Download Real Estate Investment Vehicles and Agency Theory

Dept of Real Estate and Construction Management
Div of Building and Real Estate Economics
Master of Science Thesis no. 384
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Real Estate Investment Vehicles and Agency Theory
Author:
Wendy GharteySam
Supervisor:
Hans Lind
Stockholm 2007
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Master of Science thesis
_______________________________________________________
Title:
Real estate investment vehicles and agency
Theory.
Authors
Department
Wendy Ghartey-Sam
Department of Real Estate and Construction
Management
Division of Building and Real Estate
Economics
Master Thesis
number
Supervisors
Professor Hans Lind
Keywords
Adverse selection, Moral Hazard, Direct Real
Estate Investment, Indirect Real Estate
Investment (Reits, Non-Listed Real Estate
Investment)
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Abstract
The objective of this study is to review inherent agency problems in direct and indirect real estate
investment, from an investor perspective.
The agency problems can be divided into problems of adverse selection and problems of moral
hazard. The objective is also to discuss how they try to counteract and deal with these problems.
One such aspect is how offering incentives to agents can be one way to deal with the problem.
This study reviewed the most eminent agency problems associated with direct real estate
investment and indirect investment vehicles such as the US Reits and European non-listed real
estate. For this purpose the agency theory was employed. Two sources of agency problems were
identified as the asymmetric distribution of information between investor and management (agent)
and the inherent conflict of interest between investor and management (agent).
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To curb these problems it was found out in direct real estate by providing incentives to motivate
agents is not the only way to deal with the agency problem. The investor(s) participating closely
throughout the whole process and to develop a close relationship with the agent are some of the
solutions.
In Reits, studies have shown that standardized financial reporting or incentive based
compensation structures among others have helped to mitigate such agency problems in US Reits.
For non-listed real estate investment, it was identified that industry associations such as INREV
and corporate governance is a better way , than applying Adams Smith’s tight governmental
regulation and supervision of non-listed real estate investment vehicle to limit the agency problems
as describe from the theory.
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ACKNOWLEGEMENT
This thesis is in partial fulfillment of the requirements for the master degree of Science in Real
Estate Management at The Royal Institute of Technology, KTH Stockholm, Sweden
First I thank God for making it possible for me to go through this study.
I wish to express my sincere gratitude to Professor Hans Lind, my supervisors, for his
recommendations, advice, and reading materials for this work to be accomplished.
Finally, I am grateful to my adorable husband and daughter for their love and support, all my
family members and friends who encouraged me through out my studies at KTH.
I am responsible for all errors and shortcomings in this thesis.
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TABLE OF CONTENT
CHAPTER ONE
BACKGROUND TO THE STUDY
1.2 Objectives
1.3 Methodology
1.4 Disposition
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CHAPTER TWO
LITERATURE REVIEW
2.1 Concept of Agency Theory
2.2 Adverse Selection
2.2.1 What is Adverse Selection?
2.2.2 Remedies to Adverse Selection
2.3 Moral Hazard
2.3.1 What is Moral Hazard?
2.3.2 Remedies to Moral Hazard
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CHAPTER THREE
APPLICATION OF AGENCY THEORY TO REAL ESTATE ISSUES IN GENERAL
3.1 Evidence of Agency Theory on the Real Estate Market
3.2 Conclusion
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CHAPTER FOUR
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DIRECT REAL ESTATE/PROPERTEY INVESTMENT AND THE CONCEPT OF AGENCY
THEORY
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4.1 What is Direct Property Investment?
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4.2 Possible Agency Problems in Direct Real Estate
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4.3 How to Mitigate the Agency Problem in Direct Real Estate/Property Investment
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CHAPTER FIVE
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INDIRECT REAL ESTATE INVESTMENT (US REITS) AND THE CONCEPT OF AGENCY
THEORY
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5.1 What is Reits?
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5.2 Possible Agency Problems in Reits
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5.3 How to Mitigate the Agency Problem in Reits
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CHAPTER SIX
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INDIRECT REAL ESTATE INVESTMENT (REAL ESTATE FUNDS) AND THE CONCEPT
OF AGENCY THEORY
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6.1 What is Real Estate Funds?
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6.2 Types of Funds
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6.2.1 Open-Ended Property Funds
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6.2.2 Closed-Ended Property Funds
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6.2.3 European Non-Listed Real Estate Funds
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6.3 Possible Agency problems in Non-Listed Real Estate Funds
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6.4 Dealing with these Agency problems in Non-Listed Real Estate
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CHAPTER SEVEN
7. CONCLUSION
REFRENCES
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CHAPTER ONE
BACKGROUND TO THE STUDY
1.1 Introduction
Property is one of the main investment assets class beside bonds and shares, often being
considered as a real value secured investment.
There are various ways in which investors gain access to the property market. The main two ways
are by owning property directly or through indirect property investment vehicles. Many countries
have their own unique vehicles, such as the USReits, Real estate mutual funds in Switzerland,
Australian listed property trust, Real estate funds, European non-listed real estate funds etc.
Both investors who invest in indirect property and institutional investors that invest directly in
property need the services of various types of “agents”. This is especially so for indirect vehicles
where someone manages the investment vehicles on the investors behalf. These services are highly
valued nowadays and are in greater demand than before. As ownership and control is more or less
separated and market imperfections/information asymmetries are present, Agency problems will
exist between the investor and agent. It is therefore interesting to investigate these problems and
what remedies there might be to handle them, as it is of great importance to investors to be aware
of these agency problems and how they can be handled.
1.2 Objectives
The objective of this study is to review inherent agency problems in direct and indirect real estate
investment, from an investor perspective. The agency problems can be divided into problems of
adverse selection and problems of moral hazard. The objective is also to discuss how they try to
counteract and deal with these problems. One such aspect is how offering incentives to agents can
be one way to deal with the problem.
1.3 Methodology
The analysis has been conducted by assimilation of information from a variety of sources; factual
data have been gathered from literature, thesis, articles, reports, official publications and internet
sites as indicated in the following text and in the list of references.
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1.4 Disposition
Chapter 2 begins with the basic concept of agency theory.
Chapter 3 discusses the significance of agency theory to real estate issues.
Chapter 4 discusses direct property investment and it relationship to the concept of agency theory.
Chapter 5 discusses the concept of agency theory in the light of US REITS.
Chapter 6 discusses the concept of agency theory in the light of European non-listed real estate
funds.
Chapter 7 concludes the study.
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CHAPTER TWO
LITERATURE REVIEW ON AGENCY THEORY
This chapter deals with agency theory in general; the two concepts of agency theory (adverse
selection and moral hazard).This will form the basis for analysis and discussion.
