Tokenization of Real Estate -- Game Changer and the Future of Investing!
Updated: May 25, 2022
It is 2022 and I feel like the future is building rapidly out in front of us. It seems like a video game—maybe guitar hero, or something like that where you see the notes that are coming down the screen and your goal is to play the right notes when the time arrives. That is how I feel about the future of real estate as we know it. I feel like I can see the future laid out in front of us. It looks a lot different than it does today—and yet, it is recognizably similar. I am trying to figure out how to play the notes I see out in front of me as we go! Many are much farther along in their understanding of what is to come, than I am, so if you are one of those people, please reach out. I want to know what you know.
Disclaimer—I am not an expert on ANY of this, but I am learning as I go and I find it to be fascinating and I believe the applications for the technology sometimes referred to as Web 3.0 is limitless and a bit overwhelming. I will try to break it down as simply as I can and I hope that you will find this information intriguing and do your own research and find your own lane going forward to tap into what I think is going to be the next tech revolution that will affect every aspect of our lives.
The biggest change that I see on the horizon is what the idea of tokenizing assets will do for (or to) our industry. Right now, investors around the world are working on the first few investment offerings of tokenized real estate. What does that mean? An N.F.T. or Non-Fungible Token, is a digital representation of a fraction of a real-life asset. Investors or syndicators of real estate deals can elect to “tokenize” their real estate assets in endless configurations, but the basic result is that the ownership rights of the asset (all or part of the bundle of rights), or even an equity position in the entity that owns the assets, are broken up into smaller pieces, called “tokens”, and sold to investors on an exchange similar to the common stock exchanges. As an example, a 40,000 square foot retail building that has several tenants and is worth $10,000,000 might be divided into 100,000 tokens worth $100 each or it could be divided into 10,000 tokens worth $1,000 each. You might even decide to divide into 40,000 tokens (one per square foot) and sell those for $250 each.
Those tokens that are created, along with their ownership are tracked on a framework known as block-chain. You might be familiar with the term block chain in reference to crypto-currencies like Bitcoin or Etherium. I am no expert in crypto or block chain, but breaking it down to its simplest explanation I can, Block-chain is basically a series of computers or servers around the world that are all storing identical bits of data related to the tokens. So, there might be 100’s of those computers/servers, which are called “nodes” that are issued a record regarding the creation of the token and who owns it along with other data and smart contracts associated with that token. The same record is stored on each node and is continually being verified against the records for that same token on the other nodes. In order for someone to change the data on one node, they would have to be able to access a majority of the nodes in the block chain infrastructure network and simultaneously change the records on all of those nodes at exactly the same time. That is what makes block-chain such a useful real-world technology—the historical records stored within the block-chain framework are “immutable”, or in other words unchangeable.
What this does, is it allows a wider pool of investors to immediately be able to invest in commercial real estate, which is an asset class that until now, has be reserved for the wealthiest investors. Once the tokens are created, the marketplaces already exist and more are popping up around us as we speak to allow trading of these tokens. The fact that fractional ownership of a real world asset can be bought and sold effortlessly via these exchanges, will undoubtedly throw a wrench in the historically slow and cumbersome real estate purchase and sale process making it almost instant. That liquidity that is created by allowing buyers and sellers to move in and out of an investment rapidly changes real estate’s largest deterrent for many. Many don’t invest in real estate because it is illiquid compared to stocks and bonds and other types of investments. This, historically, has created what some refer to as the liquidity tax, meaning that real estate prices have been somewhat lower than they might be if it was a more liquid asset. By overcoming the illiquidity challenge, we therefore overcome the “liquidity tax” on real estate, prices should, in theory, go up in comparison to other investment vehicles. As the capital required to get into an investment in commercial real estate is reduced from the traditional 20% minimum down payment, to theoretically, pennies, investors may choose to hold their checking or savings account balances in real estate tokens in the future, rather than an interest bearing account or money market account—selling off enough tokens to fund purchases and living expenses as needed. This type of investment, once placed on an exchange, can become international as well. The potential implications of opening up real estate investment in the United States to virtually anyone with an internet connection and a crypto wallet, could result in massive appreciation for those who are in early. Once the early adoption wave subsides, those increases may subside with it.
Syndicators. REITS, and even Tenants In Common ownership structures have been offering fractional ownership in real estate assets for decades. The vehicle and the strategy selling fractional ownership interests in an asset is not a new one. Tokenization of real estate is simply applying cutting edge technology to these already prominent investments making it more accessible, streamlined, reliable, and removing barriers to entry currently in place. Many syndications require minimum investments of $50,000 or more. Many require that you be an accredited investor. There are still many Securities and Exchange Commission (SEC) rules and guidelines that are going to have to be followed.
Tokenization and the use of exchanges and trading platforms will allow syndicators to access more capital, cut down due diligence timelines, do more deals, and potentially earn higher profits. I foresee that many experienced syndicators may begin to tokenize existing assets that they already own as well. In doing so, they would allow the investors who have been on the journey with them since the asset was purchased to access the equity they may have gained a little at a time, by selling off a few of their tokens, or all at once if they desire to liquidate and move to another deal or use the funds for something different. You, as the syndicator, would not have to sell or even refinance the asset, hypothetically in order to allow the partners to move in and out of the deals.
