Institutional Real Estate Investing Processes, Due Diligence Practices and Market Conditions
Roulac, Stephen E., Journal of Real Estate Portfolio Management
Executive Summary. The institutionalization of the real estate capital markets has created a market in which those who put capital at risk are increasingly separated from those who make the investment decisions. Investors expect their investment fiduciaries' actions to be consistent with the prudent man standard, employing appropriate due diligence prior to investing. Effective due diligence can improve the prospects of investment performance and mitigate loss exposure. The findings confirm that more resources are devoted to due diligence during times of difficult market conditions than during times of optimistic expectations. The preponderance of due diligence factors are considered by the institutional investor to be important, indicating that for it to be effective, it must be comprehensively rather than selectively implemented.
The integrity of the due diligence function as practiced by institutional investors responsible for major capital commitments is central to the effective functioning of the real estate capital markets. Since institutional investing has become a more dominant component of the market, and because of securitization, investors are more and more separated from the decisions concerning specific real estate acquisitions, due diligence is even more important. The institutionalization of the real estate capital markets-involving both direct participation by pension funds and pervasive real estate securitization through commercial mortgage backed securities, commingled real estate funds, real estate investment trusts and real estate limited partnerships-has created a market in which those who put capital at risk are increasingly separated from those who make the investment decisions.
Investors committing capital to real estate investments in reliance on professional management expect their fiduciaries' actions to be consistent with the prudent man standard, employing appropriate due diligence prior to investing capital. How the prudent man investing standard is operationalized-through the investing processes and due diligence practices of those who hold the fiduciary responsibilities-is of particular importance.
Due diligence is central to concerns about whether the degree to which those making commitments to real estate investing may realize their expected outcomes. The abundant evidence of disappointing financial results from real estate investments made in the 1980s, suggests less than stellar due diligence was associated with those capital commitments. "Extraordinary financial losses and market disruptions in the late 1980s and early 1990s are eloquent ... testimony to the proposition that the quality of many real estate decisions is less than distinguished," (Roulac, 1994). Effective due diligence can improve the prospects of superior investment performance and mitigate the loss exposure.
This article represents original findings concerning how investors make decisions. While there have been numerous studies on the aspects of institutional real estate investing, and even a plethora of studies on participating mortgage returns, risks, taxation, ownership form, evaluation, equity effects, structure, accounting and other topics, as summarized in Roulac and Friedman (1993), there is a paucity of literature on institutional investing decision processes. In addition to considering the growing emphasis placed on the due diligence function, this article contributes insights into the relative importance institutional investors place on sixty-eight elements of the real estate investment due diligence process and the relative importance of these elements in the weak market of 1993 as compared to the strong market of 1987. Among the elements of real estate investment due diligence process considered are investment factors, property characteristics, borrower/developer attributes, market factors, economic factors, financial factors and legal/documentation factors. …