2.1 Concept of Agency Theory
According to Adam Smith, the welfare of all will be maximized if each individual maximizes his
or her own welfare. This is the result of an invisible hand coordinating all individual actions
through the market (price-) mechanism. However, this clearly does not work in all cases. It
assumes that all individuals work within a legal structure where there is complete and accurate
information which create specific incentives. This is a situation that hardly is given in reality, as
theft, falsehoods and other forms of misrepresentation clearly fall outside. Adam Smith mentioned
in1776 the central problem, the agency relationship, that occurs, when ownership and control in a
firm is separated, backed by the disgraceful behaviour of the East India Company.
“The directors of such [joint stock] companies, however, being the managers rather
of other people's money than of their own, it cannot well be expected that they should
watch over it with the same anxious vigilance with which the partners in a private
copartnery frequently watch over their own. Like the stewards of a rich man, they are
apt to consider attention to small matters as not for their master's honour, and very
easily give themselves a dispensation from having it. Negligence and profusion,
therefore, must always prevail, more or less, in the management of the affairs of such
a company.”
Adam Smith (1776)
According to Cieleback (2004), as institutions and institutional arrangements play a central role in
agency relationships the new institutional economics is a suitable starting point for an analysis. It
builds on, modifies, and extends neoclassical theory and retains and builds on the fundamental
assumption of scarcity and hence competition - the basis of the choice theoretic approach that
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underlies microeconomics. The new institutional economics has developed as a movement within
the social sciences, especially economics and political science that unites theoretical and empirical
research examining the role of institutions in furthering or preventing economic growth. One sub
domain is the agency theory, which deals with the analysis of legal contractual relationships when
ownership and control is separated and market imperfections/information asymmetries are present
(Cieleback, 2004; pp 5-7).
Following Jensen/Meckling an agency relationship exists when “one or more persons (the
principal(s)) engage another person (the agent) to perform some service on their behalf which
involves delegating some decision making authority to the agent.” If both parties maximize their
own utility there is good reason to believe that the agent will not always act in the best interest of
the principal. As a result the principal will try to limit the divergence from his interests by
monitoring the agent. The dilemma is that the cost of monitoring the agent’s actions (monitoring
expenditures) can be significant and can in fact exceed the loss due to the agency relationship. The
principal will therefore try to establish incentives for the agent in a contract so that the agents’
actions are in the interest of the principal without costly monitoring. Additionally there will be
situations where it will pay for the agent to expend resources on actions to guarantee that he will
act in the sense of the principal (bonding expenditures) or to ensure that the principal will be
compensated in such cases. As a result it is impossible for the principal and the agent to ensure at
zero cost that the agent will make optimal decisions from the viewpoint of the principal.
Given the complex structure of agency relationships, these costs will be pecuniary and non
pecuniary as well. In general, the principal and the agent will have positive monitoring and
bonding costs and there will still be some divergence between the agents decisions, subject to the
optimal monitoring and bonding activities, and those decisions that would maximize the welfare of
the principal. The value (in money terms) of this divergence is often referred to as the residual loss.
According to Jensen/Meckling (1976) agency costs could therefore be defined as the sum of:
• the monitoring expenditures by the principal,
• the bonding expenditures by the agent and
• the residual loss .
There are two concepts of agency theory that is relevant in association with real estate investment
vehicles: adverse selection (or hidden information) and moral hazard (or hidden action). In this
thesis, I am going to discuss these two.
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2.2 Adverse Selection
2.2.1 What is adverse selection?
Adverse selection can occur if information asymmetries exist before a contract is closed, e.g. when
agents misrepresent abilities and claim to provide outcomes they know they cannot achieve. It is
important to note that the cause of the information asymmetries does not matter for the problem of
adverse selection (Akerlof, 1970).
Akerlof first noted adverse selection problem (sometimes referred to as the lemon problem), which
arises from the inability of traders/buyers to differentiate between the quality of certain goods. The
most cited example is the second hand car industry, in which a trader dealing in, for example,
Minis possesses product information that the other buyers/sellers in that market lack. He thus
operates at a comparative advantage as the other people in the market cannot tell if he is selling a
‘lemon’ (poor quality car).
Consequently, there is risk involved in purchasing the good and while the lower price buyers are
willing to take this risk, traders selling quality cars are not willing to sell at such a low price.
There are three components to this theory:
(1) There is a random variation in product quality in the market;
(2) An asymmetry of information exists about the product quality;
(3) There is a greater willingness for poor quality car seller to trade at low prices than higherquality owners. Insurance and credit markets are areas in which adverse selection is important.
2.2.2 Remedies to Adverse selection
There exists remedies to adverse selection, one of them is screening: which is an action taken by
an uninformed person to determine the information possessed by informed people example
insurance company learning health history of potential customers, example, information on age,
occupational status etc. A car buyer getting the car independently checked etc.
The other is signalling: which is an action taken by an informed person to send information to a
less-informed (an example is labour market signalling of productivity via educational attainment
(Michael Spence 1973). Spence began his model with a hypothetical situation. Suppose there are
two types of workers, high or low productivity workers. These workers privately know their own
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productivity, or at least are better informed about it than are prospective employers. Employers are
willing to pay a higher wage to the high-productivity worker than the low- productivity worker.
Spence assumes that for employers, there’s no real way to tell in advance which workers will be
high or low productive type. Low-productivity workers aren’t really upset about this, because they
get a free ride off the hard work of the high-productivity workers. But high-productivity workers
know that they deserve to be paid more for their effort, so they invest in the signal. In this case,
some amount of education. Spence assumes that education doesn’t enhance the worker’s
productivity at all. But he does make one key assumption: high-productivity workers pay less for
one unit of education than low-productivity workers. In his results, Spence discovered that even if
education didn’t contribute anything to a worker’s productivity, high productivity workers would
still buy more education in order to signal their higher productivity to employers. Low productivity
workers, for their part, would accept a lower wage rather than pay the higher price (for them) of
getting more education. And employers, seeing that the education signal really is correlated to
workers productivity, would condition their wages on the signal, offering better wages to those
who had invested more in the signal.
2.3 Moral Hazard
2.3.1 What is moral hazard?
The term “Moral Hazard” was first known and defined in the insurance industry, but is now used
in several markets and organisations and is also known as “Agency problem”. In the insurance
industry, the term is used when you refer to the inclination that people change their behaviour after
they had been insured. This leads to larger claims against the insurance company, because when
you are insured you stop taking the same precautions as you did prior to the insurance (Milgrom &
Roberts, 1992). If you in advance could know exactly which precautions that had to be taken and
verify them, the insurance company could specify them as conditions in a contract. However, it is
not possible to write these types of complete contracts that enforce certain behaviour, because it is
practically impossible to foresee all future contingencies and specify actions in all these cases
(Mandell, 2004). Therefore, Moral Hazard is a problem that affects people’s ability to succeed in
making agreements that is equally favourable. This exists because of the presence of asymmetric
information since one party knows something the other does not.
