Tokenization: Hype or genuine disruptor?
There are many ways blockchain technology is set to bring benefits to the real estate(RE) industry, from smart contracting to peer-to-peer transactions. These will significantly address the many inefficiencies that the current RE industry thrives on but there is one implication of placing RE on the blockchain that requires a deeper analysis. Tokenization, for better or worse, changes a fundamental aspect of the RE industry and therefore transforms our approach to RE as an investment class.
There has been a lot of hype around how tokenization, the digitalization of assets on a blockchain, would democratize RE investing by significantly lowering the capital requirements to participate in the RE market. Strictly speaking, even if the property is only represented by one token digitally, it can technically still be considered tokenized but for the purpose of this article, tokenization will be more in line with how it is used in the discourse around RE: the creation of multiple tokens, each representing a share of a property. Although this is definitely a great opportunity equalizer, the envisioned influx of new investors needs to be carefully weighted against the likely impact which they will have on the market, namely increased volatility.
Tokenization provides investors greater liquidity and flexibility in allocating capital in what has traditionally been known as a slow-moving, illiquid asset class. However, it is this very aspect of RE market that makes it a valuable diversification asset as it forms a hedge against economic uncertainty, greatly reducing portfolio volatility in irrational markets. Underlying RE’s attractiveness as an asset class is the assumption that RE has relatively minimal downside as it is real, has an obvious value proposition, and most importantly, is limited in supply where it matters.
The stability of RE is greatly aided by the amount of friction in the industry. Outdated business models involving middlemen who provide a fraction of the real value charged maintain their positions due to inefficient and redundant contract processing as well as opaque non-standardized data models. Blockchain technology will definitely generate a lot of surplus value when it is used to solve the above issues (as I will cover in an upcoming article). However, for our purposes here, this reduced friction would increase market volatility as the transaction costs becomes much less of a barrier to trade.
This is not necessarily a bad thing as the increased market activity brought about by reduction in trade friction is a much welcomed advancement of the RE industry. I would even go so far as to say that it is an inevitable step in the industry’s evolution as it comes to terms with an increasingly digital world. Nevertheless, we need to approach RE tokenization with caution as the volatility it introduces will likely be largely driven by human impulses rather than increased process efficiency.
The human element: why do people invest in RE?
Though numbers differ around the world, RE as an investment product generally takes up anywhere between 10% of an individual’s portfolio. Whether this proportion rises or falls with the introduction of tokenization will depend on the extent that people continue to think of it as a store of value. As such, this is largely subjective and heavily influenced by cultural tastes. Nonetheless, tokenization will likely undermine this aspect of RE as it further exposes RE assets to the whims and complexities of the free market.
An investor is more likely to mark-to-market in a downturn as though the percentage loss might be the same, the volume is much less painful. If a $10 million property loses 10% of it’s value, a loss of $1 million is much harder to swallow psychologically then a loss of $1,000 on $ 10,000 if the property were split into 1,000 equal tokens. On the flip-side, the urgency to sell in order to lock-in $1 million in profits on a $10 million property investment would likely be higher than $1,000 on a $10,000 property token. This will likely introduce the much needed downside risk in a market that hardly seems to have a price ceiling. However the catch here is that tokenized properties will be the first ones taking the hit so it is not clear if developers will take this risk in the first place.
Another likely effect of tokenization is that tokenized property becomes increasingly abstracted resulting in unforeseen market behavior made possible due to the technology. This is akin to the introduction of payment (credit/debit) cards which actually changed the way people spent money. Promotions and loyalty schemes aside, one would expect that, for any rational spender, there would be no difference in spending volume via cash or card but reality proves otherwise. It is hard to predict behavioral changes owing to tokenization but it is likely that valuations would see wider variances as investing becomes more of a game of numbers with the increasing abstraction from the underlying asset.
Needless to say, all of the above are not necessarily bad for the RE industry as price discovery will align closer with the free market rather than the self-referencing valuation models in use today. Moreover, the increased resolution will greatly aid investors in pricing and managing their risks. Nonetheless, this increase in data will have to be finely balanced with the increased complexity that would ensue. After all, outside of a very small minority of knowledgeable investors, complicated financial instruments are usually an indication that the real value generated is increasingly difficult to quantify.
It is important to note that tokenization is not an all-or-nothing proposition. A landlord/developer can easily choose whether the property should be tokenized depending on which models suits them best. This in turn is determined by how society rethinks RE as an asset class in light of the alternative investment models that tokenization offers.
If the demand is for RE to continue being a store of value and portfolio diversifier, tokenization will likely be relegated to a side market that appeals to a niche group of investors, much like REITs or SPVs. Alternatively, in the less likely scenario that tokenization does reach a critical mass and becomes the industry standard, there would still be demand for non-tokenized assets so as not to deal with the governance complexities of multi-shareholder properties. As always, the most likely outcome will probably be somewhere in the middle.
Tokenization will democratize RE investments by significantly lowering the barriers to entry but at the same time increase the volatility of the asset. Tokenization will empower ‘crowdfunding’ business models but introduce much more governance complexity. Tokenization will facilitate better price discovery but expose RE to the less desired aspects of the free market. Tokenization will give investors the tools to better manage risks but at the expense of over-complicating the industry.
Ultimately, blockchain technology is likely an inevitable part of RE’s future as it solves much of the inefficiencies inherent in core RE business processes today but tokenization is not necessarily a part of that conversation at it solves a different issue. This distinction is key as digital identity for properties, smart contracting, and p2p markets are possible without tokenization but not vice versa. Tokenization is an active decision that the market makes with regards to whether individual properties should change their governance and capital allocation models. This in turn will be determined by how the alternative models enabled by tokenization will shape how societies think of RE in the future. Optimizing complex processes is easy, predicting the human element is a fool’s game.
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