If real estate tokenization were to become popular, several innovations become conceivable, including structured finance, hybrid real estate tokens and digital fund exchanges.
Where and how
Inevitably, due to the possible opportunity, the media headlines regarding real estate tokenization focus on the potential for digital fractionalization of single assets. For a variety of reasons, this focus is likely to be misdirected. Experts are more confident of the prospects for the tokenization of debt, and (especially) funds. But there may also be more creative possibilities.
Someone guess that with tokenization technology, one could create leveraged longs and leveraged shorts. And all this concept is possible with real estate. Yes, there will be some gambling going on, but what’s interesting is that if someone is a property developer and he just puts a huge amount of capital into Manhattan, he could effectively hedge his position very cheaply and efficiently”. Another opinion is that the real estate market will change significantly over the coming years, with change being driven primarily by digital technologies, such as blockchain, AI, and the Internet of Things (IOT) that will transform the lifecycle of a real estate asset. This opinion envisages new ways of financing real estate as an alternative to traditional investment models. Over the past years, we have seen digital technologies transform many industries. Real estate has been relatively unaffected until recently. With the ability, we now have to implement digital technologies, such as IOT, Big Data and AI cheaply and in scale, Proptech has emerged as a new market possibility that will bring significant change. Any property, whether commercial or residential, can now become ‘live’ with the ability to collect data that can be used in many ways, not least to measure and track every aspect of any asset and its tradable value. The data that can be produced from an asset includes:
These and many other factors will transform into valuations, and how real estate will be used, via tokenization. As real estate tokenization achieves scale, decentralized structured finance and structured products coordinated in smart contracts will become prevalent.
If summarize the benefits of real estate tokenization we can include structures products. Information, payments, and requests for votes could be transmitted to all token holders simultaneously through their blockchain address. Investors would be able to achieve greater diversification and customizability simply by purchasing property-specific tokens. Issuers could create different tokens for different assets pertaining to real estate investing (ownership of the land, use rights, infrastructure, cash flows from leases, etc). The issuer could also create different classes within each type of token; for example, tokens on fixed lease payments and tokens for the variable component of commercial leases. The waterfall of payments can be hard-coded into the smart contracts, providing both a layer of transparency at creation and compliance and verification upon each payment.
Another brand new hype around real estate tokenization is single asset exchanges (IPSX). This instrument appears to be an initiative designed to achieve a conventional, non-tokenized market for shares in single assets. It has an advantage over tokenization because there have already been considerable sunk costs in a creative yet familiar and regulated solution without the need to jump into the unknown blockchain world. However, other objections (especially a lack of evidenced demand plus pricing uncertainties) remain. The opportunity remains to pivot this proposition into a financing tool for owners, for example by selling income strips, and hence a means of developing structured finance products. It would also make sense to develop this instrument further into the tokenization world – to develop tokenized securities (digital tokens representing IPSX shares in IPSX-listed single-asset property companies), subject as always to evidence of demand for fractionalized single real estate assets, or (better) portfolios of single assets and funds.
Also we have keep in mind the Digital Fund Exchanges as the opportunity to create a scalable next generation B2B real estate investment platform with greater liquidity and transaction efficiency. Digital Fund Exchange’s objective is to make less liquid asset class funds like real estate and alternative assets more accessible to investors through lower cost structures with increased fund unit liquidity, made possible in part by using digital ledger technology as the main fund register. Professionals are looking to enable evolution in existing industry fund structures into digital traded funds. This ecosystem will bring together investment managers and investors for new digital fund issuance, and developing both primary and secondary markets in a fund industry network linked by private distributed ledger technology. The application of transparent and fair price matching auction algorithms offers a new approach to fund unit liquidity leveraging existing investor networks without the need for market makers. Experts envisage a wide range of opportunities for digital traded funds to hold less liquid alternative investments. In real estate digital funds could cover UK/EU/US/Asia open ended real estate funds; unlisted REITs; loans and real estate debt funds; and real estate private equity vehicles. Proposed benefits from digital traded funds for managers and investors include near real time settlement, near instant re-allocation across instruments with different risk factors, anonymity preserved, improved liquidity, a near real time audit trail of activity to approved parties, and significant operational and investor reporting cost savings.
