Real Estate Tokenization: Some Possible Token Structures
I have been thinking quite a bit about real estate tokenization as of late, and wanted to take some time to examine some possible token structures.
“Real estate tokenization” refers to the practice of taking a piece of real estate, or a portfolio of real estate, and selling interests in the real estate in the form of bespoke, cryptographically secured tokens, which can be bought and sold on security token exchanges such as openfinance’s. The practical consequence of tokenization is that it makes what is usually considered to be an illiquid asset more liquid.
Real estate tokenization is an especially interesting opportunity to examine because real estate is the world’s largest asset class. Globally, there is something like $215 trillion worth of real estate, and only a couple of trillion dollars worth of sales per year. Therefore, the ratio of illiquid real estate to liquid real estate is very large. If even 5% of the world’s illiquid real estate is tokenized, this would mean that a few trillion dollars of liquidity would be unleashed on the world’s markets. That would have some rather profound effects on the economy.
There are already vehicles for making real estate more liquid, such as Real Estate Investment Trusts (REITs). In the United States, REITs come with a number of drawbacks, including limits on the number of non-US shareholders, limits on shareholder control, and other statutory prescriptions required for an investment fund to operate under the REIT structure. Other countries have REITs, which may or may not have similar drawbacks, or which may have other drawbacks not contemplated here.
Let’s focus briefly on liquidity. Real estate, as previously mentioned, is usually illiquid. However, if you tokenize a portfolio of real estate, buyers of the tokens can sell their tokens on the secondary market, should they so choose. This is functionally equivalent to buying shares of Microsoft one day and then deciding a year later to sell the Microsoft shares so that you can buy some Exxon shares.
It’s important to realize that liquidity is a spectrum, not a binary quality. Too many people think that an asset is either liquid or not, but that’s the wrong way to think of liquidity. Rather, there is a spectrum of liquidity: the US dollar is one of the most liquid assets in the world, while private business interests, certain collectibles, and, traditionally, real estate, are among the most illiquid. Merely tokenizing real estate won’t make it as liquid as US dollars. The token must be structured such that buyers think it is a compelling opportunity. The rest of this article speculates on what properly structured real estate tokens could look like.
One of the interesting features of these bespoke tokens is that you can embed smart contracts in them. Smart contracts are pieces of software, which can provide certain rights and options to issuers, buyers, and sellers of tokens. Given that an issuer can code almost any form of right or option in a token (assuming it is legal to do so), we can speculate on the types of token structures that would be compelling:
- profit sharing, in the form of dividend payouts to token holders, paid on a pro rata basis
- profit sharing, in the form of capital gains distributed to token holders on a pro rata basis, upon sale of a property or portion of a portfolio
- voting rights, based on a pro rata share of outstanding tokens
Let’s take a simple real estate investment fund, which owns a portfolio of real estate. The General Partner (GP) of the fund can tokenize the Limited Partnership (LP) by selling interests in the LP in the form of bespoke, cryptographically secured tokens. Technically, these tokens would probably conform to the ERC20 standard that has become common for security tokens. One aspect of the ERC20 standard that is especially compelling is that it allows for the aforementioned smart contracts to be baked into the token.
My purpose here is not to provide sample code, but rather to think about this conceptually. Let’s assume that the LP sells 100 million tokens, at $1 per token. Cash used to pay out the dividend would be based on the fund’s Net Operating Income (NOI). Let’s use round numbers to keep it simple. If the fund’s NOI is $10 million, then it could pay a maximum of $10 million / 100 million tokens = $0.10 per token. If you bought 1 million tokens, you would be looking at a dividend payout of $0.10 * 1 million tokens = $100,000. (The perceptive reader will note that this is somewhat unrealistic: no fund would pay out all of its NOI in dividends. The fund would retain some cash to save for a rainy day.)
Similarly, we can think of a situation in which a real estate fund sells a property in its portfolio and distributes capital gains, on a pro rata basis, to token holders. Let’s assume that a property was sold for $10 million, realizing a $5 million profit. (I am ignoring a lot of the complexities of real estate accounting here, for the sake of simplicity and concision.) That $5 million capital gain could be distributed to token holders on a pro rata basis. As above with the dividend payout structure, if you own 1% of the tokens outstanding, you would receive a capital gains distribution of 1% of the $5 million profit, or $50,000.
Now consider voting rights in the fund. These could be apportioned on the basis of number of tokens owned. Again, if you own 1% of the tokens outstanding, you control 1% of the votes for any fund decision that is put up for a vote.
I hope to return soon with some more sophisticated token structures. One of the most interesting things about security tokens is that they create the opportunity to optimize all kinds of different investment opportunities. The three structures I propose here are relatively straightforward and are, frankly, things that can be done without tokenization. Nonetheless, they are a starting point for thinking through the benefits of real estate tokenization.
Finally, and perhaps most importantly, all of this is just scratching the surface. For the sake of simplicity, I am ignoring a lot of critically important details, among them being: security of the smart contracts, lockup periods for the tokens, the regulatory exemptions under which the tokens are sold to investors, and ensuring that there is sufficient liquidity upon expiration of lockup periods for there to be a market for the security. These are all critical issues, and each deserves its own post.