Given our background as both real estate and venture capital investors, the topic of real estate tokenization is almost unavoidable. As one of the hottest (and most controversial) trends in PropTech today, we are constantly asked for our thoughts and viewpoints on the space. We conducted a “deep dive” and were excited to meet with talented and ambitious entrepreneurs going after a massive market opportunity.
We were relatively well informed of the potential benefits of tokenization (democratization, liquidity, blockchain efficiencies, etc.), and were pleasantly surprised to learn of the multiple properties that had already been “tokenized.” The promise of a “liquid real estate stock exchange” and the “ease and lower costs of asset transfer” were particularly appealing. For instance, imagine a world in which you can transact in real estate without needing to deal with lawyers, escrow and title. From both a time and savings perspective, this would be an enormous upgrade that would benefit the entire property industry (at the expense of lawyers, escrow and title companies of course).
We had three distinct goals that we wanted to accomplish with this research. Firstly, we are in the business of real estate technology investing. We came in relatively bullish, and eager to find a company that we could place a big bet on. Second, and related to investing, we felt it was important to have an informed opinion of the space that we could share with our own LPs (investors) and the broader PropTech ecosystem. Given the collaborative nature of early stage investing, we wanted to publish our views so that founders and co-investors could reference our thoughts for future potential collaboration. Lastly, we were selfishly intrigued about the potential of tokenizing our own assets. While our VC fund, Corigin Ventures, is completely independent, we have the benefit of leveraging Corigin’s real estate portfolio and operations to help us diligence startups and add value to our portfolio companies.
During this deep dive, we met with eight emerging tokenization startups – all with their own unique models and visions. While we still believe that the potential benefits of tokenization are enormous, our realization was that we are still in very early days.
For those who are not familiar with tokenization, let’s start with a definition. To tokenize real estate is to fractionalize the ownership of real world assets digitally. Since “who owns what” is such an important (and valuable) piece of information, technologies like blockchain are utilized to help prevent mistakes or fraud. The way that information is stored on the blockchain creates an “immutable ledger” that is stored on multiple points, or nodes, in a system. The ledger is double-checked to make sure that every node agrees on the information and reverts to a consensus when any incongruencies exist. This makes these systems very hard (if not impossible) to hack since it would require 51% or more of the nodes to be hacked simultaneously.
From our perspective, the main potential benefits of real estate tokenization are democratization, liquidity and efficiency. To frame the conversation, let’s start with two questions:
Why would an investor allocate funds to a tokenized real estate asset?
First and foremost, investors want exposure to real estate in their portfolio. Historically, investors haven’t had enough capital to purchase an entire building or property. However, by purchasing a fraction of multiple properties, investors gain real estate exposure in a diversified manner. Lastly, tokenization promises the potential of liquidity for their tokens.
Why would a sponsor (developer/general partner) want to tokenize an asset?
The most obvious answer here is the potential for cheaper (and more forgiving) capital vs. traditional lending institutions. Lowering the barrier to entry (by decreasing the minimum investment) can open up a property to a more diverse investor base including those that would not normally consider real estate. The ability to sell minority ownership interests gives the issuer a desirable level of flexibility, allowing them to extract liquidity while simultaneously maintaining control of the asset. This is because fractional owners have less governance than institutional investors who traditionally control major decision rights (e.g. when to sell or refinance). Finally, a system like the blockchain promises lower costs since there will be reduced need for lawyers and less subscription paperwork.
Tokenization Startup Business Models
For confidentiality, we’ve decided not to name the startups that we engaged with. The majority of the companies are starting out by tokenizing single assets and forming a REIT structure. They will then issue shares (tokens) of the REIT (T-REIT), which are backed by a single asset. We made a small investment (personally) in one of the first tokenized projects, the St. Regis Aspen ICO to experience the process first hand.
One of the companies we spoke with took a different approach. Instead of tokenizing real estate assets, they plan to tokenize real estate private equity funds. This has already been done successfully on several occasions with Blockchain focused venture capital funds, most notably SpiCE VC & Blockchain Capital.
