Real Estate Transactions. Strategic Relevance of Due Diligence

Table of Contents

TABLE OF CONTENTS

LIST OF FIGURES

LIST OF TABLES

LIST OF ABBREVIATIONS

1 INTRODUCTION
1.1 BACKGROUND, RESEARCH QUESTION AND OBJECTIVE
1.2 RESEARCH METHODS AND EMPIRICAL APPROACH
1.2.1 Literature Research
1.2.2 Qualitative Research
1.3 ORGANIZATION AND DESIGN OF RESEARCH

2 THEORETICAL BACKGROUND: REAL ESTATE INVESTMENTS AND THE TRANSACTION COST THEORY
2.1 REAL ESTATE STUDIES AND TRANSACTION-BASED REAL ESTATE MANAGEMENT
2.2 FUNDAMENTALS OF DUE DILIGENCE IN THE CONTEXT OF PROJECT MANAGEMENT
2.3 CRITICISM ON THE NEOCLASSICAL FINANCIAL THEORY
2.4 FUNDAMENTALS OF THE TRANSACTION COST THEORY BYWILLIAMSON
2.4.1 The Transaction Cost Theory Approach
2.4.2 Basics and Assumptions of Principal-Agent Relationships
2.4.3 The Transactional Factor of Uncertainty and Hidden Characteristics
2.4.4 Market for Lemons and Information Asymmetry byAkerlof
2.5 THE TRANSACTION COST THEORY AND REAL ESTATE TRANSACTIONS
2.5.1 Preliminary Remarks and Background
2.5.2 Real Estate Characteristics and High Transaction Costs
2.5.3 Types of Transaction Costs in Real Estate Transactions
2.5.4 The Real Estate Transaction and Due Diligence
2.5.5 Information Asymmetry as the Basis for Due Diligence
2.6 SUMMARY AND FURTHER PROCEDURE

3 EMPIRICAL STUDY: STRATEGIC RELEVANCE OF DUE DILIGENCE REAL ESTATE
3.1 RESEARCH METHODOLOGY
3.1.1 Multi-Method Qualitative Study
3.1.2 Focus Groups
3.1.3 Expert Interviews
3.2 APPROACH, RESEARCH QUESTION AND DESIGN
3.2.1 Applied Research in Business
3.2.2 Action Research and Grounded Theory
3.2.3 Research Question and Design
3.3 PROCESS OF TRANSCRIPTION, OPEN CODING AND CATEGORIZATION
3.4 RESULTS OF THE EXPERT SURVEY
3.4.1 Importance of Due Diligence within Real Estate Transactions
3.4.2 Content of a Due Diligence Analysis
3.4.3 Outsourcing of Due Diligence
3.4.4 Challenges during the Due Diligences
3.4.5 Buy-side and sell-side Due Diligence
3.4.6 Information Asymmetries between Vendor and Buyer
3.4.7 Strategic Importance of Due Diligence Real Estate
3.5 EVALUATION OF QUALITY CRITERIA
3.6 LIMITATIONS OF RESEARCH AND EMPIRICAL STUDY

4 SUMMARY AND OUTLOOK
4.1 SUMMARIZING OVERVIEW OF RESULTS
4.2 OUTLOOK AND FUTURE RESEARCH

BIBLIOGRAPHY

LIST OF FIGURES

FIGURE 1: THESIS DESIGN

FIGURE 2: REAL ESTATE-ECONOMIC TRANSFORMATION PROCESSES

FIGURE 3: HOUSE OF REAL ESTATE

FIGURE 4: REAL ESTATE CHARACTERISTICS

FIGURE 5: TRANSACTION-BASED REAL ESTATE STUDIES

FIGURE 6: DEFINITIONS OF DUE DILIGENCE IN CHRONICLE ORDER

FIGURE 7: APPROACHES OF INSTITUTIONAL ECONOMICS AT A GLANCE

FIGURE 8: BEHAVIORAL ASSUMPTIONS: BOUNDED RATIONALITY AND OPPORTUNISM

FIGURE 9: HUMAN AND TRANSACTIONAL FACTORS

FIGURE 10: ADVERSE SELECTION DUE TO INTERNAL UNCERTAINTY

FIGURE 11: TYPES OF TRANSACTION COSTS AND DESCRIPTION IN LITERATURE

FIGURE 12: INFORMATION IMPACTEDNESS: DRIVERS OF TRANSACTION COSTS

FIGURE 13: THE PROCEDURAL REAL ESTATE TRANSACTION PROCESS

FIGURE 14: TYPES OF DUE DILIGENCE REAL ESTATE

FIGURE 15: AGENT’S TYPES OF BEHAVIOR AND THE DANGER OF ADVERSE SELECTION

FIGURE 16: HIDDEN CHARACTERISTICS WITHIN DUE DILIGENCE REAL ESTATE

FIGURE 17: COSTS OF COORDINATION BEFORE CONTRACT SIGNING (EX-ANTE)

