A Theory on REIT’s Advisor Choice and the Optimal Compensation Mechanism

This paper proposes a model which examines the power of monitoring and forcing contract on improving managerial efficiency. We put particular focus on its implication regarding the choice of advisor type used by REITs. This question has long been a puzzling one in real estate literature. Our model provides a theoretical justification regarding the potential appeal of external managerial structure, which is usually regarded as being inferior to internal managerial structure. A crucial driving force regarding advisor choice is the heterogeneity on monitoring power between internal and external advisors and across REIT firms. Provided that the gap of monitoring power is large enough between internal and external advisors, shareholders could make use of the heterogeneity, and induce higher effort levels from external advisors. We motivate the rationale for expecting a “monitoring advantage” over external management from two aspects: the dual-role of external advisory firm and a bigger reputational cost associated with external advisor. Furthermore, we are able to specify the range within which an improved monitoring power is Pareto-optimal for both REIT shareholders and advisors. One implication is that, as agents, it may also be to the benefit of advisors to be better monitored. Finally, we compare the difference between fixed and stochastic forcing contracts. Our findings show that with their imperfect performance measures, the stochastic forcing contracts always dominate the fixed one.