Three conditions must hold if a Moral Hazard problem is going to arise (Milgrom & Roberts,
1992). The first condition is that there has to occur some potential conflict of interests between
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people. There must also exist some kind of co-operation between them that gives them reason to
do business together that activates the conflict of interest, this is the second condition. The third is
that it must be difficult in deciding if the contract has been followed or not and enforcing the terms
of the agreement. This often arises because, as said above, it is expensive or not possible to
monitor the actions taken or check the reported information. Another way for these difficulties to
arise is if both parties know that the contract has been broken, but it is not a verifiable fact for third
party (such as a court), who have the power to enforce the contract.
One of the key problems with Moral Hazard is the incentives; people usually do not want to do
anything extra besides what they need to, without receiving extra benefit from doing it. The
incentives can easily bring forth the desired behaviour, but the problem is to determine when the
behaviour does not need to be changed and to prevent excessive use. That kind of monitoring is
often impossible or at least very expensive and that is the reason why Moral Hazard is an
information problem. It makes contracting incomplete, because it is meaningless to write a contract
that specifies each party’s undertakings in all different situations and what particular behaviour
that is desired in every situation. You cannot observe every action taken and therefore it is not
possible to enforce the contract in an effective way.
2.3.2 Remedies to Moral Hazard
There exists several remedies to Moral Hazard, one of them is monitoring, and if you increase the
resources to monitor and verify the behaviour it is easier to prevent the undesired behaviour
(Milgrom &Roberts, 1992). Sometimes it is easy to monitor a certain type of behaviour, for
example to have the workers punching a time clock to verify that they are working their hours,
which makes it easier to punish them if they do not. There can still be a problem if the cost of
punishment is too high and the punishment therefore is just an empty threat. Then it is harder to
describe how to measure a performance. Sometimes the will to maintain a good reputation is
enough to control the problems with Moral Hazard. For example in (Wallgreen 2002) he stated
that a new shipping company will depend on its good reputation to stay in business. By working
hard to provide excellent service, like transporting its goods and passengers on time, staying out of
hazardous situation by having excellent preventive and well maintenance plan etc will have a
positive impact on the shipping company. Most passengers would like to travel with it.
Another remedy is to receive the information needed by relying on the competition between the
different parties, but it can be risky if they together have interests that they do not want the
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decision maker to know about. For example, neither of two sellers of asbestos insulation was
likely to emphasize the health hazards of asbestos before these became widely known.
The last remedy is the use of incentive contracts; since the input performance of the agent cannot
be monitored, we have to measure and pay for the outcome instead. The idea behind incentive
contracts is to align the agent’s and the principal’s interests. For example by giving the worker
bonuses that depends on the company’s profitability. The main problems with incentive contracts
are to find the right performance measure so that the agent will not allocate his/her resources only
to the things measured and disregard other important aspects. Another problem with incentive
contracts is that they might allocate the risk in the wrong way.
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CHAPTER THREE
APPLICATION OF AGENCY THEORY TO REAL ESTATE ISSUES IN
GENERAL
In this chapter I will discuss how agency theory or information asymmetries are significant to the
real estate market in general and how it has been treated in earlier literature. In the coming
chapters I will focus specifically on the investor issues.
3.1 Evidence of Agency Theory on the Real Estate Market
First, Garmaise and Moskowitz (2004) conducted a study on commercial real estate market in the
US which shows that there is strong evidence that information concerns may be important in this
market, than in the used car market example by Akerlof (1970).
In their studies, they test several theories of asymmetric information.
First, they considered the no trade implications of Milgrom and Stokey(1982), who show that
uninformed agents will not trade with informed counterparts. According to them this will lead to
limited market participation on the part of agents who are particularly informational
disadvantaged. Secondly asymmetric information tends to be severe when information about local
market conditions exists, property buyers then become local. They found strong evidence that this
two predictions holds. Also evidence showed that uninformed buyers will focus on properties with
long income histories that are easier to evaluate.
Furthermore, they found out that if informed agents can be identified, and then it is efficient for
them to trade with other informed agents rather than with the uninformed. This lead to a form of
market segmentation in which the informed and uninformed markets are to some degree
distinguished. In environments where information asymmetries are severe, they found out that
informed brokers are more likely to sell to other informed brokers. They also argue that proximity,
selective offering, and market segmentation results clearly indicate that information asymmetries
are important in this market. In addition; they examine the effects of asymmetric information on
the choice of financing; in the commercial real estate market. They considered several adverse
selection models and found only weak evidence that market participants use the form of financing
to mitigate information problems in the market.
They further characterize high and low information environments by exploiting exogenous
differences in property assessment across regions in the United State; they found significant
disparities in the quality of assessments across counties and local assessment jurisdiction. By
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exploiting these differences, they test whether they give rise to variation in the proximity of
buyers, the types of properties brought to market, the extent of market segmentation, and the form
of financing. They argue that buyers located closer to a property, because is likely that they will
have a better understanding of local market conditions and can more easily and cheaply evaluate
the property. Also the distance between the buyer and the property is used as a measure of the
degree of information asymmetry. Also properties with longer income and price histories provide
investors with more information about the property and the local real estate market.
From the above, it can be seen that asymmetric information is significant in the commercial
property market.
Secondly, a study conducted by Benjamin, Lusht and Shilling (1996) on rental housing market in
Washington DC and Pennsylvania in the US, reveled that there exist a problem of asymmetric
information between landlords and renter households regarding the latter’s use of the premises.
According to them, this problem leads to a ’’lemon market” in which the mix of tenants shifts
heavily to high-utilization households and in which landlords responded by raising rents or by
demanding high up-front security deposits.Also, they argue that a moral hazard element
originating from tenant’s potential over-utilization of the premises may force landlords to raise
rents even further or to demand even higher up-front security deposits.
In another study, Benjamin, Shilling and Sirmans (1992) presents a test of whether the payment of
a security deposit counteracts the uncertainty of tenant quality in office leases. According to them,
there are two potential effects at work when a tenant makes a large up-front security deposit. The
first effect, they called an opportunity-cost effect that arises because the tenant has given up
advance funds and interest payments for a fixed period of time as security against damage to the
premises. They label the second effect an adverse selection effect. They further went on to test for
the presence of adverse selection in office markets and whether landlords can contract on the
intensity with which tenants utilize their office space. This is because landlords face asymmetric
information, in that they expect some tenants to be less opportunistic than others but often cannot
predict at the time of lease negotiation the tenant’s future behaviour. This asymmetry of
information means that landlords must charge all tenants, both low-utilization tenants and highutilization tenants, a rental externality premium. This rental externality premium gives lowutilization tenants (or tenants with better credit quality than the market perceived) a strong
incentive to sort themselves out. One way to allow different tenant types to be sorted by self-
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selection is for landlords to offer a pair of office rental contracts, one contract with a sufficiently
high enough rental price ex ante to account for excessive utilization but with no security deposit
and another contract with a lower ex ante rent but with a large up-front security deposit. Their
results suggests that payment of a security is one way by which low-utilization tenants(or tenants
with better credit quality than the market perceive) can signal to the landlord that they are likely to
perform according to the lease agreement. Such payments reduce landlord uncertainty and imply
rental discounts in excess of the forgone interest on the deposit monies.