FIGURE 18: FROM THE GENERAL TO THE SPECIFIC

FIGURE 19: PROCESS MODEL OF METHODOLOGY

FIGURE 20: BASIC VS. APPLIED RESEARCH

FIGURE 21: PROCESS OF THEORY BUILDING IN ACTION RESEARCH

FIGURE 22: TIME SCHEDULE OF RESEARCH

FIGURE 23: CASE STUDY RESEARCH BY Y IN

FIGURE 24: DESIGN OF CONTENT ANALYSIS

FIGURE 25: PROCESS MODEL OF INDUCTIVE CATEGORIES

FIGURE 26: INTERVIEW AND FOCUS GROUP EVALUATION AND PROCESS

LIST OF TABLES

TABLE 1: FOCUS GROUP DISCUSSION EXPERTS

TABLE 2: EXPERT INTERVIEW PARTNER

TABLE 3: EXPERT INTERVIEW QUESTIONS

TABLE 4: DEVELOPMENT OF CATEGORIES AND EXAMPLES

TABLE 5: EXAMPLE OF CATEGORY AND MARKING OF POSITION IN TEXT

TABLE 6: QUALITY CRITERIA AND REALIZATION IN STUDY

List of Appendices

illustration not visible in this excerpt

List of Abbreviations

illustration not visible in this excerpt

1 Introduction

1.1 Background, Research Question and Objective

Dynamic internationalization of markets, increasing competition, growing capital market expectations, and development towards more lean, strategic approaches of management are the current trends of the investor’s world today.¹ The subprime crisis affected worldwide transactions, forcefully leading to more thorough examinations of purchases. However, transaction activities of international investors are once again picking up. In this competitive environment, investors endeavor to succeed and reduce their risks by foreseeing develop- ments and adapting to new trends promptly. Outsourcing, specialization and on-demand sup- ply are the buzzwords of the day.² With time being more of the essence than ever before, investors now understand that their most efficient and economic source of information is the know-how of independent advisors and are therefore focusing more exclusively on their core business areas. The benefits of outsourcing outweigh the disadvantages and reduce uncer- tainty.³

With this in mind, acting investors cannot possess local know-how ubiquitously. Since real property is unmovable, this is even truer for real estate investments. Real Estate is the largest asset class in an economy.⁴ Despite the subprime disaster, which was caused by a lack of thoroughness in examination and reckless speculation amongst other things, asset class real estate⁵ is still as economically important as ever. In Germany, the real estate industry has proven to be a stable anchor in stormy times for the country’s economy⁶. Real estate trans- actions are almost as numerous as before the crisis.⁷ Although the crisis has taught the market and its players some serious lessons, the volume of transactions is continuously increasing and the asset real estate is becoming a commodity. The volume of transactions is continu- ously increasing and the real estate asset class is undergoing increasing commoditization.

Real estate investment management is a very old business activity. Property ownership as a symbol of wealth can be found in many societies.⁸ Today property ownership makes up more than 50% of global wealth. Professionalization of real estate investment has become increas- ingly important.⁹

Trading and exchange of real estate assets, as with any asset, entails risks. In order to minimize risk and determine the risk potential, advisors are commissioned to evaluate the real estate in a transaction. This is called due diligence.

This study contextualizes Transaction Cost Theory as well as aspects of Principal-Agent Theory within transaction-based real estate management. Within real estate transactions, asymmetric information between vendor and buyer result in opportunistic behavior, and agency problems such as adverse selection can occur.¹⁰ If one party in a transaction has more or superior information than the other party, information advantage is subject to agency theory and related to significant transaction costs.¹¹

In order to capture the current developments and trends and to set the best practical solution to the agency problem, the following research question can be raised:

-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?

This research question implies a design of research and pursues inter-related objectives within this thesis which are outlined below:

-Description of transaction-based real estate management with the focus on due diligence in the context of project management,
-Reflection of fundamentals of Transaction Cost Theory by Williamson, Discussion of the common background and origin of Transaction Cost Theory and Principal-Agent Relationships inasmuch as the problem of hidden characteristics is involved and with a focus on the transactional factor of uncertainty, Outline of the possible relationship between the Transaction Cost Theory and real estate transactions, highlighting the real estate characteristics and the information asymmetry within a contractual relationship,
-Examination of theoretical fundamentals in practice with the investigation of a multi- method qualitative study according to Grounded Theory with the central objective to find approaches describing the strategic relevance of due diligences within a real estate transaction.

This master thesis paper serves to point out the strategic relevance of due diligence and to determine the significance of asymmetric information within real estate transactions due to hidden characteristics and the resulting high level of uncertainty in the vendor-buyer relationship. It aims to illustrate the importance of the project-management-based analysis by conducting a multi-method qualitative study. To this end, a focus group and expert interviews allowed access to significant, first-hand practical data. The company REAG GmbH - Real Estate Advisory Group Germany made significant contributions to the results of this thesis paper by enabling access to experts in the real estate sector.

