RET vs. REIT: Weighing the Benefits and Limitations

The information provided in this article does not constitute financial advice. Readers are encouraged to conduct their own research (DYOR) and consult with professionals before making any investment decisions.

CapitaSky Tower, located at 79 Robinson Road. Photo courtesy of CapitaLand.

“What’s the difference between Real Estate Investment Trusts (REIT) and Real Estate Tokens (RET)?”

“Don’t REITs already solve what RET is trying to solve? Why bother?”

Welcome to the third installment of my series on Real Estate Tokenization. Having previously explored the reasons why real estate tokenization hasn’t quite taken off yet, we now turn our attention to the potential of this innovative investment model. In this article, we will look into the benefits and limitations of Real Estate Tokens (RETs) as an alternative to traditional Real Estate Investment Trusts (REITs).

Introduction

Please note that this article is not intended to undermine or criticize REITs. Instead, its purpose is to shed light on the potential advantages of RETs, in the realm of tokenization. While blockchain and web3 technologies have faced skepticism in recent years, they also offer innovative possibilities that are worth exploring.

To keep this article brief, I’ll assume that you already have knowledge on REITs as an investment. I will introduce you to RETs, and we will dive straight into its various benefits and limitations.

What is a RET

Real Estate Tokens (RET), sometimes known as Property Tokens, are digital assets that represent a fractional ownership interest in a real estate property. These tokens are created through a process known as tokenization, which involves issuing blockchain-based tokens to represent shares in an underlying real estate asset.

Let’s illustrate the formation of RETs with an example: Imagine a scenario where an income-generating property, such as a hotel, is under the control of a local Special Purpose Vehicle (SPV). This local SPV, responsible for property management, is entirely owned by an offshore SPV. The current owners of the hotel maintain a majority stake, holding a 51% share in the offshore SPV. This stake translates to a 51% ownership interest in both the property and the management company.

The remaining 49% of the shares in the offshore SPV undergo a process known as tokenization. These shares are converted into Real Estate Tokens and issued to investors. Each token represents a fractional part of the 49% ownership interest in the property and the management company. The details of these token holders are then recorded on a digital Register of Members (ROM).

Typical structure of real estate tokenization. Source: KPMG

Benefits

In this section, we will cover only benefits that are exclusive to RETs. These benefits generally do not apply to traditional REITs.

1. Direct Ownership: RETs offer direct or fractional ownership of specific properties, providing investors with a more direct stake in real estate assets. This can be more appealing to investors who want a tangible connection to their investment.
2. Increased Capital Efficiency: RETs could potentially allow investors to collateralize their tokenized property rights, leading to more efficient use of capital. This flexibility can free up capital for other uses, such as further acquisitions for financial institutions, and provide liquidity to investors if needed.
3. Interoperability with DeFi Protocols: RETs can interact with various DeFi protocols, providing opportunities for staking, borrowing, lending, and earning yield. This opens up a whole new world of financial possibilities that are not available with traditional REITs.
4. Access to Global Liquidity Pools: RETs can tap into global liquidity pools through DEXes and other DeFi protocols, potentially leading to more efficient price discovery and increased liquidity. This can be a game-changer for investors who are looking for more liquid, global real estate investments.
5. Granular Investment: Unlike REITs which 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.
6. Flexible Payment Options: RETs can be purchased with different types of currencies, including cryptocurrencies, providing flexibility for investors.
7. Alternative to Traditional Financing: Tokenization can serve as an alternative to traditional financing methods, such as bank loans, for real estate development. This can be particularly beneficial for property owners with limited access to credit and banking services, or in situations where owners may not meet the strict lending criteria of traditional banks.
8. Flexibility in Activities: Tokenized real estate provides investors with the ability to engage in a wider range of activities compared to REITs. For instance, investors could participate in “fix and flip” activities, where properties are purchased, renovated, and sold for a profit. This flexibility can provide additional opportunities for profit that may not be available through REITs, which can be restricted in their activities by regulations in various jurisdictions.
9. Flexibility in Leverage: Tokenized real estate may offer more flexibility in terms of leverage. In some jurisdictions, REITs are subject to leverage limits. For example, in Germany, REITs are allowed a maximum of 45% leverage. In contrast, tokenized real estate may not be subject to such restrictions, allowing investors to potentially achieve higher returns through the use of leverage.
10. Flexibility in Distributions: Unlike REITs, which are mandated to distribute a significant portion of their taxable income to shareholders, RET holders could have more flexibility with their distributions. They could choose to reinvest the distributions, use them in DeFi protocols for additional yield, or even opt for a buyback and burn mechanism where the supply of RET tokens is reduced, potentially increasing the value of remaining tokens.
11. Liquidity and 24/7 Trading: RETs can be traded at any time on digital asset exchanges, providing greater liquidity and flexibility for investors. This can be a major advantage for investors who value the ability to buy and sell their investments at any time, especially during liquidity crunch.
12. Transparency: Leveraging blockchain technology, RETs offer real-time transparency and immutable ownership records, reducing the odds of fraud. In contrast, REITs, while subject to regulatory oversight, only disclose financials quarterly or annually, and property valuation can lack transparency, potentially leading to conflicts of interest.
13. Cost Efficiency: The use of smart contracts can automate various processes, reducing the need for intermediaries and potentially lowering costs. This can be a major selling point for investors who are tired of the inefficiencies and high costs associated with traditional real estate transactions such as settlement, trading, and post-issuance coupon payments.
14. Programmable Ownership Rights: RETs can incorporate programmable features that define the rights and obligations of token holders. This can be particularly appealing to investors who want more control and customization over their investments. For instance, in the case of timeshares, tokens could be redeemed anytime by the token holder since the tokens provide the rights to use the property. Otherwise, idle tokens could either be sold or lent, adding an extra layer of flexibility and potential income.
15. Access to Unique Properties: RETs can potentially offer access to properties not typically included in REITs. This can be attractive to investors who are looking for unique and diverse investment opportunities. Examples include tokens representing ownership in a boutique hotel, an Airbnb, or even a resort in Bali.
16. Innovative Use Cases:

