Due Diligence Real Estate

Written on-the-job with support of REAG GmbH – Real Estate Advisory Group Germany

Master Thesis on due diligence real estate

Source: The Economist; May 16th, page 55

Born October 12, 1986 in Frankfurt am Main/ Germany

High School Graduation 2004 in Indiana/ USA

Abitur 2006 in Frankfurt am Main / Germany

German Navy 2 Years Military Service on board of the Frigate Hamburg

Master of Science Bachelor and Master Studies in Münster/ Germany and Bilbao, Spain

Investment Consultant at REAG GmbH – Real Estate Advisory Group Germany

Member of the Society of Property Researchers, Germany

Board Member of the Urban Land Institute Germany Young Leaders Committee

Fluent in German, English and Spanish

My Background

Research Question:

To what extent does real estate due diligence, in light of the Transaction Cost

Theory and the Principal-Agent Theory, reduce the existing information

asymmetries in the form of hidden characteristics before signing of contract

(ex-ante) between vendor and buyer? In other words: How strategically relevant

is such an analysis?

Strategic relevance of due diligence

Source: Adapted from: Rottke (2004) p. 209

Real estate markets recovered quickly after sub-prime crisis

High number of examinations of real estate assets

Thus, practice of due diligence real estate is gaining in importance

Literature is exiguous and lacks theoretic approaches

Transaction Cost Theory and agency-relationships offers assumptions and

approaches

Parameters such as bounded rationality, opportunism and uncertainty help

describing how to

Reduce information asymmetries,

Uncover hidden characteristics,

Prevent adverse selection.

Background of thesis’ topic

Problem of Information bias/information asymmetry within a transaction

Akerlof explains the problem of quality uncertainty using the example of market

for used cars

When parties are unsure of the product quality; forced to assumptions based on

price

Buyers assume that goods are of poor quality if their price is low and vice versa

Asymmetric information due to the fact that no one can assess the real value of

the product

In an increasing complex world, individual decision making relies on advice

given by experts

In real estate markets, due diligence examinations conducted to avoid

information failure

Goods of inhomogeneous characteristics, distribution of the knowledge plays an

essential role

Daily experience: Market for Lemons

Note: Akerlof is an American economist and professor of economics at the University of California, Berkeley. He is well known for his article: “The Market for Lemons: Quality Uncertainty and the Market Mechanism" and beyond winner of the Nobel Memorial Prize in Economic Sciences. He distinguished between different problems and characteristics concerning the level of information within a transaction: information asymmetry.

Source: Akerlof (1970) p. 488

Real estate markets is particular characterized by:

immobility,

heterogeneity,

durability,

the long-term project development

high transaction costs.

Due diligence is an instrument to fill in the information gap between vendor and buyer

Benefits of due diligences within transactions are:

Reduction of transaction costs, and supervision of transaction process,

Equal level of information and minimization of information asymmetries,

Fast, cost-efficient and transparent presentation of the real estate,

Increased attractiveness of the vending process.

Contextualizing the information failure to real estate markets

Assumptions and transactional factors leading to information bias

Source: Adapted from: Williamson (1985) p. 45; Source: Williamson (1973) p. 317; Williamson (1985) p. 47; Wil-liamson (1973) p. 317

Transaction climate characterized by information asymmetry and uncertainty

Source: Adapted from: Picot (1991) p. 143

Importance of Due Diligence within Real Estate Transactions:

The interview experts noted that the due diligence analysis is obligatory

A crucial tool for removing information asymmetries

Due diligence has become a standard procedure, simply out of liability reasons

Investors often use due diligence as a form of insurance to give weight to their

decisions

Many experts claimed that due diligence real estate will gain increasing

importance in the future

Results of expert survey (1/4)

Outsourcing of Due Diligence

In the past analyses were performed in-house; today outsourced due to possible

lack of know-how

Unfeasible for companies employing specialists, so due diligence services are

outsourced

Since the subprime crisis the question of liability since then has gained remarkably

in importance

Challenges during the Due Diligences

Different areas intersect and overlap – e.g. legal, commercial etc.

Clear and quick communication is essential to prevent time constraints and

bottlenecks

consulting companies face challenges such as imperfect information flow,

increasing costs and time pressure due to short deadlines

Results of expert survey (2/4)

Buy-side and sell-side Due Diligence

Vendor due diligence is not as a much market standard as the buy-side due

diligence

If a vendor due diligence is conducted then it is normally less comprehensive than

a buy-side due diligence

A vendor due diligence is rather a legal and technical update

Information Asymmetries between Vendor and Buyer

Due diligence contributes to reducing information asymmetries between vendor

and buyer

A due diligence reduces information asymmetries considerably. Documents are

examined and approved. However, there is always an information gap which

cannot be closed

the experts emphasize that it is mainly used for price reductions

properties always possess hidden defects and characteristics which cannot be

ascertained

Results of expert survey (3/4)

Strategic Importance of Due Diligence Real Estate

Experts reiterated that due diligence is essential and strategically for purchase

price reduction

It is true that the due diligence analysis makes up a big part of the transaction

costs

Strategic element considering the trend of real estate assets functioning as

commodities

Real estate as an asset is becoming a trading-good

Many investors are jumping on the wagon, thus increasing importance of due

diligence real estate

Results of expert survey (4/4)

Due diligence not only reduces information asymmetries but also

contributes to exposing unexpected problems

Ex-ante opportunistic behavior leads to screening by to a third party

can relieve these uncertainties and uncover hidden characteristics

Research is limited in the results, it provides only a view of ex-ante

contractual relationships

Further specialization of value, e.g. relevance for principal/ buyer side,

ex-post considerations

Complexity and heterogeneity of real estate call for a more remote,

macroeconomic analysis

First steps made, increasing strategic relevance of due diligence seeks

for further theoretical research in order to pave the way for further

practical steps

Summary and Outlook

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