Real estate is being tokenized.
Property owners can issue blockchain-based tokens, which represent shares in an asset.
Investors can buy such tokens and become fractional owners of the underlying asset. They then participate in the asset's appreciation and cash flows.
They can likewise, at any time, sell their shares in a secondary market online.
The underlying blockchain technology unlocks value across the stack. It automates legal compliance. It makes clearing and settlement more efficient. And it enables new products to be built on top, like smart contract-based derivatives and indices.
The signing of Senate Bill 69 in the Delaware General Assembly paved the way in 2017. It officially allowed for blockchains to maintain corporate share registries.
Though tokenization offers a compelling vision, there are complexities beneath the surface.
We can think of tokenized real-estate as a two-sided marketplace. On the one side, there are asset owners who issue tokens. On the other, there are investors who buy these tokens and become fractional owners.
In this post, we will take a look at both sides of this marketplace, and analyze the challenges and opportunities that lay ahead.
For token issuers
Tokenization has different value propositions for the owners of small-cap and trophy assets.
For owners of small-cap assets
Envision the independent owner of a small-cap asset, say an apartment building valued at $20m in Los Angeles. They have locked up significant capital in this building’s equity.
To recover some of this capital, owners have traditionally opted to sell their property in its entirety.
The alternative is to sell shares in the building while maintaining majority ownership. Though this has always been an option, it involves significant complexity. The owner first has to form a Special Purpose Vehicle (SPV) to hold the asset. Once formed, they have to source buyers and negotiate prices with them. They then sell shares in the SPV via a private placement (ensuring they comply with relevant regulation). The owner, then, has to perform a number of ongoing fiduciary duties, like maintaining the SPV’s cap table and providing disclosures.
Security token platforms simplify this process. They automate compliance, by checking factors like the investors accreditation and jurisdiction on every token transfer. They also help with cap table management and disclosures. Owners can now sell partial equity, and recover cash, with much lower overhead.
For owners of trophy assets
For the owners of trophy assets – say the Plaza Hotel in New York, or Faneuil Hall in Boston – the value proposition is different.
These institutional owners have access to capital markets. They sell large chunks of their holdings to institutional investors, who hold for extended periods. For these infrequent and large transfers, legal hurdles are a comparatively small inefficiency.
The value add for owners of trophy assets could be increased prices due to the liquidity premium.
On a related note, real-estate developers can sell shares in a project. They gain access to permanent capital – allowing investors to trade out without pulling out their funds. The liquidity premium, moreover, effectively lowers their cost of capital.
Having looked into the different types of token issuers, let’s turn our attention to challenges on this side of the marketplace.
Imagine a future world where real-estate assets are routinely tokenized. Many new tokens are issued each month, and many more are listed on secondary exchanges.
How will an investor decide in which to invest?
Compare this with the world of equity investing. A breadth of information is available on each stock – from annual reports, to sites like Yahoo Finance, and forums like the Motley Fool. Analogous infrastructure needs to to be built for security tokens.
Existing platforms, like Skyline.ai, analyze commercial real-estate by pulling in neighborhood crime rates, walk scores, Google Maps footprints, and related property sales. Security token platforms can potentially do even better, by leveraging the token holder’s status as a shareholder of the property. This entitles them to disclosures of underlying financial data (such as occupancy rates and rent income)
The burden of disclosure can, in turn, discourage potential issuers.
Real-estate developers, in particular, see disclosure as problematic. Extra reporting requirements reduce their ability to react to roadblocks during development. Information shared with a changing investor base can also leak to competitors.
Adverse selection has historically affected equity crowdfunding platforms. High-quality startups continue to raise from VCs. Some companies who cannot succeed through the traditional channels, list on sites like Angellist and Republic. This has led to negative perception around these being “platforms of last resort”.
There is a risk that this carries over to security tokens. Asset owners who can source funds from a small LP base of institutional investors, do. The rest resort to issuing tokens. This could lead to a downward spiral. Weak offerings on the platform lose investor money and drive away demand over time.
To counter, security token platforms need to set a high bar and only list high-quality assets. To gain trust, they may also need to put down their own capital as principal.
Now let’s turn to the other side of the real-estate marketplace: investors.
