Tokenization – Will it survive the Real Estate Cycle?

Apr 29, 2018 Articles Tokenization – Will it survive the Real Estate Cycle?

Tokenization of real estate assets is a fundamental reform of indirect property investment[1]. The current model of indirect real estate investment (public or private real estate funds) relies on many rather expensive agents to function: asset and portfolio managers shave off a good chunk of the yield as part of their compensation, costly market infrastructure is needed to issue and transact shares while property appraisals are opaque and at best happen at monthly frequency. The daily market price of a real estate fund is thus linked to unobserved monthly valuations and is moved about by market volatility. All these features are well explained by the very nature of real estate assets: large and heterogeneous, rarely transacted in highly informationally inefficient markets with dual function, acting both as investment and long-term consumption good. On top comes another layer of complexity, the objectives of portfolio allocation and management.

How can tokenization solve this? A cryptographic token, representing partial ownership of one or more properties, may be issued on any of the existing public blockchains at costs several orders of magnitude smaller than shares, their traditional counterparties. These tokens may be managed in a far more transparent way as well with total issuance and token transaction easily tracked by anyone. Rental income from properties can be appended to smart contracts which automatically pay them to the token holder in proportion to their investment as long as they hold the token. When the crypto token represents a claim to cash flows of a broad portfolio, a potential investor obtains so the benefits of portfolio diversification at a very low cost. Currently, only wealthy investors can afford to put together a well-diversified portfolio. Math says one needs about 50 different assets of similar size to cancel out the asset-specific risks. How many potential investors can buy and hold 50 different pieces of property?

By reducing issuance and management costs, tokenization opens the possibility to invest to a much larger base of investors than before. Investments as low as 100 Euros can now be placed in a properly composed portfolio. The market for 100 to 1000 Euros property investment may well be several times larger than the current market with minimum size contributions in the tens of thousands. Nevertheless, a rather large portfolio is still needed to achieve the diversification benefit. Otherwise, when the token is linked to the performance of one building only, all the inherent building risks will be added to market risks. This is one of the current challenges of the property tokenization model, where ICOs raise money to fund the acquisition of a few assets only.

Nevertheless, once the new model gains acceptance and access to funds, it will allow small-scale investors to gain access to the same level of diversification as any large investor, something which until now was simply not cost efficient. But this will only remove the impact of asset-specific risks (risks related to one particular property not affecting any other property in the portfolio). Broad market risks, also known as beta risks, will still lurk inside the portfolio ready to impact all properties at the same time. Spells of unemployment depress sales of most retailers (boosting only revenues of those selling low priced items) and so shrink sales, a financial crisis restricts access to credit for most firms driving them in default and subsequently increasing vacant space and decreasing rents. These types of risks are risks for which one expects a premium. A smart choice of different property sector exposure (retails, office, residential) at different periods in the cycle in a global market may deliver better risk-adjusted returns than a purely national invested portfolio. This is because country-specific risks are not perfectly correlated. Whereas some countries may witness prolonged unemployment episodes, some others may be in a cyclical upswing.

Blockchains are essential components in the new model as the technology is developed to minimize the trust needed among transacting parties. This is achieved through commitment to a transparent set of rules which govern the essential aspects of the business relationship, from contract formation to payment details. Blockchains using legal smart contracts decrease the cost of property acquisition and make the due-diligence process faster. Smart buildings fit with a host of sensors broadcasting data to the blockchain on space usage or heating and electricity costs may so become the primary acquisition targets of blockchain-powered real estate funds (tokenized or traditional). A potential investor can get access to the package of space usage data and rent data and decide if valuations are stretched or not, maybe even without having to pay much for the property-specific data. All in real time. This is a different universe from the private data silos charging substantial fees witnessed today.

Tokenization is a great way to democratize access to property investment by dramatically lowering costs. But breaking a large rock in smaller pieces won’t turn them into gold nuggets. A well-diversified portfolio is still needed. Macro risks are still present and will drive cash-flows in the same direction across several properties (with impact even more dramatic when prices also correlate).

One potential avenue improving further the tokenization model may be the use of tokenized real estate derivatives, where each property token will be hedged by a derivative token. This may be achieved either at the asset/portfolio level where a traditional property derivatives market is already functioning. It may also happen at the token level, but here a different hedging model still needs to be developed, with new pricing and hedging techniques. The same benefits that support tokenization in the first place may spur the development of tokenized derivatives. Investors can decide whether they want to hold the risk inherent in the real estate token or get rid of it by also holding an additional derivatives token – for investment levels of 100 Euros. Entirely new forms of investment products are possible thanks to blockchains.

[1] Investment in property not managed by the owner

Posted on Apr 29, 2018 by

Mihnea Constantinescu

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