1.2 Research Methods and Empirical Approach

1.2.1 Literature Research

Various sources of information were used for this thesis. The main source was library re- search at the following institutions: University of Applied Sciences Münster, University of Münster, University of the Basque Country, Goethe University Frankfurt am Main and the German National Library (DNB: Deutsche Nationalbibliothek). The company REAG GmbH

- Real Estate Advisory Group Germany also contributed significantly; subsidiary of American Appraisal based in Frankfurt am Main it provided its know-how and access to its consulting practice for use in this thesis paper.

Various reports and studies were also found to be useful. Market reports of established ad- visors in the real estate transaction market provided practical data. In order to assume the reliability of internet sources, only homepages of established academic institutions were made use of.

1.2.2 Qualitative Research

As the literature on the present research question is insufficient, a qualitative research approach was considered a viable to shed light on this complex issue. Observations from practical experience in the form of a focus group and expert interviews were used.

This multi-method qualitative design targeted experts in the field of real estate transactions. A wide approach was undertaken to cover as many points of view as possible.

The results and findings of the study revealed common understanding and the expected trends. The experts’ know-how adds further knowledge, sometimes opinions.

When data is limited, as is certainly the case here, the qualitative approach, which is a more interpretative and open form of research, allows the proposal of new considerations, per- spectives, and theories. The non-numerical procedure is composed of a combination of guideline-based interviews with the sampled experts and a focus group. Both focus group and interviewed experts, who were kind enough to provide information and attributed significantly for this study, are listed in chapter 3.1. All participants have extensive real estate backgrounds and work-experience of at least ten years.

The focus group and the interviews were transcribed for later evaluation. The evaluation was based on hard facts, figures, as well as personal points of view.

Research triangulation provides significant contribution to data validity and reliability. It is used to ensure that different methods arrive at the same conclusion. The method of triangulation enables a systematic employment of different approaches, which are thereby allowed to complement each other. In order to meet the requirements of triangulation and to put this theoretical research into a practical context, the requirements of triangulation were met by conducting a multi-method qualitative study.

1.3 Organization and Design of Research

The young field of study and lack of conclusive literature calls for an empirical approach. This master thesis is composed as follows:

illustration not visible in this excerpt

Figure 1: Thesis Design¹²

This first chapter gives the background and objectives of this research. The research methods and the empirical approach are explained and implemented in the organization of research.

In the second chapter the theoretical background and basic definitions crucial to this study are illustrated. After the explanation of transaction-based real estate management, the origin of due diligence is discussed, in particular from the project management perspective. Then, an explanation and criticism on the Neoclassical Financial Theory is provided. The Transaction Cost Theory by Williamson lays the foundation which is decisive for the later investigation in this study. The view on various factors such as the information asymmetry, hidden characteristics and adverse selection is tightened to focus on the time period before the contract signing within a real estate transaction. Moreover, common factors between the Transaction Cost Theory and Real Estate Transactions are discussed. Finally, the theoretical basics are summarized and the further procedure is proposed.

The third chapter deals with applied research methodology. An explanation of the approach, research question and design is given. The methods of transcription, coding and categorization are described. Mayring ‘s Content analysis is displayed. The results of the expert survey with regard to each individual question are offered. The results and findings from the expert survey are verified with the quality criteria of Mayring ’ s qualitative social research. The limitations of this study are also discussed in this chapter.

The fourth and last chapter summarizes the results and interprets them. Final thoughts and an outlook are presented. Suggestions for possible future research are made.

2 Theoretical Background: Real Estate Investments and the Transaction Cost Theory

2.1 Real Estate Studies and Transaction-based Real Estate Manage- ment

Real estate management (REM) is a complex issue due to its interdisciplinary and cross- subject background. To begin with, the term “management” is derived from the Italian ex- pression “maneggiare” (= to handle) and from the Latin word “manus” (= the hand) respec- tively “manus agere” (= to act). In general, management theory examines organizational leadership of purpose-orientated social systems.¹³ Three management levels provide the ba- sis for this approach: normative, strategic and operative management levels.¹⁴ Needless to say, the term management differs considerably from the term administration since manage- ment is a more active, foresighted, and goal-oriented form of leadership.¹⁵

Real estate-related subjects are today enveloped in the term real estate management. Real estate management is a complex field which has its origin in the academic discipline of busi- ness economics. According to Graaskamp ¹⁶ real estate management is more than a micro- observation of business economics. It is a multilayered research discipline.¹⁷ He defined:

“ Real estate is space and money over time ” .¹⁸

2 The Transaction Cost Theory and Real Estate Investments

2.1 Real Estate Studies and Transaction-based Real Estate Management 9

His approach of real estate economics redefined the role of university education in real estate and urban land economics as a multidisciplinary, holistic base. He described property as objects made by human beings, integrated in the context of psychological, social and politi- cal aspects.¹⁹ Graaskamp follows a problem-solving approach of business economics and defines real estate “ as a special application of a cash cycle enterprise [ … ] perhaps a contemporary real estate program could have its home base in either a school of physical design or a school of busi- ness administration, so long as it was permitted to be inductive, multidisciplinary, and prob- lem solving. ” ²⁰

The focus rests on decisions-based real insights dealing with real estate related economic subjects. The objective is to assist decision-making processes and to identify them as well as to propose solutions.²¹ Real estate management is very much influenced by business eco- nomics while highlighting property topics. Basically scientific research started with the lo- cation factor. Questions on provision of commercial property in terms of spatial planning played a major role in early stages. Furthermore, it was discussed how production facilities can be provided. These facilities included not only properties but also mobile equipment such as machines. Then, equity and foreign capital gained importance; therefore real estate finance was established. The discussion on real estate finance and investment gained in im- portance in the last decade.