While there are a few different business models, the monetization strategies range from a listing fee (charged to the property sponsor), a trading fee (charged to the investors), an asset management fee (charged to property sponsor and/or investor) and some form of data analytics that could potentially be sold back to the industry. We think that if a platform can attract enough users, the asset management fee model seems to have the highest potential for an exchange to generate a lucrative and stable cash flow. Several tokenization startups we spoke with also plan to be a deal sponsor on the platform that they are building, and therefore can also monetize the deals they list by charging investors a promote and/or take a percentage of the rent revenue generated by the asset.
Potential Benefit #1: Democratization
The mission statements of many of the companies we spoke with involved “democratizing the CRE asset class” so that high net worth and retail investors can get exposure in their portfolios. We support this mission and believe that investors historically have been locked out of institutional quality commercial real estate deals due to minimum investment size. However, Real Estate Crowdfunding platforms (see our landscape from April 2018) have been around since 2010. While many of them require you to be an accredited investor, a number have democratized their investments all the way down to a retail level with minimums as low as $100. In addition, many of these platforms offer “managed accounts” allowing investors to receive underlying exposure to multiple deals with a low bite size. We believe that the demand for minority interests is already being absorbed by the real estate crowdfunding space.
From an investor perspective, there is also a downside to this democratization. As mentioned above, a sponsor (developer) will have less governance (and more control) with many small shareholders vs. having a handful of institutional investors. A typical real estate deal will have major rights and decisions that are governed by the “lead investor” (e.g. when to sell or refinance). This is not the case in a tokenized asset where there is not necessarily a lead investor. We can only hope (and hope that investors do their diligence) that an intermediary, the tokenization platform, will negotiate market terms into their operating agreements, to which token holders will be subjected. This is not exactly an arms-length negotiation. Perhaps in the future token holders will be able to vote their rights within a smart contract. However, there is a long way to go before these governance mechanisms will funnel down to the small investor and it’s highly unlikely that a sponsor will relinquish these rights to an unknown democratic (potentially unsophisticated, uninformed) token holder base. Enforcement of those rights with a fractionalized, passive ownership base is yet another hurdle.
Potential Benefit #2: Liquidity
The current state of the real estate market lacks any real liquidity for a minority interest. The tokenization platforms believe that a marketplace solution can provide liquidity by making these interests available to a pool of buyers and sellers similar to a stock exchange. In a marketplace with actual trading volume this would unlock the potential to turn traditional, illiquid real estate investments into more readily tradable assets. In addition, the US equity markets are only active Monday through Friday 9:30 AM – 4:00 PM EST, and subject to closure on US holidays. The goal is for blockchains to enable tokens to trade 24/7 with near instant settlement.
We question whether the tokenization of an asset is necessary in order to create an effective marketplace? Again, we see real estate crowdfunding platforms already making progress in solving this pain point. Several crowdfunding platforms, such as CADRE, have recently launched secondary exchanges. Granted they are acting as a centralized party, but as it stands right now the tokenization platforms are doing the same. The tokenization startups that we spoke with have an “OTC Desk” (it looks like a message board) in which buyers and sellers can post indications of interest and the tokenization platform will facilitate a trade.
“The main potential benefits of real estate tokenization are democratization, liquidity and efficiency.”
So, what will it take to create a truly liquid marketplace for minority real estate interests? Let’s look to other marketplaces first. Minority equity positions in public companies trade freely on stock exchanges. The stock exchanges of the world trade roughly $6.36 trillion worth of equity every month but as you look within these markets there are companies that trade more liquid than others. It is generally thought that stocks with less than $20-25M/day of volume are not institutional in nature and have more pricing and volatility risk. We believe the road to creating a truly liquid marketplace in real estate will require very large transaction volume.
Let’s go one level deeper. While stocks are all traded on a few major exchanges, all the distribution channels have access to these exchanges. Whether you are using TD Ameritrade, ETrade or J.P. Morgan, all broker-dealers can buy and sell stocks for you on the NYSE or Nasdaq. However, that concept is not immediately possible in the real estate tokenization market.
