should be included in determining the rate of return for a particular investment in real estate. The investor must understand that a risk free return is the return that can be generated from the most secure of investments.

The savvy investor will establish additional return expectations, generated from the evaluation of the incremental risks associated with the investment premium above the risk free rate of return, the incremental risk created by the extenuating circumstances of the real estate and capital market, as well as the limits of the property. The prudent real estate investor will always start with the risk free rate for low risk investments, such as government bonds or notes. Whatever rate of return is used, it must be considered realistically within the decision-making process and within the context of calculating and considering the risk of the transaction.

In order to understand this more operationally, consider an investment in a shopping center that is on the outskirts of town, with no surrounding home tracts to support the stores in the shopping center. This type of an investment would have an increasingly higher risk associated with it, since the "demand" for the goods and services being sold at the shopping center would be extremely low, when compared to a shopping center located adjacent to a major highway. These risk characteristics can be quantified by developing an appropriate "hurdle" rate for more or less risky investments.

In the context of an office building, a brand new office property that is not functionally obsolete, and can provide the highest degree of service, such as telecommunication needs and parking, when compared to an older building, with no elevator, and lower ceilings, will have a totally different set of risk characteristics associated with it.

Risk, in the context of investment, can be evaluated within each of the factors indicated above, and will impact the overall return characteristics. The investment manager who understands this will include it in the economic evaluation of the project.

Transaction Analysis

The creation of the investment and operating strategy at this stage requires the inclusion of all of the due diligence and the identification of opportunities to create or add value to the investment. This additional value can be management related, leasing, physical, or capital market driven, but it all comes from and is confirmed during the due diligence process.

Transaction analysis is primarily related to the acquisition mechanics of an investment and is used to ensure that the property is properly transferred, to review and approve the transaction costs, and to confirm that the property meets the investment goals of the client. Transaction factors analyzed as part of the acquisition due diligence process include (but are not limited to) the following:

• Determination of the appropriate entity structure to hold title to the property
• Review and approval of closing costs, including prorations
• Determination of customary market practices, especially typical allocation of transaction costs such as transfer taxes, title insurance premiums, and closing costs
• Comparison of the investment, after transaction analysis, to the investment goals of the client
  

ERISA Analysis

For pension plan investors that are governed by the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), the due diligence process must also confirm that the transaction is not prohibited by ERISA. Generally, the prohibited transaction provisions of ERISA limit transactions between a pension plan and any "party-in-interest". Parties-in-interest, as defined by ERISA, include the following:

• The investment manager
• Any trustee of the pension plan
• Any fiduciary and/or service provider to the pension plan
• The employer of any participants in the pension plan
• Any union whose members are covered by the pension plan
• Any entity with a 50% or more ownership interest in a party-in-interest
• Certain shareholders, directors and officers of entities whose employees are covered by the pension plan
• Even certain relatives of the above can be considered parties-in-interest

If a proposed transaction is not allowed by the general prohibited transaction provisions of ERISA, then the investment manager must determine if an exception from the prohibited transaction is available. The most commonly used exemption is Prohibited Transaction Class Exemption 84-14, also known as the Qualified Professional Asset Manager ("QPAM") exemption. The QPAM exception can be used by investment managers who are qualified professional asset managers under ERISA.

This is a complex area, which requires a careful review and insight. The prohibited transaction review requires that the investment manager work very closely with the trustees of the pension plan and the plan counsel, to ensure that this area of concern is properly addressed.

The most important point to remember is that the consequences of violating the prohibited transaction sections of ERISA are significant. Investment managers must be mindful of this area when doing due diligence to protect the best interests of their pension plan clients.

UBTI Analysis

Another area that is often overlooked by the unsophisticated pension plan investment manager, is whether the income generated from the investment is unrelated business taxable income ("UBTI") as defined by the Internal Revenue Code. UBTI can expose a tax exempt pension plan to the obligation to pay federal income tax on certain income generated by real property investments. Particular caution must be exercised when acquiring leveraged properties and when acquiring investments that have additional business activities beyond collecting rents from tenants, i.e., hotels, and assisted-living facilities.

This area of inquiry is beyond the scope of this article, but it is important that the due diligence of real estate investments for tax exempt pension plans includes a thorough analysis of whether income generated from the investment constitutes UBTI income. Working closely with tax counsel, it is possible to restructure many income sources that have been identified through due diligence as UBTI to avoid exposure to the UBTI regulations.

Conclusion

Looking at the technical complexity of the above nine areas, one can understand why it is crucial that the investment manager have the experience and technical capability to analyze and integrate data from many specialized areas. The strategy for the investment and support for the final decision to acquire the property will depend on it.

It also helps to explain why due diligence costs so much. From a purely financial standpoint, though, it is worth doing correctly the first time. Deficiencies in the process can be very difficult to correct and can have a significant impact on the investment returns. As we noted above, deficiencies in the process may also force the investor into reactive, rather than proactive, management of the asset.

From a positive perspective, the process significantly reduces the risk of the investment and should present opportunities to increase the return on the investment. Since real estate investments generally are large, the cost of the due diligence process is cost effective in reducing the risk and increasing the return on the investment.

The first contribution a trustee can make to the due diligence process is to ensure that the investment manager has the experience, depth, and capability within their team to perform high-quality, comprehensive due diligence. It is critical that you and your consultants understand the strengths or weaknesses of the real estate investment manager’s due diligence process. As part of the search for a real estate investment manager, the scope of past analyses should be compared and evaluated.

The selection process should also review how a manager has communicated to consultants and trustees in the past. This communication should be evaluated for thorough analysis, reasoned decision to acquire the investment and development of an achievable investment strategy.

