Real estate tokenization benefits and challenges

Written by Gabriel Sadoun from DigiShares (https://digishares.io/)

According to Savills, the value of real estate globally is estimated to be $379.7 trillion. However, the way in which shares in real estate properties have been bought and sold, has not altered significantly in recent years. Blockchain technology is poised to change this, as it is making sending and receiving value or ownership rights as frictionless as sending and receiving information on the internet. Let's explore the concept of real estate tokenization

First, the definitions of relevant innovations:

·      Tokenization: the process of representing, on the blockchain, shares in a legal entity that owns an asset (e.g. real estate).

·      Smart contract: a bundle of self-executing lines of code - written on a blockchain - that contains the terms of an agreement between parties.

·      Atomic swap: a type of smart contract that enables peer-to-peer transactions without a counterparty, by locking the tokens - and the crypto used to purchase them - until both sides are validated (otherwise, the transaction cannot happen).

·      Stablecoin: a type of cryptocurrency that is pegged to a fiat currency (e.g. USDC is a USD stablecoin).

·      Self-custodial wallet: a digital wallet in which crypto and tokens can be stored, and that can only be controlled by its owner.

How do these innovations tie together in the context of real estate tokenization?

Investors from around the world can purchase tokenized shares in a real estate asset, with stablecoins contained in their self-custodial wallet. These investors can enter into an atomic swap smart contract directly with the issuer (e.g. a real estate developer) or with other investors (on a secondary market).

Now, let’s explore what this means for real estate investors, developers, funds, syndicators, etc

Lower barriers: Anyone from around the world can invest seamlessly, and at an insignificant cost, in fractional shares. Cross-border transactions on the blockchain are a breeze compared to using the archaic SWIFT system. The only fees paid by investors are “gas fees”, i.e., the fees required to use a blockchain, which, in the case of blockchains such as Polygon, are a few cents, even to send thousands of dollars. This means that real estate firms can broaden their investor base to include smaller investors, foreign investors, as well as investors that have most of their wealth in crypto assets. Furthermore, they can send these individuals frequent, small distributions, at an insignificant cost.

Liquidity: Once investors have completed the relevant KYC and AML checks, they have the flexibility to trade their tokenized real estate assets directly with other investors. Eliminating intermediaries in the trading process contributes to faster and lower cost transactions, with less error. This peer-to-peer trading feature can enhance liquidity and provide investors with the ability to exit or adjust their positions. This is significant because studies show that an equity share (A) can have a valuation on average 20% lower than another share (B) in the same entity, solely because it is not possible to trade A, whereas B is listed on a stock exchange (this is called the “illiquidity discount”). It makes sense, because if you were presented two identical projects, with the only difference being that in the first you can sell your shares whenever you’d like, but in the second you’d be locked in for years, you’d choose the first project.

Compliance: Security token protocols such as the Ethereum blockchain’s ERC-1404 play a crucial role in tokenization by embedding rules and obligations related to governance and compliance directly into the token code. This automation reduces the need for extensive manual work on the part of issuers, investors or lawyers. Examples of this are the KYC white-listing, setting lock-up periods, trading amount restrictions, etc.

Transparency: The use of public blockchains for recording ownership is a significant advantage for investors, as they can independently verify their ownership on a blockchain explorer such as Etherscan, fostering a higher level of trust and accountability.

How easy is it to use this technology?

Let’s compare the web3 tech stack to web2 products most people are familiar with:

·      It is now as easy to set up a self-custodial Coinbase wallet with its Chrome extension, as it is to download Chrome and open a Gmail account.

·      It is now easier to convert any fiat currency into USDC - and vice versa - at no cost, than it is to initiate an expensive online wire transfer to send fiat monies.

·      It is now as easy to send USDC from that wallet at almost zero cost to/from anywhere in the world, as it is to send a PDF with Gmail.

·      It is now as easy for issuers to sell private shares in real estate via a blockchain-based SaaS platform as it is for stores to sell clothes via Shopify.

·      It is now as easy for investors to trade private shares via a peer-to-peer marketplace as it is for them to trade public shares via a broker such as Schwab.

To finish, let’s look at some challenges

Having more investors: Issuers selling fractional shares and enabling a secondary market will mechanically have more investors on their cap table. This could lead to the need for increased communication, compared to having a small number of large investors.

More price discovery: While appraisals will still be the basis used to make an informed investment decision (just like annual reports in the public markets), ultimately, supply & demand will set the price if/when the token starts trading. This could lead the market valuation to sometimes be below Net Asset Value, if many investors wish to exit at the same time.

Legal complications in some jurisdictions: While real estate tokenization holds great promise, it faces legal challenges in certain jurisdictions, particularly in some Latin American, African and Asian countries (not all!). Regulatory frameworks vary globally, and some regions may not have clear guidelines or may outright prohibit the tokenization of real estate.

User comfort with crypto wallets: Despite the growing popularity of cryptocurrencies, some users may still feel uncomfortable using crypto wallets to manage their tokenized real estate investments. This discomfort could stem from concerns about security, unfamiliarity with the technology, or a general lack of trust in digital wallets. Overcoming this barrier requires education and the development of user-friendly interfaces to enhance overall user experience, to the point where people will feel as comfortable with wallets as with bank accounts.

Low liquidity in tokenized secondary markets as of today: While the concept of peer-to-peer trading of illiquid assets is a gamechanger, the reality is that tokenized secondary markets are still in their early stages of development. The ecosystem is currently facing a chicken & egg situation: issuers are waiting for more investors, whilst investors are waiting to see more issuances on these security token exchanges. Overcoming this challenge will require network effects to play out over time.

Tokenization has the potential to increase global accessibility of real estate investments, liquidity, compliance automation and transparency. Despite these benefits, challenges exist in the areas of investor relations, price transparency, legal processes in some jurisdictions, crypto wallet adoption and tokenized secondary markets. How fast this new technology will be adopted by real estate companies and investors will depend on several elements, including the ecosystem's ability to offer products with a high quality user experience, the regulators' ability to provide clarity and real estate firms' willingness to change their current modus operandi!