Nonetheless, real estate management mainly deals with the management of social systems in the real estate industry. Key tasks are the planning of target value, organization of strategy development, and the control of real estate performance of related transformation processes such as real estate finance and investment, planning, construction, and running of the real estate, provision of real estate for production services.²²

- Enforcement: normative implication which describes the state-of-the-art and the target requirements,
-Planning: anticipation of the future action; defines ways of achieving objectives,
-Organization: process of guaranteeing implementation,
-Control: last phase of management process and comparison of state-of-the-art.

Going forward, figure 2 illustrates the transformation process from resources to services explained before.

illustration not visible in this excerpt

Real estate management being a complex and mostly practical economic discipline interfaces according to Schulte²⁵ especially with the disciplines of economics, law, spatial planning, architecture and engineering science. His so-called “House of Real Estate” below gives an impression of the complex structure of real estate management today:

illustration not visible in this excerpt

Figure 3: House of Real Estate²⁶

The whole construct is seen from a business administration perspective. Interestingly, the interdisciplinary aspects lay the foundations. The next one differs between institutional as- pects on the one side and typological aspects on the other. In the real estate market various institutions are involved, e.g. real estate investors, construction companies or real estate con- sultants. Typological aspects constitute the different types of real estate: commercial prop- erties, residential properties, industrial real estate and special types of real estate.

On the strategic level diverse managerial aspects of the real estate business are described. Relevant established business types of real estate management are: real estate portfolio man- agement, corporate real estate management, real estate appraisal, real estate finance, real estate development, facilities management and/ or different real estate advisory services.²⁷

The so-called “House of Real Estate” by Schulte was the first holistic approach trying to describe all aspects of the real estate industry in Germany. The figure reveals the multi- dimensionality of the real estate sector. It classifies the various aspects and the relevant ter- minology. Nevertheless, an internal logic of the approach by Schulte to draw exact delimi- tations is missing.²⁸ At the time of its inception it provided an important contribution to the then young scientific research in real estate. However, it still has great legitimacy in practice.

The last dimension, the management levels, has its origin in business management theory on the basis of the St. Galler Management Model²⁹ (SGMM). In practice, top, middle and lower management are the main managerial levels. The St. Galler Management Model divides managerial levels into the normative, strategic and operative level.³⁰ The normative level is the framework of the business management and focuses on objectives and values. The strategic level considers the superior objectives of the company and has the goal to align the ability for development. The operative level manages the business in order to implement the agreed objectives and is seeking for further improvements.

It becomes clear that real estate management is a wide assortment of property-relevant no- tions. Down to the present day, clear delimitations are still missing. For instance, there is currently a discussion about the difference and delimitation of terms “Property Manage- ment” and “Asset Management”. It lacks completeness and conventional sustainability.³¹

In order to describe real estate in more detail, a sole view on real estate characteristics is of big advantage. The figure below extracts the main characteristics of real estate:

illustration not visible in this excerpt

Figure 4: Real Estate Characteristics³²

The asset real estate can be covered mainly by five characteristics. The most essential char- acteristic is the immobility which is the property-related value trigger since a specific loca- tion cannot be changed to another. The quality of location and its surroundings significantly determines the salability of the property. The immobility implies the heterogeneity of real estate. Every location is unique. Architecture for instance differs in any case. The develop- ment of real estate - from the idea of its use and exploitation - often takes years and therefore satisfies demand albeit with delay. Real estate transactions are characterized by high trans- action costs.³³ They occur before the contract signing and as a result consume much time in investigation and research. Generally it is associated with high transaction fees and taxes. In some cases it can amount to more than 10% of the sales price.³⁴ Moreover, the real estate as an asset holds a high durability. The real estate life cycle can be seen as an unlimited period of time. Due to the characteristics of real estate it is a unique asset which is hypothetical and depends highly on valuations.

Real estate investment management (REIM) is the origin of the transaction-based approach of general real estate management. Real estate investment management pursues the target of maximizing the performance of a real estate portfolio. Among other things, yield, asset and liquidity objectives are derived and followed according to the overall investment strategy.³⁵

A real estate transaction is a process of transferred rights of property. In order to classify it as a real estate transaction, the minimum prerequisites are change of ownership, notarized purchase agreement, payment of purchase price and the acquisition of real estate.³⁶ Types of real estate in terms of investment objects are properties and forward deals, project developments as well as undeveloped plots for further value-adding.

illustration not visible in this excerpt

Figure 5: Transaction-based real estate studies³⁷

A real estate transaction is defined by the type of transaction, either asset or a share deal of either a sole object or a portfolio, purpose of investment or the risk category.³⁸ A transaction is characterized by a limited period of time starting with the signing of contract, the performing and the final closing.