Tokenized Property Improvement Loans: Homeowners could tokenize their property to raise funds for improvements, such as renovations. By selling a portion of these tokens, they can finance their projects without a traditional loan. The increased property value post-renovation could provide a return for token holders.

Tokenized Financing for Green Initiatives: RETs can be used to raise funds for green initiatives, such as the construction of energy-efficient buildings or the installation of solar panels. Investors who purchase these tokens are essentially funding these environmentally-friendly projects, potentially earning returns once the projects are completed and operational.

Tokenized Incentives for Green Initiatives: RETs can also serve as a unique incentive mechanism to encourage green practices. For instance, tokens could be issued to homeowners in a residential complex who consistently demonstrate energy-saving habits. These tokens could then be redeemed for various benefits, creating a tangible reward system for sustainable behavior.

Tokenized Co-Living Spaces: Tokenization can provide benefits to tenants in co-living spaces. For instance, tokens could be used to incentivize community engagement or reward tenants for certain behaviors. This could create a more vibrant and cohesive community within the co-living space.

Tokenized Historical Buildings or Attractions: RETs could fund the preservation of historical sites, museums, or protected natural areas. Organizations could issue tokens representing shares in these attractions. Investors buying these tokens provide the necessary funds for preservation, potentially earning a return from any generated revenue, such as from tourism. This appeals to investors interested in socially responsible or impact investing, while keeping organizations accountable with the transparency offered by blockchain.

Virtual Real Estate: Tokenization can be applied to virtual properties, creating new opportunities for investment. While this may not appeal to all investors, it represents a new area of potential growth in the real estate market. As generative AI, virtual worlds and metaverses continue to develop, we could see increasing demand for virtual real estate, and tokenization could play a key role in facilitating these transactions.

It’s not all sunshine and roses

Limitations

The outlined benefits assume a frictionless, well-regulated environment. However, as a nascent investment form, it’s crucial to acknowledge potential limitations and challenges when investing in RETs.

Legal and Tax Complexity: The legal and tax landscape for RETs is intricate and varies across jurisdictions. While unregulated markets may be legal, they could still be susceptible to market manipulation and fraud. Therefore, investors are advised to seek professional counsel to fully understand these implications.

Limited Investor Protections: Unlike REITs, which are regulated by securities laws and offer certain investor protections, RETs may not offer the same level of protection. This can expose investors to greater risk. (Could we establish some level of insurance for these real-world assets?)

Technology Risk: Like all blockchain-based assets, RETs are subject to technology risks, including potential security vulnerabilities or issues with the underlying blockchain. If platforms or smart contracts are compromised due to outdated security measures, it could pose significant risks to investors’ assets.

Custody Requirements: In the U.S., securities, including some tokenized real estate deals, must be held by a Qualified Custodian (QC). However, there are currently few QCs capable of holding digital assets, which could pose a challenge for investors.

Disclosure Challenges: The transparency of blockchain ledgers and the potential frequency of token ownership changes could deter developers who prefer to keep their information confidential from competitors. Balancing transparency with privacy remains a key challenge in the tokenization process.

Conclusion

RETs offer a compelling alternative to traditional REITs. They provide unique benefits such as direct ownership of specific properties, increased capital efficiency, and access to global liquidity pools. The integration with DeFi protocols opens up new financial possibilities, and the transparency offered by blockchain technology can provide reassurance to investors.

However, it’s important to acknowledge that REITs currently have advantages over RETs in certain areas. REITs offer robust investor protections through regulatory oversight, a feature that RETs, in their current form, may lack. REITs also have a proven track record and are widely accepted in the investment community, while RETs are still in their nascent stages and may face skepticism and regulatory uncertainties.

Despite these challenges, the potential of RETs is undeniable. As the technology matures and regulatory frameworks evolve, RETs could offer a revolutionary approach to real estate investment, combining the tangible asset backing of traditional real estate with the flexibility and innovation of blockchain technology.

I hope this article has been insightful to you! If you enjoyed the read, a clap or a share would be much appreciated. 😄 Feel free to drop your comments on whether RETs could be a superior investment to REITs!

References

Boucher, B. (2022, November 2). REITs vs. Rental Property vs. Fractional vs. Tokenized. Mynd Property Management. Retrieved from https://www.mynd.co/knowledge-center/reits-vs-rental-property-vs-fractional-vs-tokenized

Crebar, A. (n.d.). How Real Estate Tokenization Will Go Mainstream. HoneyBricks. Retrieved from https://www.honeybricks.com/learn/how-real-estate-tokenization-will-go-mainstream

KPMG. (2020). Real Estate Tokenization. Retrieved from https://assets.kpmg.com/content/dam/kpmg/cn/pdf/en/2020/04/real-estate-tokenization.pdf