Also in Arnold’s (1992) study of the principal’s-agent relationship between a home- owner and her
broker, he found two principal-agent problems between them. He first found out that since brokers
play the central role as the agent who search for buyers to purchase the house, he (the broker)
advises the owner in setting a reservation price and provide information about current market
condition for the owner, an agency problem exist. According to him, this is because if the owner is
unable to monitor the broker’s search activity, the broker may have an incentive to provide an
inefficiently low level of effort (search).
The second problem was that as compared to brokers who are well informed of market conditions,
homeowners are infrequent market participants, because they are not fully informed of demand
and supply conditions in the housing market.Therefore, the owner frequently relies on the broker
to guide her in setting a reservation price. This informational asymmetry can create an incentive
for the broker to misrepresent market information. To overcome this principal-agent problem
inherent in the relationship between the broker and the owner, he investigated three systems for
pricing real estate brokerage services; fixed-percentage commission, flat-fee, and consignment. He
found out that the most effective of the three is that of the fixed-percentage commission system.
Finally Azasu, (2003) research on the use of incentive schemes among real estate firm’s in
Sweden, he tested for differences in the probability of the use of incentive contracts between real
estate firms in the private sector and their public sector countrperts, which according to him are
mainly Municipal Housing Companies.
He identifies agency theory as one of the principal theoretical models of incentive contracting. The
principal-agent model suggests that either investing in information systems or contracting on the
outcomes of the cooperation process (with more risk being passed on to the agent) can solve these
problems. The model points to a trade-off between the costs of monitoring and the cost of
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measuring outcomes and transferring risk to the agent. Thus incentive contracts, with the
associated performance-related pay or merit pay, are an attempt to align employee interests with
those of the owners of the firm.
In his work, he found out that motivation is the most important reason for using variable pay, even
though their recruitment and retention role has been recognized. According to him, using incentive
plans to retain workers may not always be efficient, especially if the firm-worker relationship is
not characterized by specificities. Private firms are more likely to use variable pay than firms
owned by government. To him, this does not necessarily put the latter at a disadvantage if they
recognize and take advantage of the motivation role of non-monetary factors in the workplace.
According to him, one cannot conclude that firms that use variable pay are better at motivating
their employees, if they do not complement this with supportive human resource management
practices. He affirm that due to the desire by small firms to match large firms’ use of such contract,
firm size does not appear to be a good predictor of the likelihood of a firm’s use of incentive
contracts.
3.2 Conclusion.
This section outlines agency theory to real estate issues in general by reviewing studies conducted
on commercial real estate market in the US, what Rental Contract reveal about Adverse Selection
and Moral Hazard in Rental Housing Market in Washington DC and Pennsylvania in the US, a
test conducted on whether the payment of a security deposit counteracts the uncertainty of tenant
quality in office leases, The principal-agent Relationship in Real Estate Brokerage Services and the
use of Incentive schemes among Real Estate Firm’s in Sweden. In the following chapters, the
study will focus on how investors perceives the problems of agency theory to direct and indirect
real estate investment vehicles, and how to counteract these problems.
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CHAPTER FOUR
Direct Real Estate/Property Investment and the concept of Agency Theory
Literature pertaining to direct real estate/property investment is reviewed in this chapter. It is also
used as the bases for discussion.
4.1 What is Direct Property Investment?
Direct property investment involves the rights of owner to a piece of land, typically with a building
(Hoesli and Macgregor 2000).Direct ownership of properties is the most common form of
ownership. This is because property is not only an investment, but also holds a utility value.
Owning property directly comes with a number of management obligations, such as maintenance,
rent collection, rent reviews etc.These obligations mostly are done by the owner himself, in other
words owning property directly include control of the use of the property.However, there are
instances where the owner/investor engages the service of an agent especially when it comes to
selling or renting the property to another person. In the next section that follows, I will concentrate
on how an agency problem exists when the owner/investor engages the services of an agent during
the sale of his property.
4.2 Agency problems in Direct Real Estate/Property Investment
As stated by Jensen/Mekling (1976)
an agency relationship exists when “one or more persons
(the principal(s)) engage another person (the agent) to perform some service on their behalf which
involves delegating some decision making authority to the agent.”In direct real estate investment
the owner has control of the use of the property, but at times engages the services of an agent in the
sale of the property. There are possibilities that Moral Hazard may occur. When this happens the
owner/investor is faced with how to deal with the problem. Studies conducted by Andersson and
Hanson (2005) have shown that the following are some of the Moral Hazard problems they face.
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(1)Market knowledge
It takes time for the investor to understand the mechanism of the market as he might not have the
same information as the local investors have especially when he is new in the market or from
another market. For the investor, to understand the mechanism of the market, he needs to know
how to do business and be aware of the customs in the country; otherwise there tends to be
misunderstandings and disagreements. Since the market participants rely on each other, they do not
treat Moral Hazard as a significant issue. By being updated and informed about what is going on in
the market, they think the problem is reduced. Nonetheless, even having the same amount of
information, Moral Hazard can still exist depending on how the investors interpret it.
(2) Supply of Agents and Temptation
In markets where there are few agencies, the investors do not have an option to choose and that
creates a good opportunity for the agents. In some cases, Moral Hazard can occur when the agent
does not justify his existence and the investors do not have other agents to turn to.
Another problem arises when the selected agents are too few to handle the load of work.
Normally, for a good agent the amount of work will grow if the agents are too few. It is hard to
turn down new business opportunities and the temptation to sign up with to much work can occur.
Principally, the agents are 100 percent organized but there is always a risk that the agent cannot
give every participant a 100 percent dedication. The reward tempts the agents and it is hard to
refuse a business opportunity. Hence, the agents may rush over to the next deal and not perform
their duties in the best way, creating a Moral Hazard circumstance.
Changes in the workload or other circumstances will also cause setbacks for the agents
and leave them behind in the time schedule. This could sometimes been seen as a Moral Hazard
problem as a result of deficient communication.
