Security Smackdown: Art versus Real Estate Fund
In one corner is Masterworks, selling a painting in the form of a tokenized security. This is a very simple asset that results in a simple security. In the other corner is BlockEstate, selling tokenized shares in a real estate fund. Their offer is more complicated, and it has a number of structural problems. This comparison reveals a lot about the economics of tokenization, and the type of deals that will work.
Masterworks
Masterworks.io says that they help you “invest in the world’s most valuable paintings.” They buy a painting. Then they set up a new company to own it — an SPV or Special Purpose Vehicle. Then they sell the shares in the SPV as tokenized securities. The terms are simple. They mark the painting up 10% over the purchase price to cover their expenses for acquiring the painting, organizing the company, and selling the security. They present this as a prepayment of five years of fees at 2% per year. So, if they buy a painting for $5M, they mark it up to $5.5M valuation. Later, when they sell the painting, they take 20% of any profits, and distribute the rest of the proceeds to investors.
A clever part of their process is registering the shares of the SPV as a US public security under Reg A+. This provides advantages over Reg D/S private securities. US investors can buy a Reg A+ security without going through accreditation checks, and they can trade it immediately. Even with these advantages, Reg A+ offers have not been common because it costs a lot for an issuing business to make the required offering documents and reporting. However, a painting is not a business. It’s just a canvas. the disclosure and reporting about a painting is cheap and easy. You can make an offering document by cutting and pasting the acquisition story, price and picture. The painting doesn’t do anything that you would want to report on. The annual income statement might be two lines, “Revenue: 0 / Insurance expenses: $1000.” Simplicity is a big advantage in creating a public security. This makes it easier to deliver liquidity.
They present some evidence that paintings have been a good investment, at least for selected “masterpieces” (a category that probably has survivor bias) during a selected period from 1997 to 2017. This graph is a bit misleading in that it understates the S&P total returns, but it illustrates some eye-popping returns.
Before buying the initial offer, you only need to ask a simple economic question: Is the value of the extra liquidity in tokenized shares worth more than the 10% cost? Liquidity premiums are often estimated at 20% or more, so the answer to this question might be “Yes”.
BlockEstate
BlockEstate.com is a real estate fund that competes with public REITs, and private real estate deals, by offering a private tokenized security.
There are a lot of things that I like about the fund.
- It has experienced managers. Presumably they already have access to teams that buy and manage real estate, which will lower their costs and increase their effectiveness.
- It’s being sold through a collaboration that brings together talent from different parts of the security token industry, with advisors from Polymath and a sales channel from Coinlist.
- I like their investment methodology, which is to invest in cities that they consider to be attractive and fast growing. They find these cities by analyzing a set of factors — demographics, economic development, migration, and climate. Their list includes small cities like Eugene, Des Moines, and Asheville, as well as growing bigger cities like Dallas.
Even if I like their underlying fund, there is NO WAY that I would buy their initial offer. Their security has structural problems that may result in very low returns for the initial investors. Even if the fund makes 10% per year on its investments, the return to initial investors over three years could easily be zero. To see why, let’s look at their terms.
They take 10% to set up and sell the fund. So, if you invest $100, on closing you end up with $90 worth of assets (Net Asset Value or NAV).
Let’s accept their estimate that returns will be “12%-18% minus 2% management, minus taxes, minus mortgage”. I interpret this as around 10%.
After closing, the fund holds cash, which only earns 2% returns. It will take a while to invest the funds and start earning higher returns. They will have transaction costs while they do that. Let’s be generous and say that transaction costs will be zero. Let’s hope that they can invest all of the money in a year, so they only give up half a year of returns. So, after the first year, you made 5%, and you’re up to $95 in assets. And after the second year, you’re up to $105.
At that point, BlockEstate managers take another 10%. They are not taking a carry fee on profits. Instead, they are taking 10% of the entire fund, which they receive after they make 20% from the “opening NAV”. The opening NAV for our $100 investment was $90, so they hit the 20% trigger when the NAV gets to $108. Let’s give it to them at 105 to move this along at the end of the second year. Then your NAV gets knocked back to about $94. After a third year of 10% returns, the NAV is back to $104.
In this scenario, you have a 4% gain in NAV after THREE YEARS. The initial offering investor has paid for a whole bunch of stuff — organization, sale costs, management shares, and an initial investment period. Will that investor be compensated by getting 125% of NAV when they go to sell the shares? It’s possible. However, I doubt it. This fund competes with other types of real estate funds, including public REITs, which are fully liquid and trade at an average discount to NAV of 4.5%. If this fund gets marked down the same amount (and it might get marked down more because it has less liquidity than a public fund) then your return after 3 years would be 0.