The complexity of disciplines within real estate management is expanded by Rottke³⁹ with his studies on transaction-based real estate. He points out the functional investment view within the different management perspectives whereby also financial aspects are considered. Leadership and strategy perspectives play a rather tangential role in this research.

Rottke ’ s approach aims at fostering aspects of real estate finance on the one hand, as well as adding other neighboring disciplines of real estate to understand the context on the other hand. Nevertheless, the focus on finance aspects results in a poor consideration of institution related subjects such as property and asset management as well as functional aspects such as planning and construction.

2.2 Fundamentals of Due Diligence in the context of Project Management

Dictionaries and literature do not offer a universal definition of the term “due diligence⁴⁰ ” which is comprehensible in all languages. The term due diligence was first used in the United States Security Act of 1933. Due diligence (DD) is the acronym for “due diligence investigation”.⁴¹ It has its origin in the American Securities Laws⁴² that attempts to define risks and advantages within a transaction process⁴³. Experts of all types such as consultants, auditors and lawyers dealt with securities.⁴⁴

By and large, the business world arbitrarily uses the concept of due diligence to mean the investigation of data.⁴⁵ Due diligence in this sense of investigation of data contributes significantly to the decision-making process.⁴⁶ The sourced information mainly attributes to the decisions regarding all costs, benefits, and risks.

The term due diligence describes a behavioral standard which is comparable with the Ger- man civil law term Sorgfaltsmaßstab and/or Sorgfaltspflicht⁴⁷ of the § 276 Abs. 2 BGB.⁴⁸ Due diligence also describes the examination process itself. It particularly gains significance in the field of purchasing and common law⁴⁹ in which the buyer bears the risks of defects.⁵⁰

This means vice versa that the buyer is obligated to investigate the object of purchase and to check thoroughly for any defects.

Since Due Diligence is discussed in various fields in practice, the relevant definitions of due diligence are illustrated below:

illustration not visible in this excerpt

Figure 6: Definitions of due diligence in chronicle order⁵¹

The following key words of the above mentioned due diligence definitions can be extracted: information, decision, value, strategy, benefits and risks. Moreover, due to the definitions above the following main points on due diligence can be derived:

-Need of due diligence is determined by information gaps, respectively asymmetric information between the participating parties, which needs
-Clear understanding of assets and liabilities, Evaluation of potential and risks,
-Final report of all relevant information within the scope of work.
-The general objective of due diligence is to improve the level of information during an acquisition process in order to take decisions with regard to the achievement of objectives. The core element of the due diligence is the risk minimization while chances of the investment are evaluated.⁵² The benefit of a due diligence is the step to a clear decision-making. Due diligence is a comprehensive and holistic assessment in order to determine all decision-sup- porting information of a real estate acquisition.⁵³ The focus is laid during the acquisition process when offer prices are announced, dealt and set.⁵⁴

However, due diligence is highly project specific. In today’s complex and dynamic society project management is ever-present. The business world is characterized by a huge variety of challenges and trends which inevitably force us to entail project management into today’s international and intercultural business practice.⁵⁵ Every day organizations face new chal- lenges in diverse surroundings and cultures of all kind.⁵⁶ Strategies of companies and even whole economies are gearing towards the only goal growth. This goal is followed by oper- ating on a regular basis with all kinds of projects. To handle this, projects are created con- tinuously. Dynamic markets and complex structures demand more established forms and standardization.⁵⁷

The International Standard Organization (ISO) defines project management clearly as:

“ ( … ) the application methods, tools, techniques and competences to a project. Project management includes the integration of the various phases of the project life cycle. Project management is accomplished through processes. ” ⁵⁸

Regardless of the standardization and other definitions on project management, a project can generally be summed up to:

-Delivering a result, mostly product or service,
-Limited period of time and amount of money (budget), Involves certain number of people,
-Unique and not on a regular basis with same content.⁵⁹
-Therefore, a project is a type of organization which is created to edit and finish a business venture with a certain budget in a limited period of time guided by a project manager with clear goals to deliver.⁶⁰ A typical project starts with a kick-off meeting⁶¹ and ends with a final closing and thereafter follows the so called lessons learned⁶².