(3) The Fee and Payment for Agents
Moral Hazard can occur when the agent’s fee, paid by the investor, is too low. Some may say “you
get what you pay for” and mean it reflects in the effort and easiness of doing business. This could
cost the vendor a lot if the agent does not act effectively, for instance by slowing down the process
and therefore missing out on other business opportunities. Consequently, it is important to get a
balance between the agency fee and the services expected. Agents can either work for a salary or
on commission and mostly there is no problem with this, even if there can be a bigger risk in
working only on commission.
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(4) Short-sightedness
The short-sightedness of agents is another problem. With or without the agent’s fee it is important
to enhance the agent’s performance or it may lead to short-sightedness. An agent generally gives
100 percent of effort during the deal but once the deal is completed, the agent will disappear. The
connection and the time to search for future business opportunities that gives both the agent and
the principal income are not there. The agents are only involved for a short period and that causes a
short-sighted relationship. This could be something for the agent to work on and develop.
(5) Double Loyalty
The agent can sometimes have trouble in showing his loyalty towards the owner/investor; this is
because the agent sometimes represents the purchaser, since there is no guarantee that the agent
acts in the best interest of the owner/investor. This situation, where the agent sometimes represents
the investor and sometimes the purchaser against the investor could cause hesitation and create
doubts if the agent keeps the secret information to himself.
If the principal is not aware of the agent’s double loyalty, he conceives the problem as serious.
4.3 How to mitigate the agency problem in direct real estate investment
Studies by Andersson and Hanson (2005) have proved that by providing incentives to motivate
agents is not the only way to deal with the moral hazard problem. The investor(s) participating
closely throughout the whole process and to develop a close relationship with the agent are some
of the solutions.
(1) Providing Financial incentives to motivate the agent
The primary meaning with incentives is to create a situation where both parties can feel they are
gaining from the agreement and are used to keep the agent stimulated in the whole process. Studies
by Andersson and Hanson (2005) have shown that in Sweden the investor provides financial
incentives to the agent by linking his fees to the purchase sum of the property. Meaning the agent
has to reach out in the market and create competition between the purchasers, they will outbid each
other and the agent will get a higher price for the property. This high price for the property is what
the investor will use as the bases for the agents needed incentives. Another way of providing
incentives to agent(s) was found in New Zealand where the agent gets a percentage, connected to
the price.
21
(2) Investor participates closely throughout the whole process.
The investor by working closely with the agent in the transaction process, reduce the risk of Moral
Hazard. To be in charge and control of the agent, the investor can contribute and organise by being
in close contact with the agent. They can create a time schedule together over the different
deadlines during the deal. They can also act as a group, represented both by the agent and the
investor or create a standard model for the agent to follow etc. The crucial issue is to have a clearly
defined and structured process that is developed and agreed on by both parties, with the intention
that both of them are strictly following it.
Moral Hazard is an existing problem and to avoid it, the investor(s) demand reporting and
feedback from the agent. It can be achieved in various ways, from a strict written report to a
normal conversation or mail contact, depending on what the investor wants or agrees on with the
agent. The main issue is to enable the investor to follow and understand the actions taken by the
agent. Normally, the investor and the agent agree on how to report and how often. The investor(s)
are generally very clear about the way they expect the agent to report back to them. It is mostly
done by a few meetings and close contact over the phone.
(3). Investor develops a Close Relationship with the Agent
A relationship is a bond between two parties that can be a common interest or a mutual agreement.
By building a relationship the investor and agent look out for each others interest and sometimes
the business relation also develops into friendship. A well functioning relation is good and healthy
for the person and his business and is therefore important. By maintaining a close relationship with
the agent, they create a “win-win situation” and reduce the Moral Hazard problems.
The investor puts demands on the agent, in order to develop a relationship. The investor wants to
work with people they can trust and improve the relationship with. To achieve the goal of a
successful relationship, both the investor and the agent need to have an open and honest mind. The
agent also needs to have integrity and be able to handle information that is a delicate subject for
each property and company. It is of high importance to know what information to share and what
to keep to you. Since delivering out information from the investors can be sensitive, the agents
need to show their professional ethics in handling confidential information even within their own
office. A successful and well-maintained relationship depends on many variables and that is why
the agent’s personality is of high importance. When it comes to work, the agent must be
professional; he has to take his job serious and competence. He needs to have a positive attitude
22
and behavior, be innovative and flexible. Another important factor in sales is that an agent needs to
be sociable and outgoing. The ability to get along with people is half the way for success of the
relationship or business connection.
23
CHAPTER FIVE
Indirect Real Estate Investment (US Reits) and the concept of Agency Theory
Literature pertaining to US Reits is reviewed in this chapter. It is also used as the bases for
discussion.
5.1 What is Real Estate Investment Trusts (REITS)?
A REIT is a corporation or business trust that invests in large-scale, income-producing commercial
real estate, mortgages or real estate-related securities. REITs are not taxed at the corporate level.
They are pass-through entities that distribute income and capital gains from investments to their
shareholders untaxed.
5.1.2 Characteristics of REITs and their Corporate Governance Structure
Due to REIT legal requirements, the amount of manager discretion wielded by REIT managers is
significantly less than in regular corporations. These requirements are as follows:
■ Insider ownership of stock, the 5–50 rule: In contrast to a regular corporation, the Internal
Revenue Code (IRC) restricts the five largest shareholders of a REIT to controlling (directly or
indirectly) no more than 50 percent of the REIT’s shares. Institutional holdings are not regarded as
a single investor for purposes of this rule. As such; many REITs have a provision in their articles
of incorporation that permits five persons to acquire up to a maximum of 9.8% each, or an
aggregate of 49% of the outstanding common stock. Due partly to this restriction, REIT insiders
and in particular, the trustees and advisors typically own only a minimal amount, if any, REIT
shares. In the REIT sample, the median insider ownership was 9.5% of the outstanding common
stock (13.6% mean) at the IPO. This amount decreased to 7.5% (median, 12.4% mean) a year after
the IPO. The 5-50 rule was originally designed to diffuse ownership and to prevent management
from expropriating wealth from small shareholders.
Consequently, we expect initial value (Q ratio) to increase as management increases their
ownership in the firm in accordance with the agency theory of Jensen and Meckling (1976)
(ownership hypothesis).
■ 95% Dividend payout requirement: To qualify as a REIT, a company must distribute at least
95 percent of its taxable income excluding net capital gains as dividends. Since managers of REITs
24
have less discretion over their cash flows relative to regular corporations (see Jensen (1986)), this
payout requirement tends to mitigate agency problems. This restricts a REIT’s ability to fund
growth internally through retained earnings. Wang, Erickson, and Gau (1993) find that REITs
generally pay out more than 95% of their taxable income as dividends. As a result, REITs must
continually raise capital through seasoned debt or equity offerings while expending free cash flow
through a high dividend payout. The market for secondary equity offers thus acts as a monitoring
mechanism.
