STOs and Real Estate — Challenges and Opportunities
Solutions in search of a Problem
A lot of fanfare has been made in the crypto sphere about the potential to fractionalize investment in real estate by issuing tokens backed by individual buildings. Yes, real estate enjoys the status of being the single largest asset class in the world (there’s nearly $300 trillion worth of real estate on the planet excluding undeveloped land). And yes, the sector is begging for more liquidity, with less than 3% of “investment quality” real estate being traded each year (compared to nearly 100% of the value of stocks and 60% of bonds, the two other largest asset classes). But it’s not true that launching tokens backed by individual buildings is going to produce the big bang of fresh liquidity that the sponsors of such initiatives would have you believe.
Tokenizing individual buildings is mostly a gimmick, doing the same old thing that’s been tried countless times before only this time with the mystique of “crypto” added to it. Tokenizing individual buildings misses the point that what serious and sophisticated investors (meaning, the largest ones) need, in true fact, is for specialists to create for them portfolios of properties fitting a specific return (and risk) profile, to fulfill a carefully prescribed role in their overall portfolio allocation.
No different than stocks
Just think about the stock market. Investors are perfectly able, and quite easily so, to buy individual shares of their favorite companies. And some do. But the vast majority don’t. The vast majority of shares (80%) are owned by professionally managed funds, each with a specific profile designed to perform a certain role for a pre-defined target group of investors. These funds are, in turn, owned by (or on behalf of) sophisticated institutional and individual investors.
In exactly the same way, investors (large and small) rely on professional managers to build portfolios of real estate. These portfolios are designed to achieve a particular type of exposure, by country, by sector, by strategy, by expected return, by risk profile. By creating such portfolios, the idiosyncratic risk of individual holdings is reduced through diversification, the larger size and scale produces significant cost efficiencies, and the professional manager leverages their deep knowledge and experience. The portfolio is then fractionalized or securitized or unitized in one way or another.
The idea of tokenizing individual buildings is a solution in search of a problem and is based on naive thinking. This solution seems to be based on the thought that it is the large individual size of investments in buildings (e.g., office towers, shopping malls) that is beyond the reach of most investors. And fractionalization of ownership would allow a larger audience of investors to gain exposure to such type of assets by bringing down the minimum investment size. But there is the same problem with regard to investment in a cement plant, a mobile phone manufacturing facility or a car factory. But the market doesn’t fractionalize these individual production assets, and trade them, it fractionalizes investment in companies that own portfolios of these assets and actively operate them in a coordinated way, pursuing a specific overall business strategy.
Tokenizing individual buildings misses another fundamental point. It puts the onus on the investor to select for themselves the individual tokenized buildings (in theory, one of many thousands) to achieve the desired investment result. Most sophisticated investors realize they have neither the knowledge, the resources nor the experience to make such selection decisions, to continuously monitor the portfolio and to adjust positions to adapt to a continuously changing investment landscape.
Think of the model of the REIT, a company that actively owns and manages a portfolio of real estate investment properties. The typical REIT owns dozens (sometimes hundreds) of individual buildings, with the aim of producing an overall blended risk exposure and return profile for the investors in the REIT. The investor can then buy a share or bond issued by a REIT in whatever amount, large or small, they need to suit their portfolio.
Been tried before
Securitization of individual buildings has been hyped before as the next big thing, many times over the last century or more. Before the internet, there were attempts to launch exchanges on which individual buildings could trade (and some are even trying to revive this concept again today). With the internet came the online crowdfunding approach to fractionalization of individual properties. You’ve probably never heard of these initiatives before. That’s because they’ve all failed, and none delivered the promised result. And they’ve failed for mostly the same reason. That reason is, it’s a pointless exercise. Yet, over and over again, new players try. There are at least a dozen of these efforts underway today in the crypto sphere and several in the legacy world. More often than not these projects are sponsored by property brokers or other real estate advisors, and not by investment professionals coming out of an institutional asset management firm with an understanding of the fundamentals of the real estate capital markets.
What’s really needed
The market doesn’t need another one of these misconceived exercises. But what it does need is a newer, better form of REIT. The REIT (a type of real estate company) is a well-established category of security issuer, it’s a company traded on a stock exchange (usually) and focused on active investment (usually through ownership) in a diversified portfolio of real estate to generate and pass through rental income to investors in a low/medium risk and tax efficient format. And while REITs do exist in most developed countries and altogether own upwards of US$4 trillion of real estate worldwide, this is actually quite small relative to the overall opportunity set of some US$280 trillion. By comparison, most other major industry groups are well consolidated under the ownership of a small number of stock exchange listed companies. The REIT model has been around for decades and has been more successful in some markets than others, but the track record is no better than mixed. As an innovation from the 1950s based on early 20th century financial technology, there’s an opportunity to create an updated and modern equivalent to a REIT enabled by 21st century technology and in so doing, to allow for the consolidation and more efficient management of large portfolios of real estate, while making such investment available to a broad audience through securitization (by way of tokens).
Put differently, the relevant application of a tokenization model for real estate is not in the token itself. It is in the smart contract embedded in the token, which allows a sponsor to custom design a capital instrument to suit the specific needs of the modern investor. The smart contract allows the sponsor to incorporate highly successful and well established direct real estate investment market concepts, like bespoke distribution waterfalls, into a transferrable security with transparency and liquidity. The direct real estate market realized a long time ago that real estate investors have specific needs that are not satisfied with the generic tools of straight equity and debt. So direct real estate investors invented their own joint venture and partnership structures, and often incorporate mezzanine and hybrid capital. But these direct investment tools, until now, haven’t transposed well into transferrable securities. Or, to be fair, these structured approaches haven’t done well outside the RMBS and CMBS markets for mortgage-backed bonds. These types of mortgage-backed bonds, developed specifically for the real estate industry in the 1980s and 1990s, incorporate some of the risk tranching and other mechanics developed to suit the preferences of sophisticated investors in real estate. The fact that there are a few trillion dollars worth of such securities (and more, including mortgage-backed covered bonds in Europe) in the market suggests there is a strong preference for customized solutions for real estate investment beyond the rather clumsy one-size-fits-all tools of generic equity and debt.
What’s to come
At some point soon, we can expect every existing legacy security will be tokenized. It’s only a matter of time before there’s a token equivalent version of shares of Apple and every other share or bond traded on an exchange. This will include every REIT share too. So what will be different? Tokenization of individual buildings, just like tokenization of existing securities, won’t do much to add value to investors other than to marginally reduce some transaction costs and speed of trade settlement. The much bigger opportunity is to fully exploit the potential of the smart contract technology to create a totally new tool, a customized instrument that provides a fundamentally better risk/return profile to investors and alignment of sponsors in a securitized format.
 A Real Estate Investment Trust (“REIT”) is a US company focused on the active ownership of real estate, adhering to certain operating and financial parameters that allow it to qualify for reduced tax. There are REIT equivalent structures of various types in most major developed countries around the world.
Mark Abramson is a co-founder of BrickMark AG. His 25 years in the global equity capital markets includes 12 years on the buy-side as hedge fund and portfolio manager specializing in the REIT sector and partner at a leading US-based global real estate investment firm with $40 billion of assets under management. He also spent 11 years as a top-ranked sell-side equity research analyst covering multiple industry groups, including real estate, for a leading Wall Street investment bank. He serves as Independent Director on the board of a publicly traded real estate company in Europe (and vice-chairman of the Audit Committee), and as senior advisor to a number of the world’s largest asset management and private equity real estate investment firms. He serves as a member of EPRA (European Public Real Estate Association) Committee on Tax and Regulation.
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