To sum up, a project delivers a result, is operated within a period of time and limited budget e.g. money, involves a number of people and only happens once and therefore every project is unique.⁶³

The Guide to the Project Management Body of Knowledge (PMBOK⁶⁴ ) defines a project and its content as:

“ A temporary endeavor undertaken to create a unique product, service or result ” ⁶⁵

-Project management as a process is subdivided into five different parts. The relevant known five steps are:
-Initiating,
-Planning,
-Executing,
-Monitoring and Controlling,
-Closing.⁶⁶

This is a procedure which applies to every project and helps using experience from former projects. So, the process itself can be accelerated and optimized. Projects can be part of a segment of the core business providing earning contributions. Nevertheless, project activities are always special and something additional to the day to day business. It requires explicit rules concerning the specific task operation. Thus, the project is a form of a problem-solving method in order to get to the bottom of complex assignments.⁶⁷

A Due diligence possesses the project management characteristics. It is a module analytic system providing information to analyze potential and opportunities in order to examine the pricing. The due diligence presents a solid basis for the exchange of products or property.⁶⁸

2.3 Criticism on the Neoclassical Financial Theory

Since the second half of the twentieth century, a trend of approaches using theories and models to discuss the influence of institutions on human behavior in the area of social sci- ences is noted. The so-called “Rediscovering of Institutions”⁶⁹ found its way into economics, sociology and political science.⁷⁰ The focus of the following considerations lies on the eco- nomic analysis of institutions, particularly the New Institutional Economics (NIE).

illustration not visible in this excerpt

Figure 7: Approaches of institutional economics at a glance⁷¹

Aside from the main three classical strands of the New Institutional Economics namely the Transaction Cost Theory (TCT), the Principal-Agent Theory (PAT) and the Property-Rights- Theory (PRT)⁷², the NIE originates from its historical precursors of the classical economics and its early institutional currents. In particular, the following school and its ideas can be summed up as shown above in figure 7. In the course of this thesis we will concentrate on the framed approaches: The Transaction Cost Theory and the Principal-Agent Theory. It seems reasonable since the Transaction Cost Theory is the point of origin of many institu- tional analyses.⁷³

The Neoclassical Financial Theory in general examines under which conditions financing and investment problems can be solved. It is presumed that investors only follow the objective of maximizing their return on investment.⁷⁴ In this context the conflicts of interests do not arise due to total rationality of the actors and completely free exchange of information in the capital markets.⁷⁵ Thus, there are no conflicts of interest as all actors involved have access to the same information.

The approach of the Neoclassical Financial Theory says that on transparent capital markets any market participant is perfectly rational and so there is no chance of opportunistic behav- ior.⁷⁶ Information can be shared free of charge and immediately. There are no occurring transaction costs since all market participants dispose of the same amount of information at the same time. These specific assumptions of the neoclassical approach only take place far off the real economic life.⁷⁷

The Neoclassical Theory explains economic behavior under the assumption of perfect information. Under these conditions, the market is the efficient exchange and organizational instrument of the economic division of labor.⁷⁸

Based on the Neoclassical Financial Theory, the New Institutional Economics explain the premises for rational and economic action.⁷⁹ Actors tend to behave opportunistically. Motivation and coordination problems result from these behavioral assumptions.

While the Neoclassical Theory sees institutions as given and immutable, the New Institu- tional Economics (NIE) deals with the origin and the function and mutability of institu- tions.⁸⁰ Coase⁸¹ came up with the first considerations on the NIE. Williamson⁸² took up the topic again in 1975 and delivered the first coherent theoretical model.⁸³ The New Institu- tional Economics mainly deals with the economic analyses of the institutional environment and its arrangements in the economy.⁸⁴ Williamson identifies institutional arrangements as „ an arrangement between economic units that governs the way in which these units can cooperate and/or compete. It [ … ] can provide a structure within which its members can cooperate [ … ] or it can provide a mechanism that can effect a change in laws of property rights. ” ⁸⁵

The New Institutional Economics assumes an economic disequilibrium; the approach of homo oeconomicus⁸⁶ is amended by more realistic assumptions. The NIE is based on (1) bounded rationality, (2) existence of transaction costs and (3) opportunism.

2.4 Fundamentals of the Transaction Cost Theory by Williamson

The New Institutional Economics arose from the dissatisfaction and criticism of Neoclassical Financial Theory as reflected in chapter 2.3. From there on, it is clear that the NIE is not a homogenous theory. Thus, the Transaction Cost Theory with its characteristics is subsequently investigated in the following subchapters.

2.4.1 The Transaction Cost Theory Approach

The New Institutional Economics is very much affiliated with the path-breaking essay “The Nature of the Firm” by Ronald H. Coase in 1937.⁸⁷ To put his research in a nutshell, Coase stated:

“ Without the concept of transaction costs ( … ) it is impossible to understand the working of the economic system, to analyze many of its problems in a useful way, or to have a basis for determining policy. ” ⁸⁸

Initially, Coase raised the question why organizations⁸⁹ develop and work in a collaborative labor economy if they can outsource the tasks, too. He introduced the Transaction Cost Theory approach as a new perspective to point out those there two forms of coordinating economic activity: hierarchy and market.⁹⁰

This question was revived by Williamson, who was examining the most efficient form of coordinating tasks and subsequently analyzing a possible outsourcing of activities.⁹¹

[...]