By placing a portfolio of syndicated properties on an exchange and tokenizing the portfolio, it is possible to further mitigate investor risk, and sub-market volatility. If the syndicated property has debt in place, the lender would need to approve the tokenization. Or, a separate token could be issued and sold to replace the debt on the property with more capital from investors via the exchange (see the section below regarding “DeFi” or Decentralized Finance). There is a whole other chapter to be written on the subject of “smart contracts” and how utilizing them can streamline the management and operational burdens of syndicators going forward. By having these predetermined outcomes programmed into the block chain history of the tokens, an action or trigger, such as a set dollar amount accumulating in the operating account, might trigger an automatic disposition of funds to the partners. How does the syndicator know who to pay with all the ownership changes happening on the exchanges? Through the block chain. The distributions follow the historical trail of ownership using these smart contracts and the money magically ends up in the pocket of the owner (much like a dividend does on a traditional stock). This removes the administrative burden from the syndicator and handles most of the operational decisions for the asset automatically through the smart contracts using what are similar to “IF statements” you may be familiar with from software such as Microsoft Excel. This again is going to allow syndicators to do more deals and have more bandwidth. There is even a platform that has been developed that allows smart contracts to put things to a vote of the members if needed and it will do it all automatically, electronically and in real time giving investors more of an active say in what happens in the operation or disposition of an asset. Syndicators seem to have the potential for the biggest benefits of this technology in my mind.
Title Companies/Real Estate Agents
For every winner, is there a loser? Maybe. Title companies and real estate agents seem to be the sectors poised to miss the boat if they don’t shift quickly. The block chain technology applied to land-title and chain of title, could be the low hanging fruit here. An initial upload of all historical chain of title documents could be uploaded to the block chain for each token as a starting point, and then it would never have to be pulled for that token again and it can be insured and instantly transferred. The new ownership data will automatically populate in the chain of title stored on the block chain and be forever listed and tracked. The cost associated with insuring title, would be significantly reduced, if not eliminated. Real estate agents may also face a similar realization that their role in transactions may become irrelevant once the majority of assets become tokenized and available on an exchange. As a real estate agent, I think it is critical that we start to think through ways that we can capitalize on this coming shift. We can’t bury our heads in the sand and just keep doing things the same way. We have to get out in front of this change and find ways to help our clients navigate the transition.
Lenders/Decentralized Finance “Defi”
Acquisition loans and refinances of tokenized property will likely have to seek full funding from investors and not acquire a loan, or lenders may catch on and start to “syndicate” the loans to investors through tokenizing the debt vehicles. Lenders could sell shares/tokens of the loan with a set interest amount allowing investors to park their funds with defined returns. The term, decentralized finance, means peer-to-peer financial services on a block chain framework such as Etherium’s block chain. How that piece will fit into this tokenization process and ever evolving landscape, I can’t say, but the infrastructure already exists and there are crypto currency investors that are earning income on their crypto currency holdings by lending money to other users. I am admittedly, not smart enough to really grasp how all of the pieces will come together here.
Token exchanges seem to be the most obvious place to focus attention for those trying to find a way to capitalize this emerging tech. Charging trade fees or membership fees or some transactional charge, whether percentage, or fixed dollar amount, seems to be the simplest way to envision monetizing the idea of tokenization.
How to make money
I can’t say that I really have the answer to the question, “so how do I make money with this knowledge?” Create an exchange, tokenize an asset and sell all or part of the tokens, invest in tokenized real estate, who knows how many ways there are to make money in this ever-evolving Web3.0 universe. One step beyond creating an exchange platform, would be building a business around helping others set up the infrastructure and tech needed to roll out the tokenization process. Want to be ahead of the game? Ask yourself, “what am I doing now in my business that might benefit from tokenization, block chain or smart contracts?” Identify those things. Then determine what it would take to be one of the first in your industry to do that. Do it. Cash checks!
Challenges: Taxation and legal treatment geographically
Tokenization is fairly new. The first time I heard the term was in 2021. I am sure that means it has been around for several years before it came to my realm. Regardless, it’s entry to the vernacular is fairly recent and therefore, we don’t really know how the IRS is going to treat it. We can imagine it will fall under the definition of a security, but there are those that argue it is not a security, so it may be a while before that is settled. How will capital gains be treated? Will 1031 exchanges be allowed?
Another challenge is what jurisdiction it will fall under. With real estate, we can usually assume that we can’t get away from the fact that the actual physical asset is located in a specific location on a specific parcel, in a specific state, county, city, etc. and that those rules and laws will likely come into play. But what about where the investor and holder of the asset is in another country, on another continent? What laws apply there? Who is subject to those laws? The investor? The syndicator/tokenizer? All these and more legal debates will be had and decided as we march forward.
I am not telling you all of this because I want to sell you a tokenized asset. I only write this in hopes that it will trigger in you, some idea, some angle, some business that will make you successful and help you grow your wealth and create generational wealth that will change the lives of your kids and grandkids. The only thing I ask in return, is that you help someone else do the same.