Liquidity and Tokenization of real estate explained
BY WERNER RIEKERT
In Part 1 of this series (found in the September issue), we looked at how blockchain technology will transform the way land ownership and title deeds are transferred, recorded, and protected. In this part 2 (found in the October issue), we focused on how blockchain based real estate transaction would look like when utilizing smart contracts and what the implication of this would be. In this part, we will be looking at how blockchain technology could impact liquidity in the real estate investment industry.
Before we offer a glimpse into what the future of real estate investment might look like, it is worth highlighting how the industry is constructed and deals with new technologies today.
Real Estate is the largest asset class in the world, with an estimated value of $217 Trillion in total. Of all this value, only 1% changes hand each year. Although Real Estate is a popular investment class and even on small-scale remains one of the most reliable ways for individuals to boost their personal wealth, real estate investment is complicated, convoluted and expensive. This makes it, by far, the investments category with the biggest barrier to entry. The cold fact is that most of the industry still runs on hard copy paper and Microsoft Excel. Research shows that there is not only a lack of innovation but also a lack of understanding of what innovation is and its potential impact on the industry
Why is this a problem?
Well, if we consider that the global real estate market is estimated to be worth over $200 trillion dollars and only 1% is being moved and transacted, there is a largest sum of illiquid assets sitting there on the balance sheets of corporations, investment firms or individuals. With only 1% of the world’s property being traded, however, a comparatively small amount of people is granted the capacities to benefit from real estate trading and investing.
What are the entry barriers excluding so many people from investing in real estate?
High minimum investment
The world of real estate investment is comprised of increasingly-high ‘buy-in’ prices. Whether you’re an individual or an organization, if you’re looking to purchase or trade real estate, a large, concentrated sum of capital is required. Naturally, not every small-scale investor has access to this.
Even if an individual does have the required capital to invest into a piece of real estate, most investment opportunities sit outside of a person’s immediate periphery (country, city or neighbourhood), where they don’t have the necessary know-how, connections or entry-ways to possible investment opportunities.
Arguably one of the most important barriers to entry for small-scale investors into the world of real estate trading is that of liquidity. Due to the large, concentrated sum of capital that goes into real estate development in the form of brick-by-brick construction, investor money is often ‘locked up’ for a period of several years, rendering such capital as fundamentally ‘illiquid’ within that time frame.
High trade cost
The fourth major characteristic of the current real estate market is that of commission fees and middlemen. Current trading practices and local rules and legislation require a lot of administrative hassle, which in conjunction with third-party agents or “middlemen” result in extensive costs that further decrease the net profitability of your assets.
The final barrier to entry that I’d like to emphasize is that of diversification. Because the current real estate market requires sizeable investments and capital injections, it becomes difficult for investors to diversify their portfolios. This is especially the case for the vast group of ‘small-scale’ investors that would like to diversify their portfolios with real estate, but aren’t able to due to its almost-impenetrable nature.
To summarize, the current global market for real estate trading is marked by various barriers to entry that result in the limited access to investment opportunities for those looking to invest in real estate, with an emphasis on small-scale investors.
How can blockchain technology solve this?
Real estate will be digitized in the future. Recordings will be digital, deeds transferred via the blockchain, and real estate assets will be tokenized and traded via smart contracts. Blockchain technology allows for the above-outlined challenges to be overcome.
“To recap from part 2 of this series, a smart contract is an immutable program stored on the blockchain. This decentralized contract or application allows agreements between parties to be expressed in programming language and executed transparently without the need for a trusted intermediary. If sensitive processes, from value transactions to ownership transfers are externalized as smart contracts, this creates a very high degree of transparency, trust, and neutrality.”
This is where the notion of ‘tokenisation’ comes in. This can be understood as the converting of an asset into a digital ‘token’, created, transferred and secured via immutable smart contracts.