---

¹ Refer to Gilpin (2011) p.5 and Hollensen (2007) p. XVI

² Refer to The Economist (2015) p. 7

³ Refer to Becker/ Sims (2009) p. 31; See Quinn/ Hilmer (1994) p. 45

⁴ Refer to Just/ Maenning (2012) p. 404

⁵ Note: Real estate is the biggest asset class in Germany’s economy with an enormous economic significance.
Germany’s property portfolio amounts to 7, 2 trillion € which discloses a share of 88 % of total fixed assets
which is much higher than the one of comparable nations. (See: Frühjahrsgutachten Immobilienwirtschaft
2014)

⁶ Refer to Mattner (2014) p. 3

⁷ Refer to EY (2014) p.4; also see Handelsblatt and Statista (2014)

⁸ Refer to Renaud (2003) p. 37

⁹ Refer to Ling/ Archer (2007) p. 9

¹⁰ Refer to Eisenhardt (1989) p. 13

¹¹ Refer to Ling/ Archer (2007) p. 11/ Rottke (2004) p. 5

¹² Own illustration

¹³ Refer to Malik (2007), p. 35 refer to Ulrich; Source: Das St. Galler Management Modell (1972)

¹⁴ Refer to Hungenberg (2007) pp. 35

¹⁵ Note: In comparison to administration, management is a strategic approach of leadership which does not include operational processes. It is a complex concentration of control tasks in a netlike structure of pro- duction processes. Planning, organization, leadership and the use of resources are controlled by the man- agement as a discipline.

¹⁶ Note: Graaskamp was a professor of real estate at the University of Wisconsin-Madison who had tremendous impact with his comprehensive approach to explain real estate management. He described the origin of real estate management with a Neanderthal developer who once closed his cave with a rock and thus created real estate. In this way Graaskamp ’s message is that real estate is a manufactured product with an institu- tional dimension over time. Of particular note is his approach of multi-dimensionality of the real estate asset class.

¹⁷ Refer to Graaskamp (1991A) p. 52

¹⁸ Graaskamp (1976) p. 51

¹⁹ Refer to Graaskamp (1991A) p. 53

²⁰ Graaskamp (1991A) p. 49

²¹ Refer to Kirsch (1979) p. 105

²² Refer to Kippes (2005) p. 5

²³ Refer to Staehle/ Conrad (1999); Steinmann Schreyögg (2005) p. 32

²⁴ Adapted from: Zahn/ Schmid (1996) p. 7; as well as Steinmann/ Schreyögg (2005) p. 35

2 The Transaction Cost Theory and Real Estate Investments

²⁵ Note: Schulte is a professor of real estate at Regensburg University and founder of IREBS Immobilienakad- emie formerly ebs Immobilienakademie. He established real estate economics at University level in Ger- many.

²⁶ Source: Schulte (2008) p. 58

²⁷ Refer to Schulte (2008) p. 59

²⁸ Refer to Kämpf-Dern/ Pfnür (2009) p. 11

²⁹ Note: The St. Galler Management Model describes and explains management practices in interaction with the environment (as a resource) and organization (as a system). It is the traditional approach of management in German economic literature supporting the practice of management innovation.

³⁰ Refer to Hungenberg/ Wulf (2007) p. 9

³¹ Refer to Kämpf-Dern/ Pfnür (2009) p. 17

³² Refer to Schulte (2008) p. 17

³³ Refer to Rottke/ Thomas (2011) p.43

³⁴ Refer to Rottke/ Thomas (2011) p.42

2 The Transaction Cost Theory and Real Estate Investments

³⁵ Society of Property Researchers, Germany (2004) p. 6

³⁶ Refer to Society of Property Researchers Germany (2014) p. 4

³⁷ Source: Rottke (2007) p. 14

³⁸ Refer to Society of Property Researchers Germany (2014) p. 5

³⁹ Note: Rottke is a professor for real estate and director of the Real Estate Management Institutes (REMI) of the EBS Universität für Wirtschaft und Recht. He was one of the first people dealing with transaction-based real estate studies in Germany.

⁴⁰ Note: It is often in practice described as an important tool for the decision-making process analyzing both qualitative and quantitative aspects of an investment. Due diligence provides the most needed data and information needed by an investor. The scope and type of analysis depends highly on the investment and the requested demand.

⁴¹ Refer to Picot (2005A) p. 269

⁴² Note: The Securities Laws include nine federal information laws and the protection of investors and the public since 1933. The U.S. Securities and Exchange Commission (SEC) is officially responsible. Among other provisions, the Securities Laws in particular include the Securities Act 1933 (SA) for the new issue of securities and the Securities Exchange Act of 1934 (SEA).

⁴³ Refer to Spremann (2001) p. 190

⁴⁴ Refer to Canepa (1998) p. 8

⁴⁵ Refer to Berens/ Strauch (1999) p. 6

⁴⁶ Refer to Benner (2008) p. 30

⁴⁷ Note: Literally translated it means scale or duty of due diligence.

