In 2018, New York City-based asset management firm Elevated Returns completed a tokenized real estate offering for $18 million on the Ethereum blockchain. The asset was the St. Regis Resort in Aspen, Colorado. The high-profile property and the employment of an unusual fundraising method caught the attention of investors, fintech enthusiasts, and blockchain communities. Not long after, a new 12-unit development valued at over $30 million was the first in Manhattan to be tokenized. Tokenization on a very broad level is similar to creating shares in a company. However, one of the key benefits of tokenizing is the ability to create partial ownership of an illiquid asset such as real estate. The art world has also taken notice. In the latter half of 2018, 31.6% of ownership shares on a renowned Andy Warhol painting (valued at $5.6 million) were tokenized and auctioned on the Ethereum blockchain. Tokenizing can open new doors for investors who are otherwise unable to invest in alternative assets due to high minimum thresholds while providing liquidity to owners and developers.
Tokenizing is the process of creating a fractional ownership interest on an asset (utility or security) with a token that is blockchain-based. Where:
A blockchain is essentially a distributed database of records or a public ledger of all transactions or digital events that have been executed and shared among participating parties. Each transaction in the public ledger is verified by the consensus of a majority of the participants in the system. Once entered, information can never be erased. The blockchain contains a certain and verifiable record of every single transaction ever made.
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Coupled with the blockchain’s transparency and unalterable framework across the network, a tokenized sale is embedded with a smart contract, a digital cryptographic code that will execute exactly as it was set up by the creators (Hertig, 2019). The ownership interest represented by the token dictates the value of the token. In real estate, a token can represent a variety of ownership interests including ownership of a physical asset, an interest in the debt secured by real estate, equity in a legal structure that owns the real estate, or a cash flow stream from the asset.
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Tokenized Real Estate Cases
To illustrate how tokenizing can be structured in real estate, a brief overview of The St. Regis Aspen Resort may be helpful. Elevated Returns, owner of the resort, originally planned to sell up to half the property as a single asset REIT in an IPO on the New York Stock Exchange. However, the company decided instead to offer 18.9% ownership through token sales. The sale was made through the digital platform Indiegogo and a partnership with Templum Markets LLC, a FINRA and SEC-registered broker. Aspen Coins were created (tokens), which represent a share of the company Aspen Digital, the entity owning 18.9% of the St. Regis Aspen Resort. According to a spokesperson for Elevated Returns:
Essentially you have the best of both worlds with a REIT structure in place and blockchain technology with a smart contract for St. Regis Aspen. The REIT provides tax efficient structure while the blockchain provides peer-to-peer investing and cross-border transaction made simpler for investors.”
Aspen Coins were priced at $1 per coin and all investors were required to be accredited investors with a minimum purchase of 10,000 tokens. The coins could be purchased in U.S. dollars, Bitcoin, or Ether.
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In the case of the tokenized condo development in Manhattan, the developer worked with Fluidity, a company that specializes in tokenization, and Propellr, a management and servicing platform for digitally held assets to launch token sales. The project itself was originally funded by traditional construction debt, but as the term limit was expiring, the developer turned to tokenization to raise capital. According to the developer and his team, tokenizing would enable more investors to purchase a stake in the Manhattan property and create the cash flow needed for the development without the pressures of a bank loan. The tokenization of real estate marks a new shift in real estate investment where numerous buyers are able to purchase portions of a property while controlling interests are able to maintain managing rights.
What does tokenizing mean for real estate investors?
In addition to creating fractional ownership of an asset, tokenization can create liquidity for the investor. Traditionally, real estate investment required capital lock-in for an extended period of time. With tokenization, shares in real estate can become more liquid and create access to global capital. Tokenizing allows smaller carve-outs of an asset that are then sold, creating more liquidity for majority-share owners and developers. Whereas traditional exchanges are limited to more regional investors during local opening hours, tokens can be traded at any time across borders. However, how lawmakers will regulate these exchanges has yet to be seen. Nevertheless, tokenized real estate is spreading internationally as companies like Elevated Returns recently acquired 21% ownership of Bangkok-based Seamco Securities (BKK: ZMICO), obtaining distribution capability and regulatory licenses in Thailand and other South East Asian regions. The company announced plans to tokenize 1 billion USD of real estate in its pipeline (Elevated Returns; Securitize; Tocqueville Group, 2019). Trading volumes may be limited due to smaller market caps, a limit on the number of holders (as is the case with REITs), and a large number of tokens available if the practice becomes more widespread.
Security and Investor Management
Investor knowledge and comfort around the security and inner workings of tokenization remain formidable hurdles for the mainstream adoption of this investment medium. Blockchains are essentially traceable public ledgers for stakeholders within a blockchain network. These qualities allow transparent tracking of tokens from owner to owner. The transaction process for a real estate asset in the form of token transfers cuts through much of the traditional transaction complexity and has a publicly auditable history. Incorporating smart contracts into the transaction process can create automated protocols that are in compliance with relevant regulations. Due to failures of smart contracts in the past and the unfamiliarity of the general investing public with blockchain transactions, tokenization is still far from being a perfect or even a trusted procedure for most institutions and investors.
Challenges and Considerations
Aside from the volatility and uncertainty surrounding blockchain-based systems, real estate tokens are still far from being a democratized investment solution. Headline real estate deals such as the St. Regis sale discussed above still require participants to be accredited investors (United States Securities and Exchange Commission, 2019). For an individual, this means an earned income of $200,000 (or $300,000 together with a spouse) in each of the prior two years or a net worth of over $1 million excluding the value of the individual’s primary residence. While wider adoption of tokenized real estate appears promising, it remains to be seen whether tokenized real estate will be available to retail (non-accredited) investors.
REITs are still a more accessible option for most retail investors. With several clicks of a mouse or phone, shares in a REIT can be easily purchased. However, whereas publicly traded REITs are a portfolio of assets, tokenized real estate provides an option for a more granular investment in a specific asset or within the capital stack linked to a particular property. Furthermore, token exchange platforms could develop in the future, creating accessibility and public adoption similar to web/ app-based investment companies Robinhood and Stash challenging traditional investment, brokerage models. The development of indices for tokens could be an important next step in expanding the adoption of tokenized assets.
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Tokenization might also create disclosure challenges. The accessibility to a ledger by participants and the potential frequency of token ownership changes may deter developers who do not want information shared with competitors. Some of these issues may be addressed through the development of a secure system where information is not fully decentralized and via structures within the blockchain that allow only certain information to be shared with participants (i.e. permission blocks). Tokenizing has a promising future in real estate investment. It may create more incentives for continued adoption by developers and asset managers, such as increased access to global capital and liquidity rather than traditional institutional loans. For both individual and institutional investors, the benefits of tokenized assets have collected strong supporters and may become a viable alternative investment vehicle in the coming years.
Blog Credits: Cornell Real Estate Review