■ REITs are exempt from investment company status: Although a REIT resembles an
investment company, most REITs are exempt from “investment company” status as defined in the
Investment Company Act of 1940 through the provision in section 3(c) (5)(C)7. As such, a REIT is
not subject to the same corporate governance provisions and the structure of its investment
advisory contract as an investment company.
■ Restrictions on investments: The tax code requires that a minimum of 75% of a REIT’s gross
income must come from real estate. A REIT is further restricted to be a passive investment
conduit; as such, less than 30% of a REIT’s income must come from the operation of real estate
held less than 4 years and income from the sale of securities held less than 1 year. REITs also
cannot engage in active real estate operations, including operating a business, developing or
trading properties for sale, and selling more than five properties per year. A REIT is further
prohibited from entering into tax-free exchanges to acquire properties.
If these provisions are met, then a REIT is not taxed on its distributed taxable income; Income is
taxed only at the shareholder level. However, the trust is prohibited from passing through any
operating losses to shareholders as a tax credit. Other than these conditions, the organizational
structure of a REIT is the same as an ordinary corporation. (Hartzell,Kallberg andLiu 2002:p 6-7).
5.2 Possible agency problems in REITs
Manager-shareholder agency problems arise when managers’ interests diverge from those of
shareholders, resulting in lower firm values (Jensen and Meckling (1976).
Studies by Susanne and Vogt (1994) have shown that unlike the older REITs that were externally
managed (advisor Reits); REITs of the 1990s are self-managed corporations. According to them,
under external management, agency problems exist between shareholders and REIT managers, and
also between REIT managers and external managers. In self-managed REITs (90’s REITs), the
second source of agency problem is eliminated. In this study I will concentrate on agency
25
problem(s) that exist between self managed REITs (that is between shareholders and REITs
managers).
Once shareholders (principal) have placed their capital the management (agent) of REITs could act
opportunistically, investing the money to maximize their own benefit. The likelihood of moral
hazard increases if there is no need for raising further capital in the future. Opportunistic behavior
of the management is made possible through the asymmetric distribution of information between
shareholder and agent. As the shareholder has no direct control over the actions of the agent
(management).
Moral hazard can occur in many forms. This begins with the amount of effort that the management
puts into the fulfillment of its tasks. The shareholder has no means to control the effort directly.
The output of the management, determined by the success of the investment, cannot be attributed
to the potential effort of the management as other environmental factors influence the success.
Should the investment be profitable it cannot be concluded that the success is due to the quality
and effort of the management, as sheer luck or a rising market may be the causes. The same holds
true for a less profitable investment. As the management has no incentive to put in its full effort,
through the lack of control, the likelihood of a sub optimal development increases.
Asymmetric information poses a further danger which can be seen in the managerial decisions of
the agent (hidden actions). Both the shareholder and manager have different interest. While the
shareholder maximizes his wealth through profitable investment of his capital, the manager
maximizes his wealth through the payments for his services. The compensation of managers
traditionally correlates with the value of the managed assets. This implies an inherent incentive for
managers to increase the amount of assets under his management. This can lead to investment
decisions, which are not in the interest of the principal, thus reducing the value of his investment
and shifting wealth from the shareholder to the manager.
5.3 How to mitigate the agency problem in REITs.
The separation of ownership and control of the firm provides much of the impetus for corporate
governance. To mitigate shareholder-manager conflicts, many control mechanisms have been
devised, including compensation contracts, board design, antitakeover amendments, ownership
structure, takeovers, and the use of leverage.
26
Studies by Susanne and Vogt (1994 have shown that the best way to mitigate agency problem(s)
effectively in self administered Reits is, through more standardized financial reporting or incentive
based compensation structures and thus rely less heavily on ownership structure to mitigate the
agency problems.
In self-administered REITs incentive based compensation structures (Executive compensation) is
defined as cash and quantifiable perquisites as reported on the proxy statement. Incentive
compensation in the form of stock options is common in self-administered REITs. In a survey of
REIT compensation practices in 1989, Lucas (1989) reported that nearly two thirds of the selfadministered REITs provided stock options to their top executives, and all firms provided them to
their top acquisition officer. Lucas (1989, 1991) also found that the employment arrangements
were complex and that incentives typically were based on changes in either the appraised value of
invested assets, changes in net income or cash flow, or on distributions to shareholders. The range
of perquisites offered included automobiles, country club memberships, and tax and financial
counseling. About half of the executives had employment contracts and three quarters had change
of control provisions.
27
CHAPTER SIX
Indirect Real Estate Investment (Real estate funds) and the concept of
Agency Theory
Literature pertaining to real estate funds e.g. European non-listed funds is reviewed in this
chapter. It is also used as the bases for discussion.
6.1 What is Real Estate Funds?
A real estate fund is a fund that invest 65% of it portfolio in equity securities of domestic and
foreign companies engaged in the real estate industry. For example the Nordic countries,
Germany and elsewhere, a fund do not have independent legal status. It is the fund unit
holder, who owns unincorporated units in the fund capital, and it is the fund management
company that deals with all matters concerning the fund. The fund unit holders and the
managers agree on how the fund is to be managed. It is a “model under the law of contract.”
Countries like US, France, Luxemburg, and UK etc have a model based on company law.
Fund capitals is owned by a joint stock company rather than the unit holders.Instead, fund unit
holders own stock in the company.
6.2 Types of funds
6.2.1 Open-ended property funds
An open-ended property fund is a pool of money from many investors, with which a special
investment company acts as a trustee. All assets that belong to the fund must be strictly
separated from the investment company’s own assets. The funds are allowed to invest in
properties and take certain participation in real estate companies and fixed income
instruments. Open-ended funds do not have a fixed number of outstanding units. Instead, the
number of shares changes, as the funds continually stands ready to both sell new shares and
to redeem old shares on demand from shareholders. The units are therefore not traded on the
secondary market, but they are still very liquid because investors can ask for redemption of
their fund units on a daily basis. In theory, this is not true since it could take time from the
investor’s request for redemption to that the money is repaid. As a result of the open-ended
structure there is no upper limit in these funds. The fund continues to grow as investors put
more money into it. Opened-ended real estate funds are fiscally transparent and tax-exempted
on the corporate level, which make them attractive from a tax perspective.
28
6.2.2 Closed-ended property funds
In a closed-ended fund the participants acquire a share in a portfolio of properties that are
purchased at market price. In contrast to open-ended funds, closed-ended property funds do
not admit investors to invest in the fund after the initial amount of capital needed to undertake
the investment is raised. In other words no further units will be issued or redeemed after the
capital is raised; instead there are a fixed number of shares and a predetermined tenure. In
most cases the investment horizon is between 5-20 years. During the investment horizon
dividends are paid to the participants and when time for exit the assets are sold and the capital
is repaid.