If real estate assets could be ‘tokenized’ so that investment opportunities are represented as their own digital tokens, then investment deals and trading opportunities could easily be facilitated via smart contracts. This cuts out the traditional processes required for a real estate ‘deal’ to go through. In other words, when envisioning an inevitably ‘decentralised’ future, the combination of smart contracts and ‘tokenization’ within the context of real estate trading enables us to move away from the dominant reliance on notarized documents, lawyers, surveyors, and banks. In their place, we’d have a more secure, less corruptible ecosystem of investment opportunities facilitated by smart contracts.
We could then have a real estate exchange that could seamlessly connect real estate developers, owners, and investors, regardless of investment capacity or physical location. This will bring us several steps closer to a global real estate market that is not only transparent but fundamentally accessible and inherently liquid.
‘Liquidity discount’ is a well-known phenomenon in the real estate space. Essentially, because large sums are required for certain real estate investments, the amount of capable (‘liquid’) buyers able to purchase real estate is limited. For example, if a property were on the market for R100M, only a small pool of potential investors would have the means to invest. This results in a ‘buyers’ market, whereby a real estate seller is forced to lower their price (and offer a discount), in that limited liquidity exists for buying the real estate in the first place.
With tokenization of real estate, an investment opportunity can be presented to a larger group of investors by means of a fractional ownership model. As a result, more ‘liquid’ cash comes into the equation, as the large capital sum required is dispersed between a multitude of investors. As such, the property seller is able to sell at a higher price, whilst investors are still afforded with very attractive returns. In other words, this facilitates that a real estate piece valued at R100M with a 12% rental return rate could be sold for R120M, with returns of 10% to the investor.
For ‘small ticket’ investors, this return rate is still very appealing, whilst they circumvent the issue of liquidity in relation to the large asset. Rather than having to try and sell a $120M asset, they can simply sell their asset-backed tokens on an exchange in real time.
Another way in which tokenization overcomes the challenges posed to small-scale real estate investors is by means of fractionalized real estate and investor pools. Whereas traditional investor pools normally consist of small groups of individuals, each with large amounts of money, tokenization empowers large groups of individuals to each contribute smaller amounts, such as R50 000 to R 500 000. By means of a fractional ownership model, large investor pools are simpler to manage, easier to attract, and still satisfied with reliably save returns.
“By tokenizing real estate, you don’t need to immediately sell off the full asset, but can make parts of the asset liquid.”
By tokenizing a real asset, it is much easier to transfer a partial piece of ownership thereof to other investors. By tokenizing this, you don’t need to immediately sell off the full asset, but can make parts of the asset liquid.
Tokenization facilitates liquidity, by shortening the process of buying and selling real estate. Furthermore, by tokenizing real estate assets and distributing the tokens between a large group of investors, instant liquidity is created for a traditionally illiquid asset. The token can easily be used to sell small fractions of a real estate asset. It is tradeable, easy to move and affordable.
By applying the above-outlined principles, the real estate industry can move into a new era: one where it leverages the latest technological opportunities. More than that, we truly believe that real estate trading and investment should be a far more accessible endeavour, enabling more and more people around the world to participate and benefit from.
What is Blockchain…..the basics revisited?
• A database for the internet
• A database that anyone can write to, no one can delete from and everyone can read from
• Extremely resilient, it is spread across the entire internet with no single point of failure
• Transparent, everything is publicly recorded
• Permanent, once something is written to the blockchain, removing it is “nearly” impossible
• Not controlled by any one person, country or organisation, truly decentralised
• Able to store encrypted information
You can think of it as a shared database for the entire world, in the same way that Wikipedia is the default shared encyclopedia of the web. Once you understand this basic concept, we can start to imagine what’s possible. Conceptually this graphic shows how you can think about it, with many companies sharing information and tying together applications.
Individual transactions of a specific type on a blockchain system are bundled into groups, called “blocks.” Each block is then encrypted and a copy of the code is sent to all of a network’s nodes in the form of a “hash,” which is an incredibly long string of characters.
To ensure the block is valid, the first character set of a new hash must be identical to the last character set of the preceding hash, and a majority of nodes on the network must verify the continuity between blocks as each new block is added. If a consensus of nodes rejects a hash, its corresponding block is denied entrance onto the blockchain–possibly because the block is fraudulent.