To understand the value of security tokens, one has to distinguish between institutional and retail investors.
The benefits of liquidity are less pronounced for institutional investors (like pension funds, sovereign wealth funds, and insurance companies). These investors operate with extended time horizons; they have long capital lockups and deploy their funds with the expectation of long holding periods.
Institutional investors also tend to be risk-averse. This is sometimes due to their internal organizational structure. Pension fund managers, for instance, usually take a salary (and don’t participate in the upside as they would with a 2/20 fee schedule). They are therefore incentivized to do the safe thing, preferring to invest in a Blackstone private REIT with a track record, rather than a new blockchain-based token.
For these reasons, this class of investors will likely not engage with security tokens in the short-term.
Retail investors, namely high net-worth individuals and family offices, stand to benefit from tokenization.
Individuals primarily invest in real-estate in one of two ways. They either buy an individual property, like a house. While a common option, this requires substantial upfront capital, a long-term commitment, and has high single-asset risk. Or they can buy into a public REIT. These don’t provide granular choice (as they each hold many assets) and have historically had lower returns compared to private REITs.
With tokens, retail investors can buy into individual assets and tune their exposure.
Retail investors are also likely to desire liquidity in the short-term. They might need to deal with emergencies or react to changes.
They can also take better advantage of rules like IRC 1031, which allows deferring of capital gains from the sale of a real-estate asset by buying another like-kind asset with the proceeds. With tokens, the individual can match the size of their new investment with the sale proceeds.
Let’s now look at some challenges on this side of the marketplace.
Again, imagine a future world with many thousands of security tokens issued and trading.
Tokenization enables liquidity, but does not guarantee it. Trading volume for any token will be low due to the small market caps, the limited number of holders at any time (e.g. REITs can have at most 2000 investors due to regulation), and the large number of tokens.
Secondary exchanges need to attract market makers. They may also have to explore exchange designs that do not rely on pairwise order-books (e.g. the Gnosis multi-token batch auction).
Moreover, it is hard to see an individual investors buying into individual assets at scale. Do they do due diligence on small buildings across the country and across different sectors?
As such, adoption will likely depend on the existence of investable indices. These indices can be built as smart contract baskets of security tokens, providing full transparency and simplifying payment flows (as in the Two Token Waterfall).
Driving retail demand
The retail investor base is traditionally accessed through brokerages. Firms like Fidelity and Raymond James act as gatekeepers here and collect commissions.
Following the lead of web companies like Robinhood and Wealthfront, token platforms could use web growth tactics to access this investor base. One should note, however, that real-estate listings are only available to accredited investors, who are usually of an older demographic. The asset class itself may also be less exciting than stocks. Real-estate is a low-return high-yield investment; it is not used to drive large gains, but instead to diversify risk. Lastly, there is competition from companies like Yieldstreet and Peerstreet, who offer a variety of compelling alternative investments to the same investor base.
Fractional real-estate markets are not a blockchain invention. Since the JOBS act passed in 2012, real-estate crowdfunding companies like Cadre, RealtyMogul, and Crowdstreet have used the Reg D 506(c) exemption to sell real-estate shares to accredited investors.
These companies have been generally successful, but have interestingly not had breakout growth. The gating factors for growth are the two sides of the marketplace: acquiring high-quality assets, and driving retail demand. The challenges here are not technological, and will play an equally important role in the adoption of blockchain-based platforms.
Security token platforms need to bootstrap two sides of a marketplace by onboarding high-quality assets and retail investors. To succeed, they need to navigate a set of challenges around data infrastructure, adverse selection, liquidity, and user acquisition.
In the short-term, these platforms will provide similar services to real-estate crowdfunding platforms which came into existence since the JOBS act.
In the long-term, they can unlock liquid global markets and enable an ecosystem of new products. That’s something to look forward to.
We did the research behind this post with Robbie Bent and Myles Farmer. Thanks to Zachary Michaud, Greg Peacock, Ryan Alfred, Doug Fields, Stephen McKeon, Josh Nussbaum, Connor Spelliscy, Jean Sini, Todd Lippiatt, Solly Garber, Tyson Woeste, Shamez Virani, and others for helpful conversations.