Some experts have expressed skepticism regarding the potential for the digital fractionalization of single assets. For a variety of reasons, there is a risk that a focus on this application will result in a misallocation of resources and negative publicity for tokenization. Open opinion is that the market is more confident of the prospects for the tokenization of debt, and (especially) funds. But there may also be more creative possibilities. The hybrid token, a combination of security and utility, has some promising applications in case as well. In the residential space, fractional investment has some momentum, offering semi utility, semi security tokens as the way prospective shared ownership schemes might develop. Also, community facilities – including hotels, pubs, bars, restaurants, coffee shops – have raised capital through prototype hybrid tokens. Hotel Chocolat, for example, raised capital by offering dividends paid in chocolate. Just like maybe funny example, but very evident. There is a growing body of opinion lining up behind the disruption effect of real estate tokenization and the innovation opportunities that will follow. What tokenization formats will be most popular? In fast future we hope to get the answers.
Tokenization is at an early stage of its development, and real estate applications will take time to develop and become accepted, it is obvious. In order to judge the likely future for real estate tokenization, we need to balance the advantages created and the likely effective demand created with the costs incurred. The truth is in economics. What advantages will in practice be delivered to market participants? Will this value outweigh the costs? There is a clear danger that innovation will be set back by years and possibly decades if attention is focused solely on the digital fractionalization of single assets, for which the demand is limited, the economics unconvincing and the obstacles significant.
What does tokenization bring?
What advantages will in practice be delivered to market participants? How highly are they likely to value these advantages? Will this value outweigh the costs? What capital investment is required to establish an efficient tokenization platform? What will be the running and transaction costs compared to conventional fractionalization? What demand will there be for the product, and will there be enough transactional velocity to amortize the development costs? All these questions still have no exact answers, but the direction to move forward is clear. Maybe in the ideal world tokenization would perhaps avoid regulations; avoid tax (especially stamp duty land tax in the UK); reduce fees, achieve disintermediation; speed up transactions; avoid public information being made available; exploit the efficiencies of blockchain; and enable crypto currency trades. It is clear from expert’s opinion that only three of these gains (speed, privacy, blockchain) have a realistic chance of being introduced via tokenization. The economic benefits of tokenization will depend greatly on the application being developed. The key mismatch between the popular conception of real estate tokenization and a realistic vision of the near future is the often-painted picture of a single property asset being tokenized for the retail investor, when this is very unlikely to gather significant momentum. We would go further and point out the danger of investing too much into single asset tokenization, which appears to be the largest market opportunity, but also the most challenging. It is better to invest in blockchain-supported solutions to economically advantageous innovations with a proven demand than to risk undermining the appeal of the technology by mis-applying it. Whatever opinion the market players develop from the evidence presented, it is clear that the market for real estate tokenization is in its initial ways. There are many committed followers and several examples showing the potential of the technology. To grow faster, the market needs broader adoption and understanding of the benefits and challenges of these new products, and the continued monitoring and reporting of new developments.
Table. Possible evident profits of real estate tokenization
Security tokens to help real estate tokenization
Security tokens for single assets are not to be successful in sufficient scale in the near future. Barring IPSX taking off in 2020, the history of attempts to create single asset fractionalization has been negative, with limited evidence of demand. The real problem (with SPOTs, PINCS and SAPCos) was the lack of a market for this type of security. Only investors who understood property and its foibles were interested and, for them, direct ownership was the natural preference. Traditional equity investors taking a punt on real estate stuck to the big public property companies with their track records of good management. Some obvious facts for and against tokenization of single assets for the retail investor (according to MIT Digital Currency Initiative, 2019):
We would add another couple of negatives. First, the risk of a single asset under-performing when, as is pointed out above, retail investors typically lack the skills to properly value real estate investments suggests that investors should be better served by investing in diversified REITs or funds managed by professional fund managers.
