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No, Tokenizing Real Estate Won’t Make It Less Stable

Real Estate - Commercial property

As we have seen over the last several weeks, nothing makes the global market plummet like a pandemic. It is clear that fear, panic, and hysteria exacerbate the natural economic slowdown following shutdowns and the inability of businesses to operate regularly. While this is bad news for the majority of businesses and many investors who got into the game when things were going well, it is good for anyone looking to jump into the market and make money, provided they have liquid assets to invest.

The current pandemic, or any global crisis that creates a disruption on this level, highlights the need for increased market liquidity, specifically now, when borrowers are already over-leveraged. The decade between the two economic crises, the subprime recession and the pandemic turmoil, saw unprecedented levels of borrowing from the global corporate sector due to the extremely low interest rates. Global debt on non-financial corporations by the end of 2018 was 93 percent of the global gross domestic product (GDP), according to S&P. In the post-pandemic reality, it is likely that companies will have to consider alternative liquidity providers beyond their traditional lenders. 

Here’s where tokenization can come in handy. Tokenization is a recent trend that became possible because of greater adoption of blockchain technology. The process of tokenization is a combination of securitization and digitization. It first breaks an asset into many smaller and less expensive parts while issuing a security in compliance with the guidelines put forth by an appropriate financial regulator, such as the SEC in the United States. Second, instead of issuing paper securities, these financial products are issued using a blockchain ledger, a secure and immutable database which ties the owner of the security to an asset digitally and also allows the owner of these private assets to trade these securities in a compliant way, peer to peer, as they would trade stocks for public companies. That’s why the output of tokenization is called a security token or a digital security, because these financial products are secured by the underlying asset.

The purpose of tokenization is to lower barriers to investment and open new funding opportunities for asset owners. In theory, almost any asset could be tokenized: artwork, jewelry, gold, etc., but the greatest potential of security tokens lies in real estate investment. Real estate investing presents major challenges to investors which include high investment thresholds, low access to great deals, and inability to liquidate investments quickly. In other words, when investors anticipate higher need for liquidity, they choose more liquid assets. Plus, real estate is one of the largest global industries with real estate assets consistently in demand despite varying economic conditions. Yet, a very low percentage of real estate assets are liquid, which creates an incredible potential for tokenization, which offers a host of advantages to the real estate market beyond a potential for increased liquidity, such as reduced costs, improved efficiency, and lower barriers of entry to invest.

Tokenizing a real estate asset can offer businesses an opportunity to gain the liquidity they need. And in general, the more liquid an asset is, the more accurate its price will be and the more likely they are to find investors or lenders at a time of need. 

Tokenization will also provide a host of advantages to the investors because they will hold a completely new asset class that can be their key to the world of decentralized finance. Tokenized assets can be collateralized for instant and digital loan processes, they can be moved between various indexes and portfolios, and they can be restructured for maximum tax benefits. 

Real estate has always been viewed as a life raft that can provide an essential element of stability during times of economic downturn. And that is true whether investing in real estate via conventional methods or through tokenization with its promise of increased liquidity.

That is a pretty audacious claim, since tokenization is much less tested over the long run. So I will go ahead and address the elephant in the room: Isn’t it possible that real estate returns are so stable precisely because real estate assets are not as liquid as stocks? Maybe their stability comes from the fact that they cannot be sold off quickly during times of mass hysteria. And if that is the case, isn’t it also possible that tokenization could reduce mass hysteria and eradicate the stability of returns from real estate?

While simulation models need to be built to provide more concrete proof that tokenization will not prompt a mass sell-off of real estate in times of crisis, my assessment is that property, as an asset class, is inherently different from equity in a few important ways that make it better able to weather a financial crisis. These include the fact that the demand for real estate increases as long as population grows, the fact that no matter how badly a business housed in a property is hurt by an economic crisis, at least some value of the underlying property will hold on account of the land and built structures, and lastly, the ability to “freeze” property projects and wait for the storm to pass, a privilege that businesses in many other industries do not have.

Because the premise of tokenization is to make property more liquid, like stocks, could it potentially increase the price volatility in the real estate industry? Precisely because of all the inherent properties of real estate explored above, the value of property-backed tokens is more likely to remain stable during crisis conditions.

Another important factor in the lack of extreme price volatility in the property market is the fact that when markets plummet and someone needs to sell their property, they will still have an idea of its value. While company values are highly subjective, property valuation has a very specific globally recognized methodology.

Over the past forty years, the worst fluctuation in REITs was in 2008 during the great recession. But even that fluctuation only rose to thirty percent. Based on historical data, property prices will typically fluctuate five to ten percent during economically stable times, and twenty to thirty percent during crises. REITs can be a good proxy for a prediction that we will not see the kind of huge reduction in asset prices that we have experienced in stocks when a tradable private property securities market develops further.

The final reason why we will not see huge runs in the real estate industry is the fundamental difference between real estate investors and stock investors. Property investors are not day traders. This is the primary reason tokenization will not destabilize real estate or turn it into a property-based version of the stock market with the same inherent highs and lows.

Yes, tokenization will create liquidity in the market, letting owners raise capital more efficiently and allowing investors to enter a project at any time throughout the development cycle based on their risk appetite. However, property investors understand the nature of real estate—this is an asset class that provides limited yet stable returns. Property investors are choosing to invest in this asset class because they are interested in diversifying and minimizing risk in their portfolios. This means they are less likely to sell off property-based securities in the event of mass market hysteria, partly because they do not want to lose their savings and also because they will do so only when they truly need the funds.

It turns out that asset returns are not tied to GDP. If anything, asset return growth rate is negatively correlated with economic growth. Over time, returns on varied asset classes tend to grow on average around double the speed of the country’s economy as a whole—measured by GDP.

On average, combined assets like stocks and bonds perform several times better than GDP growth. This is positive for investors who can grow their wealth and negative for those who work for a living, as their wages will not keep up with rising inflation and property prices. The wages are tied to the real economic growth, while income from investment is tied to a variety of factors impacting the rate of return including the expectation of growth. Moreover, most tax systems favor investors over employees.

Traditionally, the more diversified your portfolio is, the better your chances of surviving the downturn. Tokenization, by enabling fractional investment and lowering the threshold to invest in AAA projects and landmarks, means almost any investor can own a diversified portfolio of property assets, even if they have just a few hundred (or dozens) of dollars to invest.

Hedging, or “de-risking,” is done through diversifying. If you diversify your capital strategy, you are likely to stay afloat. Diversifying involves increasing exposure to investors you may not have considered before, possibly lowering your thresholds, increasing transparency, making it easy to invest, and providing new and creative marketing avenues.

As an asset owner, tokenization offers a very appealing way to survive a crisis.  Just like shares in a public company, which are initially purchased for a set price during the initial public offering (IPO), security tokens may later increase in value thanks to secondary market trading. However, while IPOs are slow and expensive, a security token offering (STO) can accomplish the same thing more easily and quickly, at a fraction of the cost. And as banks and other lenders are scrambling for liquidity, it’s time to open up the property market for other types of investors. Property owners with the ability to reshuffle the capital stack will be able to stay solvent, prevent bankruptcy, sell the underlying assets when it’s advantageous to do so, and as a result, provide better returns to investors.  

More importantly, tokenization opens up the possibility for investors to sell their stakes when they need liquidity. It invites people worldwide to get involved with your project, and gives you better odds of surviving the next global financial crisis.

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