The closed-ended fund sector is not nearly as structured or regulated as the open-ended fund
sector. A closed-ended fund is mostly organized as a limited partnership that consists of one
or more general partners and one or more limited partners.
In a closed-ended fund, the manager has a fixed amount to invest without the fear of mass
redemptions, which could force him to conduct a rapid sale of the property assets within the
portfolio. However the structure has certain downsides. The share price is determined by
supply and demand of the vehicle’s shares, as with any other company, and does not therefore
necessarily track the Net Asset Value (NAV), which is founded by the actual market value of
all assets held by the fund less the funds liabilities. As a result of the price determination
between buyer and seller, no frequent valuations of the underlying properties are needed.
6.2.3 European non-listed Real Estate Funds
The European real estate market for example has seen rapid growth in recent years,
characterized by property funds with different structures and objectives. A quarterly report by
Investors in Non-Listed Real Estate Vehicles (INREV 2005), showed that there are 423 nonlisted funds of which131 are open ended fund with a Gross Asset Value (GAV) of 57.4 billion
euro (when German Open Ended Fund (GOE) are added this total rises to 160.8 billion euros),
the rest are close ended funds which is 262 with a GAV 110billion euros. See figure 1 below.
For institutional investors, these private vehicles are attractive because they offer access to
product, as large lot sizes are easier accessible, access to local management, that has a proven
track record in the targeted sectors, access to geared returns, as institutions in many cases are
not allowed to gear their direct real estate holdings, but are allowed to invest in indirect
geared investments and access to immediate diversification.
29
Fig 1: The number and value of non-listed real estate funds by launch year in the
INREV database.
Source: INREV (August 2005 data)
6.3 Possible Agency problems in Non-Listed Real Estate Funds
Despite this increase popularity of non-listed real estate investing, there are agency problems
associated with it. Investors are concern about the loss of direct control and lack of
satisfaction over the investment management. Especially the second option is only viable, if
the product is attractive for potential investors. The investor, in making any decision to invest
in a non-listed real estate has to keep in mind the agency problems involved.
The first decision the investor has to make is on the relevant (targeted) part of the whole
investment grade real estate universe. Second decision will be on the defined targeted real
estate universe. The following has to be considered.
(1) Selection of the asset manager
(2) Selection of type of fund and
(3) Monitoring/benchmarking of the fund performance.
In selection of the asset manager, the investor looks at the track record of the asset
manager which shows his areas of competence and therefore a decision for a special kind
of fund will predetermine the asset (Fund) managers under consideration for the
investment. Looking at the track record of an asset (fund) manager, the investor tries to
30
reduce the adverse selection problems, as the manager has already shown that he is
competent in specific areas. Consequently, the legal frame work of the asset (fund)
manager along with the corporate structure and the incentive system within the asset
manager are of significance for the decision of the investor.
In selection of the type of fund, the management style of the fund and the countries under
consideration of the fund is crucial for the decision. The investor has to decide which type
of fund suites best his risk return profile and then has to decide which fund to invest in.
Fig 2: The management style framework of the fund.
Source: INREV (August 2005 data)
From figure 2, a look at the target return of the fund shows that on average a core fund has
a lower target return than a value added or opportunistic fund. Here there is a problem for
the investor because he must analyze the different funds or hire a consultant to advise him.
After making a decision for a fund the investor is faced with another problem, he has to
make sure that the fund management works as promised and in his interest. If the chosen
asset manager operates more than one fund, the investor has to make sure, that his fund is
treated equally in relation to the other funds. The incentive structures in the contractual
arrangements between the investor and the asset manager play therefore a crucial role for
the outcome of the investment, as they determine to some extend the potential for moral
hazard on the side of the asset (fund) manager, especially in the form of hidden action.
31
In monitoring/benchmarking of the fund performance, the investor would like the fund
management act in his interest, a way to secure this, is to benchmark the fund. Comparing
real estate to an asset class of stocks and bonds it can be observed that developing and
applying benchmarks to measure performance becomes difficult. Therefore the investor in
choosing an appropriate benchmark for real estate investment has to answer the question
weather he wants to use a real estate benchmark and if so what are the choices within real
estate.A portfolio base index such as the Investment Portfolio Databank (IPD) indices is
use as a benchmark in real estate investment. In the case of non-listed real estate investing
the investor has to be careful when using these indices for benchmarking purposes, as they
are not available for passive investments.
Fig 3: Manager defined styles by target return and gearing.
Source: INREV (August 2005 data)
Looking at fig 3 it can be seen that in non-listed real estate, considerable gearing takes
place and returns are Internal Rate of Return (IRR) targets and not total return targets.
The fund manager is faced with more complicated problems as he has to calculate the degeared return of the fund as portfolio base nature of IPD indices are calculated on standing
investments without gearing. This gives the fund manager room to maneuver in his own
interest, probably increasing his return at the expense of the investor. If his actions are not
monitored closely by the investor, this leads to high monitoring costs at the investor level
which ultimately reduce the return for the investor. Also calculation of de-geared returns
32
is not without discussion, the results are not unmistakable and therefore discussable if the
benchmark was not met by the fund manager in a given period.
In the above discussion, areas of agency problems from the investors point can be
summarize as follows:
(1) In selecting an asset (fund) manager, the investor encounters an adverse selection
problem because looking at the track record of the asset (fund) manager he has
already shown that he is competent in certain areas.
(2) If the investor uses a consultant in his discussion making process he encounters, the
agency problem at the consultant level.
(3) Finally in the management of the fund the agency problem is encountered, which
eventually affects the return of the investor.
6.4 Dealing with these agency problems in non-listed real estate.
Giving incentives to asset (fund) managers as way of dealing with agency problems in
non-listed real estate is not the only workable solution to the problem. There are other
ways to deal with these agency problems.
First, by creation of industry associations such as INREV in 2003.An industry association
is an association with voluntary membership that aim at the dispersion of best practices
and to increase the understanding of the market.INREV as an example aims to improve
the accessibility of market information and by serving the needs of investors through the
liquidation of the non-listed real estate vehicle market. In other to achieve this, INREV
has the mission to increase transparency and accessibility to promote professionalism, best
practices, sharing information and to spread knowledge.
Also it has about seven working committees with clearly defined purpose. The areas they
cover are benchmarking and performance mearsurement, standard of best practice,
secoundary market, research, tax and regulations, database and website and membership and
events. INREV also intends to create a broad European forum with a wide membership
representing all aspects of the industry. The primary focuses are the interests of institutional
investors as they control the strategy of INREV. Other market participants such as fund
sponsors and advisors are welcomed as supporters but they cannot dictate the agenda.
