The commercial real estate sector is squarely in the sights of the blockchain industry. Advocates justifiably believe that the technology offers the ability to streamline everything from capital formation to transaction settlement at hitherto unseen levels of speed and efficiency. Additionally, through a process known as tokenization, blockchain platforms can create digital representations of shares as well as ownership rights in properties and investment vehicles, simplifying the process of reselling those assets by creating a robust and liquid dual-sided market for an otherwise illiquid asset.
This is very exciting and has been a long-time coming for an industry that has largely remained on the sidelines of a digital revolution that has been impacting industries around the world. However, for this technology to truly succeed, industry participants need to engage in an honest dialogue about the hurdles — of which there are many — that could prevent a decentralized utopia.
Often times this requires combating myths that arise from blockchain hyperbole. One such prevailing opinion that needs refinement is what some call the “Field of Dreams” scenario, which is the belief that if a particular asset becomes tokenized, a deep and mature market will automatically materialize (i.e., “If you build it they will come”). However, while it is easy to deliver one-liners at conferences, few articles take the time to go into the specific drivers of supply and demand in markets such as commercial real estate and the net effect that tokenization can have on this asset class. Honest discussions along these lines are critical in order to create and implement successful adoption roadmaps for blockchain technology.
Introducing the illiquidity discount
Industries without standardized products or fluctuating supply and demand often experience an illiquidity discount. For readers who are unfamiliar with the term, an illiquidity discount refers to the reduction in price that gets applied to an asset because of a shallow market. It exists because, for certain assets like real estate or unique works of art, it is not always easy to move in and out of a cash position. Commonly used in the context of risk, Investopedia defines illiquidity as “the state of a security or other asset that cannot easily be sold or exchanged for cash without a substantial loss in value.”
While liquidity has historically been less of an issue for public equity markets, in private real estate markets (in which the commercial sector almost exclusively exists), liquidity has always been a key factor significantly affecting asset valuation — or more specifically, pricing. In fact, illiquidity discounts can often reach up to 30%-50% of the estimated fundamental value!
Reasons for the illiquidity discount in the commercial real estate sector
Looking at the nature of the commercial real estate market as a whole, one can easily identify some obvious reasons for illiquidity, such as the lack of market depth and transparency, the fact that most activity takes place in shallow private markets, and assets are often priced on an as-needed basis. Furthermore, unlike in public markets, the valuations are not consistent and regularly updated (often due to the unique nature of most properties and varying levels of inventory depending on geography), and the transactions themselves are often difficult and expensive to execute (especially with private or institutional financing involved). All of this results in high levels of complexity, counterparty risk and transactional friction, making the underlying assets less liquid.
Regulation as a source of illiquidity
However, the most important factor contributing to illiquidity in traditional commercial real estate investments is that most of these investments are considered, at least in the United States, securities or investment contracts and, as such, are subject to a myriad of transfer prohibitions and restrictions on liquidity, resulting from complex legal and tax requirements imposed by U.S. regulatory agencies like the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority and the IRS, just to name a few.
— The “Maximum 100 Investor Rule,” which states that, in order to be exempt from registering as an investment company under the two most frequently used exemptions of the Investment Company Act of 1940, most private real estate funds must choose to either (a) limit their private offerings to no more than 100 investors (or 99 investors, if the General Partner’s interest is at risk of being considered a security) under the 3(c)(1) exemption, or (b) limit the fund to only “qualified purchasers” under the 3(c)(7) exemption.
— The “Minimum 100 Shareholder Rule,” which states that, in order to qualify as a Real Estate Investment Trust (REIT) under the Internal Revenue Code, a company must comply with many relevant provisions in the code, including having a minimum of 100 investors, holding a majority of its assets in real estate and annually distributing a minimum of 90% of the REIT's taxable income to its shareholders.
— The “Maximum 2000 Shareholder Rule,” which states that, pursuant to Section 12(g) of the Securities Exchange Act of 1934, as amended on May 24, 2016, a private fund that exceeds (even if inadvertently) the maximum of either 2,000 shareholders or 500 shareholders who are not accredited investors and has more than $10 million in assets must register and file its financials with the SEC (and this includes ongoing disclosures, appointment of disinterested directors, and prohibitions on affiliated transactions and trading activities such as short sales and derivatives trading).
Historically, the only way to ensure compliance with all requirements and to maintain control of private securities has been to make them all go through a fund manager, which results in additional costs, delays and counterparty risk. Moreover, if the selling shareholders cannot find an outside buyer, they often end up having to sell their shares to another shareholder or back to the fund at a brutal illiquidity discount — a scenario that usually comes with its own set of problems and potential conflicts.
Tokenization can help, but it is not a silver bullet
The most optimistic scenario is that, as real estate (residential or commercial) becomes tokenized, the illiquidity discount can be narrowed or eliminated altogether. However, just tokenizing assets and putting them on a blockchain will not be a solution in and of itself.
— While blockchain technology should help, given the proper infrastructure, accelerate core elements of real estate transactions — such as price and title discovery, identifying any liens or easements against a property and adhering to restrictions placed on shares (because they can now be programmed into the platform and/or the token) — tokenizing real estate assets does little to change the fact that the underlying real estate is fixed to a particular location and is difficult (actually, impossible) to move. These are factors that impact demand that cannot be easily countermanded.
— Furthermore, tokenization alone will not alter the fact that real estate assets themselves are individually unique on a granular level, which can make it difficult to have clear transparent markets and data feeds.
— Finally, tokenizing real estate assets does not change the subjectivity of these shares to securities regulation, which is sometimes a common misconception in blockchain circles.
The silver lining
However, these disclaimers are not necessarily a bad thing, it just means that tokenized assets cannot alleviate illiquidity by themselves. Fortunately, there is tremendous work being undertaken utilizing blockchain technology (and tokenized assets) to streamline the capital formation process by helping to identify, broaden, and build markets and syndicates faster.
For instance, the lack of public markets will be gradually counteracted by the emergence of regulated security token exchanges and alternative trading platforms like OpenFinance and tZero. Additionally, emerging security token issuance and investor management platforms — like Templum, Securrency, Harbor, Symbiont and Securitize — are making programmable governance and built-in regulatory compliance possible on the platform and/or the security token levels.
Transactional difficulty and friction can be dramatically reduced through the implementation of smart contract functionality to automate many data-driven and task-based processes — i.e., public records maintenance, chain of ownership, escrow and real-time transaction settlements.
Blockchain-based payments are another important element that should be easily incorporated into the real estate transaction process. Be it fiat-backed stablecoins (e.g., JPM Coin or Libra), or native crypto assets (e.g., XRP or Bitcoin), it should be orders of magnitude easier, safer and faster to send funds without error or counterparty risk.
Finally, preapproved and whitelisted investors will be able to trade these private securities peer-to-peer, at virtually real-time settlement speed and with no counterparty risk — almost as quickly as sending an email. This is truly transformational, as it will bring the benefits historically enjoyed by public markets into the world of private equity and commercial real estate.
These building blocks are all complementary to the tokenization process, and I truly believe that together they will symbiotically transform and evolve the real estate industry in a way that is durable and scalable.
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