The prerequisite to all of this is for a trustee to develop a working knowledge of the due diligence process in order to understand and evaluate the investment manager’s decision, the execution process and strategic focus. (An added benefit of understanding the due diligence process is that it will provide a trustee with an excellent foundation of knowledge to understand real estate investment in general.)

Now is a good time for everyone in real estate investment to renew their commitment to a comprehensive due diligence process. Today, as the market matures and reaches equilibrium, thorough due diligence procedures are even more important than in recent years.

Over the last 7-8 years, most investors and investment managers who have made real estate investments have been rewarded handsomely by the rising market. The upward momentum of the market has had a tendency to cover up the weak level of due diligence that may have occurred by those seeking to "cut corners" or those who do not understand the importance of due diligence. Frankly, who could argue that due diligence which focused on uncovering a leaky roof or a lease with a termination clause was relatively unimportant, when values were rising 15% a year or more?

In today’s more mature real estate market, however, the rewards will not be so universal. It may be helpful for investment professionals to remember the catastrophic decline that occurred in the real estate market from 1989-1994, in which many pension fund real estate investment portfolios were written down as a result of a loss in value.

Investments with strong upside potential can be found at all points in the real estate cycle. A well-developed, in-depth due diligence process is the key to identifying them.

Most trustees of pension plans that make loan or equity investments in real estate directly through a separate account relationship or indirectly through a commingled fund vehicle, understand the importance of hiring a qualified and capable real estate investment manager to implement the pension plans’ real estate investment strategy. Pension plans who develop a real estate strategy as part of their overall asset allocation model typically invest in individual assets which are in the operating stage of the investment cycle to generate cash flow and long-term appreciation, and/or engage in the making of loans secured by real estate. It is the investment manager’s typical responsibility to:

• Source the investments;
• Perform the appropriate due diligence to substantiate the long-term value of the investment;
• Close the acquisition and/or loan transaction;
• Oversee all portfolio and asset management responsibilities;
• Develop appropriate ongoing investment management strategies;
• Oversee the leasing, financing, maintenance, and renovation of all aspects of the property;
• Develop valuation models;
• Oversee all disposition efforts; and
• Maximize the value of the asset.
  

In short, the investment manager is responsible for all aspects of the investment.

However, for the reasons discussed in this article, trustees of pension plans which are governed by the Employee Retirement Income Security Act of 1974, as amended, ("ERISA") should also make certain that their real estate investment managers qualify as a Qualified Professional Asset Manager ("QPAM") under ERISA. Not all real estate investment managers are necessarily qualified as a QPAM. In addition, trustees must be mindful that many Errors & Omissions insurance policies which protect trustees of pension plans from fiduciary liability require that all real estate transactions be reviewed, overseen, and passed upon by an investment manager who qualifies as a QPAM.

As most trustees know, ERISA has imposed significant fiduciary responsibilities on corporate and Taft-Hartley pension fund trustees with respect to the management of their pension plan assets. In fact, in certain circumstances, trustees can be held personally liable for losses incurred on investments made by their pension plan. This risk of personal liability under ERISA can be eliminated by hiring an "investment manager" (as defined in ERISA §(38)), so long as the trustees act prudently in the appointment and retention of the investment manager. If the investment manager has been prudently engaged and the responsibility for making investments has been properly delegated, trustees will not be responsible for the acts or omissions of the investment manager, or be under any obligation to invest or manage any assets of the pension plan that the investment manager is responsible for investing. Additionally, the following procedural guidelines outlined in ERISA should be followed to further minimize trustees’ personal liability: (1 2 3 )

• develop appropriate investment guidelines for the investment manager;
  
  
• effectively delegate investment responsibilities to the investment manager; and
  
  
• exercise regular and diligent oversight over the investment manager’s activities once management is delegated.

Because of the risk of personal liability involved in the investment of plan assets, most pension plan trustees typically delegate their investment responsibilities to investment managers. ERISA expressly authorizes such delegations, as long as the plan documents allow the trustees to delegate fiduciary responsibilities. An investment manager is defined under ERISA as a fiduciary who acknowledges in writing that it is a fiduciary with respect to the plan and is registered as:

• an investment adviser with the Securities and Exchange Commission under the Investment Advisers Act of 1940; or
  
  
• a United States commercial bank; or
  
  
• an insurance company qualified under the laws of one or more of the United States.

Further, the use of an investment manager who is also a QPAM allows the pension plan to engage in certain transactions that may otherwise be prohibited under ERISA. The prohibited transaction provisions of ERISA are quite broad and preclude numerous types of transactions between "parties in interest" and the pension plan. These prohibitions unfortunately are not always practical in the world of real estate investment. For example, a pension plan that owns an office, industrial, apartment, or retail property, cannot lease to anyone affiliated directly or indirectly to the pension plan. Thus, entering into a lease for building space with a tenant who happens to be a family member of someone providing services to the pension plan, or who falls within the broad party in interest definition in ERISA, may be a prohibited transaction. By hiring an investment manager who also qualifies as a QPAM, trustees can insure that they do not inadvertently violate ERISA’s party in interest prohibited transaction guidelines.

Stanley L. Iezman, Esq. is the President and Chief Executive Officer of American Realty Advisors, a registered investment adviser with the Securities and Exchange Commission, that currently manages over $4 billion (gross market value of all assets managed by American as of September 30, 2006 excluding partners' share of equity and partners' share of debt on partnership investments plus $738 million in commitments not yet drawn) in real estate investments for domestic pension plans. He is also an adjunct professor of real estate asset management at the University of Southern California’s School of Policy, Planning, & Development, Lusk Center for Real Estate, and a member of the Executive Committee of the USC Lusk Center for Real Estate. The author wants to acknowledge the invaluable contribution of Stephen R. Peterson, CPA, CMA. American Realty Advisors is located in Glendale, California (818/545-1152).

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