As it stands right now, each tokenization startup bringing deals to market requires the corresponding tokens to trade on that startup’s exchange. The analogy would be if companies taken public by Goldman Sachs could only be bought and sold with a Goldman Sachs account. This is creating a highly fragmented market that makes liquidity even further away.
Lastly, there also needs to be a place to access the financials and other data (i.e. ownership, capital structure, operating history, promote, governance, etc.) to properly value the assets. This information currently lives on the platform where the tokens were originated. However, at some point there will be a need for this information to be standardized and pulled into a “Yahoo Finance” type resource. This is yet another hurdle that needs to be overcome.
To be fair, based on our conversations with tokenization startups, everyone has a similar goal in creating tokens that can be listed and traded on multiple compliant exchanges simultaneously. They cite the benefits of smart contracts and open-source code: new exchanges will have the ability to tweak their trading engines to support programmable shares (i.e. you can trade bitcoin on both centralized exchanges as well as decentralized exchanges – and you can transfer bitcoin from exchange to exchange at a very low cost). We would expect similar dynamics to play out in the real estate tokenization space where the majority of transactions will occur on the most trusted and liquid exchanges.
Potential Solution: Institutional Lubrication
A growth hack for the tokenization platforms to overcome liquidity challenges will be to partner with institutional buyers to lubricate their markets with capital. We believe that those startups focused on generating institutional demand and bringing market makers to the platform have the best chance for success. Soros is an active player in backing both crowdsourcing and tokenization platforms for their deal specific equity requirements. Early adopters of this strategy in the P2P lending space (i.e. Lending Club) as well as the real estate crowdfunding space (CADRE partners with Goldman Sachs) have both recognized that institutional capital is more efficient and can be acquired and deployed in mass. Companies that will win in both spaces will require this type of capital to create liquidity within their marketplaces.
While we remain skeptical of whether tokenization will bring additional liquidity and not just pull from the crowdfunding platforms, the reality is that the space is still in its infancy. Private placement laws state that you cannot market a private placement until 12 months after the transaction occurs. The first tokenization project was done in Q1 2018, and therefore nobody has seen a tokenized real estate asset attempt to “trade freely” on an exchange yet.
Does everyone want more liquid markets – how about sophisticated RE PE Investors?
While most (including us) are in favor of more liquid markets and the ability to buy/sell minority interests, not everyone we spoke with agreed. Do we need or want instant, liquid trading in an asset class that requires more diligence and has benefited from not being a daily mark to market asset? Many sophisticated Real Estate Private Equity investors credit the illiquid nature of real estate to how they generate outsized returns – buying assets at a perceived discount when the seller needs liquidity.
In addition, the power of not having to mark-to-market is real. While this is highly advantageous to the sponsor, it also impacts the psychology of the investor. When your stock portfolio is down 20% you know it’s down 20% to the dollar every minute of every day. When your real estate portfolio is down you may still be getting your current cash return. If a hedge fund is levered and down 20% they could be out of business, but if your real estate is down and you have holding power then history (thus far) says you will be OK. We had the privilege of speaking with Sam Zell at a dinner recently and he echoed this same concept, “The greatest invention in the world is not having to mark to market.” Maybe we should be careful what we ask for…
The blockchain is intended to bring efficiency to the markets in its indisputable ledger of ownership and ease of transfer. This is the only real differentiator we see between Real Estate Tokenization startups & Crowdfunding platforms. Let’s dig in to these efficiencies:
A) Time to Transfer
B) Cost to Transfer
To transfer a minority interest in real estate today (depending on size and complexity) involves a lawyer drafting a share purchase/transfer agreement, getting approval by the sponsor (in most cases), transferring funds and updating the operating agreement. This is not to mention the time and cost of due diligence that needs to occur. The public market equivalent of this happens at the click of a button with a three-day settlement occurring in the background, all at a cost of $9.99 per trade to the purchaser. Imagine if a lawyer needed to draft a separate agreement and escrow your capital every time you bought shares in a public company.