Second, the asset will either need to be tokenized in a jurisdiction which allows for many owners, and complex control and management issues will then need to be agreed and eventually standardized; or it will be necessary to set up an expensive intermediate ownership structure (a company, partnership or trust, for which control and management issues are standardized and understood).
The distinction between primary and secondary markets is also important. Most of the development costs for tokenization will be front loaded and borne by the primary market, yet many of the advantages are likely to be delivered through secondary market liquidity – unless owners can expect to see a liquidity premium baked into primary market pricing.
Utility or hybrid tokens in real estate proptech
Utility tokens have good prospects of widespread short-term adoption. The likely effective demand for an efficient token-based system recording and charging for the use of space, the use of energy and the use of consumables such as food and drink is guaranteed to be high. This is a natural extension of pre-paid credit cards that act as intelligent building passes, and of the Hub model for flexible space use. The cost is unlikely to be high, and the development costs incurred will be spread over a very large number of transactions. In addition, hybrid tokens offering a combination of a utility (the use of space) and a return (income and/or capital) have a promising future. Examples include fractionalized private residential, where rent/buy hybrid structures are partially financed through hybrid tokens, and community facilities.
Debt securitisation and tranching
Debt markets are an area of great focus in the security tokenization space, including debt markets for commercial real estate. Blockchain-based smart contracts could standardize data formats and dramatically lower the administration costs of servicing debt. This will lead to more readily accessible information being made available for real estate asset-backed securities valuations. This is an area of significant promise.
This should be an easy win for tokenization. The intermediate legal structures have already been created and are well understood. This is already a fractionalized market, with a long record of demand for both primary issuance and secondary trading. Funds are already likely to be regulated, as any security token would have to be. The costs of traditional primary capital raising are very high, and tokenization is a way to produce cost savings at a time when manager fees are a high proportion of investor returns. More attention needs to be paid to this clear opportunity; if demand for this product is proven, the market for the tokenization of large single assets might then follow.
Instead of summary
The challenge for proponents of the tokenization of single assets is that two radical developments have to be simultaneously accepted. First, there needs to be an expressed demand for the fractionalization of single real estate assets. Evidence of this is at best sketchy, both through history and in the current period. Second, market participants need to be comfortable with blockchain, the digital underpinning of tokenization. Connected to this is the cost of fractionalization and the cost of tokenization. In many land markets, fractionalization requires an intermediate structure to be established because the direct ownership of land cannot be split into many pieces. Even where this is not the case, agreement needs to be reached regarding the control of fractionalized assets. For certainty and risk control, not to mention regulatory compliance, it makes sense to reproduce existing structures which have been proven to govern fractionalized investments. Globally, these appear to be limited companies or LLCs, partnerships, trusts or dedicated contractual systems.
We can suggest how debt contracts could also be suitable for tokenization. The contractual structures controlling debt investments are reasonably standardized by banks and others, and different structures have evidenced an expressed demand for the fractionalization of these assets (if only as a stepping stone to the creation of diversified pools).
It is quite possible that larger assets (The Empire State Building and others), which are already held in fund structures, will be tokenized successfully; there may also be an alternative market for social impact or community assets where investment regulation and risk/return are not the main drivers of behavior. In conclusion, tokenization offers exciting possibilities for the real estate investment market. It is, however, at an early stage of its development, and real estate applications will take time to develop and become accepted.
There is a clear danger that innovation will be set back be set back by years and possibly decades if attention is focused solely on the digital fractionalization of single assets, for which the demand is limited, the economics unconvincing and the obstacles significant. Funds and debt offer immediate opportunities to establish the credibility of tokenized real estate applications; utility tokens for building users and hybrid tokens for residential co-ownership and community assets may well follow; and, in time, there may be some successful trophy asset tokenization. The mass market for the fractionalization of single commercial real estate assets, however, may be a long way down the road.
Sergey Golubev (Сергей Голубев)