⁴⁸ Refer to Krüger/ Kalbfleisch, DStR (1999), p. 174; Voß (2004) p. 314

⁴⁹ Refer to Voß (2004) p. 313

⁵⁰ Refer to Voß (2004) p. 313; Picot (2004) p 316; Krüger/ Kalbfleisch (1999) p. 174

⁵¹ Source: Knutson/Herzberg (1993) p. 34; Crilly (1993) p. 12; Begley/ Yount (1994) p. 33; Berens/ Strauch (1999) p. 17; Lajoux/ Elson (2000) p 37; KPMG (2004) p. 1

⁵² Refer to Canepa (1998) p. 11

⁵³ Refer to Franz (2007) p. 2

⁵⁴ Refer to Berens/ Strauch (1999) p. 9

⁵⁵ Refer to See Wagner/ Grau (2014) p. 107

⁵⁶ Refer to ISO 21500 (2013) p. 12

⁵⁷ Refer to ISO 21500 (2013) p. 15

⁵⁸ ISO 21500 (2013) p. 15

⁵⁹ Refer to Conchuir (2012) p. 4

⁶⁰ Refer to Wagner/ Grau (2014) p. 19

⁶¹ Note: A kick-off meeting usually is the start of a project used in business language whenever the project is commissioned. This type of meeting provides first information and includes all team members to reach a common understanding and to get the first tasks going. The project manager inform his team about the scope of work, time schedule as well as challenges and risks (See: Wagner/ Grau (2014) p. 69, p. 204)

⁶² Note: Lessons learned describes the supervision of carried out projects. Experience, know-how, mistakes and risks are determined and analyzed systematically. Lessons learned are part of the project close-out documentation. (See Wagner/ Grau (2014) p. 205)

⁶³ Refer to Conchuir (2012) p. 5

⁶⁴ Note: The Guide to the Project Management Body of Knowledge (PMBOK) represents the guidelines of project management and describes the standard practices of project management. It is overseen and pub- lished by the Project Management Institute in the United States.

⁶⁵ Conchuir (2012) p. 4

⁶⁶ Refer to Conchuir (2012) p. 6

⁶⁷ Refer to Karl (2014) p. 21

⁶⁸ Refer to Sailer (2007) p. 188

⁶⁹ Note: The “Rediscovering of Institutions” in the second half of the twentieth century was mainly introduced by March and Olsen with their book “Rediscovering Institutions: The Organizational Basis of Politics” in 1989 proposing a theory of behavior strengthening the role of institutions and the understanding of eco- nomic systems. They presented approaches for new ideas in the decision-making process.

⁷⁰ Refer to March/ Olsen (1989) p. 21

⁷¹ Adapted from: Schramm (2005) p. 45

⁷² Note: Beside the Transaction Cost Theory and the Principal Agent Theory, the Property Rights Theory plays a minor role in the focus of this master thesis. The Property Right Theory deals with the rights of disposal and their efficient allocation.

⁷³ Refer to Schramm (2005) p. 45

⁷⁴ Refer to Schmidt/ Terberger (2003) p. 39

⁷⁵ Note: The concept of homo economicus, who acts entirely rationally, is essential for defining later theories
and approaches of this study.

⁷⁶ Refer to Göbel (2002) p. 29

⁷⁷ Refer to Richter/ Furubotin (2003) p. 9

⁷⁸ Refer to Erlei et al. (2007) p. 50; Dietz (2005) p. 46; Voigt (2002) p. 27

⁷⁹ Refer to Erlei et al. (2007) p. 50; Voigt (2002) p. 27

⁸⁰ Refer to Williamson (1991) p. 287

⁸¹ Note: Coase was an economist and professor at the University of Chicago. The Coase-Theorem i.e. explains economic efficiency with externalities. It says that bargaining will lead to an efficient outcome whenever transaction costs of bargaining are negligible. His understanding of transaction costs is still present. The British citizen received the Nobel Prize in Economics in 1991.

⁸² Note: Williamson is an economist and professor at the University of California, Berkeley. He was a student of Coase. His research focuses on transaction cost economics. He also developed the term “information impactedness” which characterizes situations determining costs of information. He explains the existence of transaction costs and “information impactedness” due to an atmosphere of opportunism, bounded ration- ality and different types of uncertainty. However, in general these issues within a transaction cannot be clearly quantified. Williamson received the Nobel Memorial Prize in Economic Sciences in 2009.

⁸³ Refer to Schramm (2005) p. 45

⁸⁴ Refer to Williamson (1991) p. 287

⁸⁵ Refer to Williamson (1991) p. 287

⁸⁶ Note: The homo economicus is a concept in many economic theories and describes humans as rational and narrowly self-interested actors. Homo economicus attempts to maximize utility as a consumer and eco- nomic profit as a producer. It is the opposite of the concept of homo reciprocans, which says that human beings are primarily motivated by the desire to be cooperative and to improve their environment.

⁸⁷ Refer to Coase (1937) p. 385

⁸⁸ Coase (1988) p. 6

⁸⁹ Note: The terms organization and company are uniformly used in this context whereby a company a rather business organization structure is, where people work for profits only to use the money for improving their business. An Organization is rather a group of people with similar goals working together to achieve a particular goal. They also receive profits to improve and achieve their goal.

⁹⁰ Refer to Pies (2000) p. 3

⁹¹ Refer to Williamson (1993) p. 3