Regarding the agency problems with indirect non-listed real estate investing benchmarks,
standards for performance measurement and standards for best practices are an important
prerequisite to prevent moral hazard. Opportunistic behavior of the management possible
33
through the asymmetric distribution of information between investor and agent is easier to
discover. If standards for the performance measurement and best practices exist the effects of
opportunistic behavior on the returns of the investor can be identified easier, as they can not
be hidden in the asset (fund) managers own performance calculation. Additionally the
introduction of a broad based industry benchmark with some sub categories according to
management style and gearing allows the investors to identify the performance of the sector
as a whole and the (non-listed) peer group of his investment vehicle.
Having said that benchmarking is an important part to deal with the agency problem in no
listed real estate investments one has to keep in mind the foundations of benchmarking.
Benchmarking requires a number of organizations to pool their information to establish a
performance benchmark. Consequently it is a collaborative effort that takes off voluntarily as
there is no legal requirement for benchmarking. Therefore the appearance of a benchmark is a
positive signal of its own. Additionally benchmarking as a periodic process enables the
investor to assess the effectiveness of the management team. Moreover it is possible to
determine remuneration levels through contracts relating measures of relative performance to
fees giving the asset (fund) manager incentives to act in the interest of the investor.
Although the headline total return is the most significant measure of success or failure,
benchmarking is also a tool for analyzing the reasons for good or bad performance.
At the same time as INREV wants to develop standards of financial reporting and disclosure
and to establish common and workable standards of corporate governance. Membership of
INREV can therefore in the long run work as a signal for investors when INREV is
established European wide as a generally accepted industry body. As INREV members will
adhere to the standards set by the INREV working committees the investor can expect less
probability of agency problems at asset (fund) managers who are a member of INREV than
asset (fund) managers who are not INREV members. Notwithstanding this does not mean that
agency problems will not occur as there is a free rider problem if a fund manager thinks that it
is likely that his behavior will not be detected for some time by the investors and INREV. At
the same time there will be asset (fund) managers who are not INREV members who operate
entirely in the interest of the investor maximizing his investment return.
Nevertheless ultimately the activities of INREV will improve the market transparency
significantly. The investors will push the asset (fund) managers to adopt the best practice
standards no matter if they are a member of INREV or not. At the same time the increasing
interest in benchmarking the funds` performance on a portfolio, sector and property level
from the side of the investors will force more and more funds to contribute to the benchmarks
34
established by INREV enlarging the database and further strengthening its credibility as an
industry wide benchmark.
Another way to solve agency problem in non-listed real estate investment is through corporate
governance. "Corporate governance is the system by which business corporations are directed
and controlled. The corporate governance structure specifies the distribution of rights and
responsibilities among different participants in the corporation, such as, the board, managers,
shareholders and other stakeholders, and spells out the rules and procedures for making
decisions on corporate affairs. By doing this, it also provides the structure through which the
company objectives are set, and the means of attaining those objectives and monitoring
performance", Organization for Economic Co-operation and Development (OECD April
1999). OECD's definition is consistent with the one presented by Cadbury (1992, page
15).Corporate governance helps to increase transparency and professionalism on the company
level. Due to this the agent can be held accountable for the corporate performance and the
return on the invested capital paid to the principal. Based on specification of the rights and
responsibilities of principal and agent a structure is established through which performance
monitoring occurs in regard to the companies objectives.
“Initiative Corporate Governance der deutschen Immobilienwirtschaft e.V”
founded in 2002 in Germany is one such example of corporate governance. The idea of this
initiative is that in the competitive global real estate market, the success of German real estate
and construction enterprises will be more dependant on qualified management and
transparency in the future than in the past. The initiative is based on the Corporate
Governance Code submitted by the Government Commission on Corporate Governance
appointed by the Federal Minister of Justice on February 26th 2002 that has been accepted in
the meantime by most of the enterprises. The goal of this initiative is of two kinds.
(1) To account for the particular characteristics of the German real estate economy as it
is in part different from the other sectors
(2) To increase professionalism and transparency by supplementing the corporate
governance code in specific areas in real estate such as current real estate valuations,
regulation of conflicts of interest and growing specialist qualification.
The second goal is relevant to the agency problem as describe in 5.4.Regarding
transactions by real estate enterprises the code states:
In case of real estate transactions by the enterprise, even the appearance of a conflict of
interest should be avoided. In every such transaction, the interests of the enterprise alone
35
must be safeguarded. Members of the executive board may under no circumstances derive
personal advantages from transactions of the enterprise.
Privately conducted real estate transactions and private commissions regarding such
transactions by members of the executive board should be disclosed to the chairman of the
supervisory board.
The members of the executive board should ensure compliance with the principles for the
avoidance of conflicts of interest, in particular in case of
• transactions between associated enterprises
• the purchase and sale of real estate
• the award of commissions in the real estate sphere.
The supervisory board should establish rules of procedure for individual cases.
The acceptance of this amendment to the corporate governance code from asset (fund)
managers can be seen as a signal of the fund manager to the investor that he can have
confidence in his actions especially regarding conflicts of interest at the management level.
The circumstances are similar to the situation in the labor market analyzed by Spence (1973)
where he identified separating equilibria where agents of different types were rewarded as a
function of different signals that they acquire e.g. education levels. Like in the labor market
example separation by signals implies separation by the cost of signaling this time through the
costs of accepting the amendment to the corporate governance code and its rules.
For non-listed real estate investment, it can be said that industry associations and corporate
governance can help to alleviate the agency problems, than applying Adams Smith’s tight
governmental regulation and supervision of non-listed real estate investment vehicle to limit
the agency problem as describe from the theory.
36
CHAPTER SEVEN
7.0 CONCLUSION
The objective of this study is to review inherent agency problems in direct and indirect real
estate investment, from an investor perspective.
The agency problems can be divided into problems of adverse selection and problems of
moral hazard. The objective is also to discuss how they try to counteract and deal with these
problems. One such aspect is how offering incentives to agents can be one way to deal with
the problem.
This study reviewed the most eminent agency problems associated with direct real estate
investment and indirect investment vehicles such as the US Reits and European non-listed real
estate. For this purpose the agency theory was employed. Two sources of agency problems
were identified as the asymmetric distribution of information between investor and
management (agent) and the inherent conflict of interest between investor and management
(agent).
To curb these problems it was found out in direct real estate that, by providing incentives to
motivate agents is not the only way to deal with the agency problem. But the investor(s)
participating closely throughout the whole investment process and by developing a close
relationship with the agent are some of the solutions.
In REITs, studies have shown that standardized financial reporting or incentive based
compensation structures among others have helped to mitigate such agency problems in US
REITs.
For non-listed real estate investment, it was identified that industry associations such as
INREV and corporate governance is a better way , than applying Adams Smith’s tight
governmental regulation and supervision of non-listed real estate investment vehicle to limit
the agency problems as describe from the theory.
37
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