Fractionalized Real Estate — Big Challenge, Bigger Opportunity

In the evolving landscape of real estate investment, a disruptive concept has emerged with the potential to democratize access to attractive property markets: fractionalized real estate. This innovative approach allows retail investors to own a fraction of real estate properties which were otherwise inaccessible to them. Investors can then participate pro-rata in monthly rent dividends, equity and home value appreciation and potential gains upon sale.

Individual investors have historically sought to diversify their portfolios by entering the real estate market, but high barriers to entry (specifically: high capital requirements and institutional competition) can hinder their participation. One investment route into the asset class is through Real Estate Investment Trusts (REITs), but their drawbacks, such as investment lock-ups and lack of selection autonomy, dampen their allure. Now, there are a number of fractional real estate platforms offering retail investors an accessible and flexible way to enter the real estate market, enabling them to choose specific properties for investment without the constraints of traditional models (see: Arrived Homes, Fundrise, HappyNest, and Lofty to name a few).

On the platform side, one approach to this fractionalization is using blockchain technology and property tokenization. This method consists of creating a holding entity of the property then tokenizing ownership of that entity, essentially creating thousands of tokens that are available for investors to buy, sell and manage. In regards to governance of the home and of the token offerings, one approach is through decentralized autonomous organizations, or DAOs. These DAOs can operate based on a series of smart contracts that serve as a governing body through a rule set and voting from the investor base.

Startups focused on this space see a large opportunity of retail (and also institutional) investors interested in adding real estate (with increased liquidity) to their portfolio, as well as a market of over $47tn in residential property assets that can be tapped into. However, with this big opportunity come big challenges that still need to be overcome for the right model to truly unlock the potential here.

We briefly overview a few of the big challenges and opportunities below.

BIG CHALLENGE

Education: Bridging the Knowledge Gap

One of the challenges in fractionalized real estate is the lack of nuanced understanding of blockchain applications and the fears surrounding reliance on cryptocurrencies. Educating investors about the technology’s potential and differentiation from cryptocurrencies can pave the way for broader adoption.

Regulation: Navigating Uncharted Waters

The regulatory landscape remains ambiguous, with the SEC yet to provide definitive statements on whether tokens from DAO agreements classify as securities. This has resulted in two different behaviors from companies — some align to the “move fast and break things” mentality adopted by other disruptive companies, choosing to assume a token is not a security. Others, monitoring the general souring of cryptocurrencies over the last 18 months have adopted a more conservative approach and securitize their tokens, increasing onboarding friction and in some cases limiting accessibility to accredited investors.

Supply: Limited Supply and Managing Quality

Finding suitable properties for tokenization can be challenging due to the high demand and alternatives of prime properties. Many of the business models attempting to fractionalize real estate are built on acquiring the real estate properties to onboard to their marketplace; acquisition not only requires significant capital, but also requires winning these real estate opportunities. The last few years have seen high competition in residential real estate from individual families, small-to-medium size real estate firms, as well as large institutional investors (example: BlackRock), driving housing prices up and potentially impacting unit economics of investment. If you are considering investing in fractional real estate, be sure to take the time to understand the asset and expected financials. In most cases platforms are establishing due diligence practices and utilizing third party inspections and titling services to mitigate potential issues and provide critical information to retail investors. However, the quantity of available homes remains a huge problem for these fractional real estate platforms as they look to scale. This is a supply-constrained industry.

BIGGER OPPORTUNITY

Homeowner and Investor Needs: Finding a Win-Win

Offering partial equity offerings to investors can meet the dual needs of homeowners seeking liquidity and investors seeking yield and diversification. This is an alternative method for homeowners to access equity without selling or taking on debt, and serves as an attractive investment options for retail investors. Most of the business models in the market today enable investors to partake in property appreciation upon sale, monthly rent cash flows, and / or predetermined monthly yields.

Overcoming the Traditional Real Estate Asset Liquidity Issue

This fractional ownership model unlocks liquidity by enabling investors and home owners to buy and sell these tokens on secondary markets, reducing the barriers to entry and exit associated with whole property ownership. As a result, investors can access real estate markets more flexibly, enhancing overall accessibility and flexibility in the real estate market. Furthermore, for many individuals their home is the largest asset to their net worth; these new models allow these homeowners to tap into that idle value, potentially selling a fraction of their home for cash that can be used for new investments, college payments, etc.

Retail Investor Participation: Lowering Barriers

The high barrier to entry for retail investors in real estate can hinder market growth. Simplifying access through fractional ownership and reduced minimum investments can attract a broader investor base. Just as Robinhood unlocked retail investors for the stock market and ultimately enhanced the stock market, fractional real estate platforms have the potential to do the same for the real estate market.

FORGING THE PATH FORWARD

We have evaluated a number of startups and solutions chasing this category and are bullish on the potential. A winner is yet to emerge, and when the dust settles there may be multiple market makers in this category, but we think a few of the potentially winning characteristics are:

• Scalable and efficient supply acquisition for new properties
• High-quality properties with verifiable documentation, inspection reports and a clean title
• Solid demand made available by a large pool of investors
• Frequent trading through a secondary market to increase liquidity and monetization opportunities
• User-friendly technology that provides all available documentation for review and execution, ideally with options to purchase in fiat dollars
• Asset-light business model that serves as a marketplace, versus an investment qualifier

Fractionalized real estate is a bold step towards democratizing a historically exclusive sector. While challenges such as education, regulation, and model selection loom large, the rewards for overcoming them are immense. Success hinges on balancing risk, building a strong brand that attracts new investors and new properties, and shaping a marketplace that benefits both homeowners and investors.

If you are a startup in this space, or an investor who agrees or disagrees with this post, please reach out we’d love to chat!

Authored by Idan Levy and Olivia Volkel (Watertower Ventures)