We might get more than NAV for this security if it has high yields. We are unlikely to be rescued by a liquidity premium — an increase in the value of an asset because it is easier to buy and sell. A US-centric private fund is not a very liquid asset. Initially, it’s a private security that US investors can’t trade for a year. After that year is up, it may be offered on the emerging exchanges for tokenized securities. However, that trading is constrained by the fact that a fund of this type can only have 100 US accredited investors. You can read more about the obstacles in my longer article on The Promise and Peril of Tokenized Funds. The fund can trade sooner and more actively among non-US investors, and they are probably the natural market for this security.
Adding it all up, I would not buy this initial offer. I would wait until I could get a more liquid security at closer to NAV.
Finally, I will bring up a pet peeve. Tokenized security offerings often present graphs that are misleading. Below you can see an example of this genre from BlockEstate. On the left hand side, they minimize equity returns by showing only “income” (dividends). This allows them to show an equity bar at 2%, where the actual total return to equity has been averaging 8% to 10%. On the right hand side, they show S&P 500 equity with a 133% total return (5.4% compounded) which is carefully minimized by starting the calculation at the very top of the last bubble (December 2000) and cutting it off in 2016 before the price increase in 2017. What about the 430%? The fine print at the bottom says “Real estate return data should not be used to estimate the return of BlockEstate investments.”
Professional real estate investors are not going to be fooled. They know why they want to invest in real estate, and it’s not because of these graphs. I infer that this presentation is targeted at retail investors who don’t normally buy real estate funds. It may not meet the ROI requirements of knowledgeable investors. It is probably targeted at non-US investors, who will have an easier time trading the security.
The economics of tokenization
These examples reveal some fundamental facts about the economics of tokenization.
There is currently a 10% cost to set up a tokenized deal. This pays for buying an asset, organizing a security around it, and selling the offering. This seems to be pretty consistent across assets. I believe that this cost will be pushed down to 6% in some standardized and liquid markets. Ideally, this cost will be justified by a “liquidity premium” of more than 10%, which buyers will pay for the privilege of more easily buying and selling.
It’s easier to create a publicly traded security from a simpler asset. The disclosure and reporting and valuation is easier and cheaper than for a complex business. In the US, we may see a surge of Reg A+ public offers around very simple assets like art or empty land. The minimum size for a deal like this could be as small as $1M.
You can’t make a US private fund into an attractive security just by replacing the private LP investors with tokenized security investors. I have looked at cases where fund managers are trying this with real estate, PE, and VC. There are problems with cost, disclosure, incentives, uninvested funds, liquidity, taxes, and other regulations. We need a new structure, and I will outline some of its elements below.
Improving on Funds
This smackdown is unfair. We are comparing a very simple asset to a complicated one. But, there are some things that a fund like BlockEstate can learn from a simple deal like Masterworks.
First, don’t set up a fee cliff. Don’t grab 10% of the whole fund early in its life cycle. That just discourages investors from buying the initial offer. Instead, use the incremental approach and take 10% or 20% of profits later.
Second, figure out how to avoid an initial period with uninvested funds. This gives people another reason to avoid the initial offer. The organizer of the deal should already own the assets, or be able to acquire the assets, before collecting money from fund investors.
Third, actually deliver liquidity. Don’t end up with a US-based, privately held fund. That’s an asset with very limited liquidity. Even offshore, it will have a small float and limited disclosure, which will limit liquidity.
A number of startups are planning to sell individual pieces of real estate the same way that Masterworks is selling art. For examples, look at Slice, Reitium, Meridio. A commercial building with many tenants will have reporting that is more complex than the reporting for a painting. However, these deals don’t have uninvested funds. You get the real estate when you buy the shares. And, they will be traded as normal private companies, which have fewer rules than funds.
A security for an individual asset will tend to have limited liquidity just because the float is small. But, these simple SPV securities can feed into funds that are bigger and more liquid, essentially acting as ETFs for a particular investment category.
Masterworks is on the right track in creating simple, liquid securities that add to the art market. However, BlockEstate has failed in their attempt to design a tokenized security that is competitive with existing private or public offers. The up-front costs are too high and it doesn’t deliver liquidity. We need a different type of fund structure. Soon, I will post a fuller explanation of this structure, so please follow this blog.
