Due Diligence Real Estate
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
www.reag-aa.comCOPYRIGHT © REAG GmbH Real Estate Advisory Group Germany 2015 (REAG)This presentation is the sole property of REAG and must not be copied, reproduced or transmitted in any form or by any means, either in whole or in part, without the prior written consent of REAG. The information contained in this presentation has been obtained from sources generally regarded to be reliable. However, no warranty is given in respect of the accuracy of this information. REAG does not accept any liability in negligence or otherwise for any loss or damage suffered by any party resulting from reliance on this presentation.