The tokenization of real estate is supposed to provide inexpensive, regulatory-compliant, near-instantaneous transfers and settlement of real estate interests on a blockchain’s transparent ledger. While this sounds like a massive improvement to the current environment, the reality of RE Tokenization (today) is that most of the real asset transfer steps still need to be followed:
The token may transfer but the smart contract will have to pause at the sponsor for approval.
An update to a paper operating agreement still needs to occur.
An administrative (centralized) party still needs to keep track of the paper ledger (the operating agreement cap table).
The hope is that the model will evolve to allow these cap table ledgers to only be digital and that all parties will accept this new norm. However, we don’t see a bank providing a loan based on a tokenized cap table anytime soon. So, while the vision of instant clearing and lower transfer costs are nice, we’re not sure that the time and cost of the pain point that this is solving for is worth solving…until there is massive transaction volume. Logically this transaction volume can be created in the crowdfunding markets before the time and capital should be invested to harvest these efficiencies. Having said that the blockchain is a great mechanism to solve it with.
Security and transparency
We agree with the assumption that blockchain is an excellent tool to enhance both the security (in terms of ownership) as well as the transparency of a real estate asset. We think that the more transparent sponsors are regarding their asset’s financials, lease agreements, building history, etc. the better chance of achieving more liquid markets.
The advantages blockchain can bring are as follows:
Ensure regulatory compliance for shares (or tokens) by systemizing KYC/AML verification.
Provision access based on investor identification and accreditation (i.e. investors can only view/purchase assets for which they are eligible).
Facilitate customizable share structure and encoded compliance.
Trading restrictions and provisions can be codified in smart contract on chain.
Restrictions based on jurisdiction or asset type can be included in smart contracts.
Improve cap table management.
The biggest hurdle that we see as it relates to blockchain technology is the decentralization piece. In order to achieve the added benefits of security and transparency, decentralization is key. However, in its current state the real estate tokenization market is simply shifting the centralized party from the lawyer to the tokenization startup.
No One Likes to be Early to a Party
From an investment standpoint, we concluded that the space is too early and that the pain points being solved for are not moving the needle in a substantial way. Specifically, we believe that the investment in blockchain technology to go from marketplace to tokenization is not worth the dollars invested today. While we are anticipating the tokenization space in its fully actualized self to be a major upgrade to real estate crowdfunding – our view is that blockchain efficiencies won’t be fully actualized until we have a massive, liquid, highly transactional market of real estate interests. While we believe that this transformation will ultimately take place, we think it is likely decades (two cycles) away at scale.
Further, the value of real estate on blockchain will only be realized when the entire property lifecycle (land title and deed recording, property sale and title assignment, tokenized property ownership, investor / tenant identity verification, payment/leasing booking, and real-time accounting) is on chain. While a number of startups are building individual solutions across the lifecycle, the industry remains in a period of infrastructure building and generally lacks a suite of fully integrated tools. Further, the amount of teams that possess the resources, ability and technology team to execute upon this are scarce.
We went into our research well aware (and maybe even enamored by) the dream of tokenization. Being able to effortlessly buy and sell small amounts of a property would eliminate a ton of friction in the real estate industry and likely open the flood gates of new investment capital. But even with that dream in mind we did not see a clear path forward. The power of tokenization is undeniable but as investors, timing is everything. We welcome a world in which property tokenization is commonplace but we don’t see a time horizon that makes us want to jump into the fray ourselves.
In addition to the Tokenization startups, we spoke with many industry professionals and experts. A few shout-outs of people include David Gogel (Techstars, Blockchain Accelerator) &Derek Schloss (Director, Security Token Academy).
Disclaimer: This newsletter contains information about Real Estate Tokenization. The information is not advice and should not be treated as such. Without prejudice to the generality of the foregoing, we do not represent, warrant, undertake or guarantee that the information in the newsletter is correct, accurate, complete or non-misleading.