Can Tokenization Mitigate Entry Barriers Into The Real Estate Industry? C Estates Might Answer That
What are the benefits of blockchain technology to real estate? Does real estate as an asset class exhibit properties that provide fertile ground for novel applications of the technology? Can C Estates take meaningful steps towards making that a reality? This article investigates…
The traditionally real estate industry is a notoriously illiquid asset class which exhibits several characteristics that blockchain purports to address for other types of securities — novel forms of fundraising, more liquid markets, tamper proof ownership history, and streamlined payments, among other benefits.
Since Bitcoin’s earliest days, attempts have been made to use bitcoins as “tokens” to represent assets. Early on, this was done by leveraging a bitcoin’s metadata field to attach meaning to a bitcoin transaction and recognize the ownership of that coin as the ownership of some other asset. The bitcoin blockchain could then track ownership of a represented asset and enable secure and direct transfer of ownership. Since then, there has been a veritable Cambrian Explosion of protocols and blockchains that have been purpose-built for the representation and transfer of many types of assets.
Today, blockchain’s application to securities issuance and trading is well underway, and the benefits of its application to many types of securities is becoming better understood. I wrote this article in an attempt to explore how tokenization can impact securities that have reference to real, physical assets. How blockchain technology can address if at all, unique challenges that come with investing in those asset classes.
Why security tokenization is needed in Commercial Real Estate?
Tokenized Commercial Real Estate (CRE) securities are a subset of the tokenized securities ecosystem. Some of the current features of CRE make it particularly attractive for tokenization. In general, a single CRE transaction is characterized by large private market investment, in an opaque data environment.
This leads to an investment ecosystem that is rife with slow transaction and settlement processes that include many intermediaries (agents, sellers, buyers, financiers, insurers, among others), redundant verification processes, and redundant information registered in isolated databases and registries. The situation is more complicated as one moves further down the value chain. Lease management, insurance, maintenance, payments from the lessee to the lessor, lessor to investors, and reporting are all cumbersome and time-consuming processes.
Given the market characteristics of the CRE space (large upfront investment, very low short term liquidity, management costs, among others), retail investors are usually precluded from investing directly in CRE. However, several financial instruments aim to reduce the frictions and costs associated with accessing CRE exposure for such investors by providing indirect investment opportunities.
Problems within the traditional Commercial Real Estates Industry
In traditional and non-traditional markets, market liquidity of an asset or a financial product is measured by five key parameters: (1) Tightness (bid-ask spread), (2) Depth (3) Resilience, (4) Breadth, and (5) Immediacy.
The broader real estate asset class is notoriously illiquid, introducing difficulties to the wider investment community to achieve real estate exposure in investment portfolios. The typical holding period for real estate debt in the Fidelity Real Estate Income Fund, for example, is four to seven years. It is not uncommon for private equity real estate funds to have lock-up periods of up to seven years.
Real Estate holdings are typically illiquid for several reasons:
● Lack of public markets — most real estate transactions occur in private markets, where daily pricing and extensive information about an asset are not available. Private markets are priced on an “as-needed” basis, lack transparency, and are harder to access.
● The difficulty of transacting — Real estate deals require several parties and significant amounts of manually generated paperwork. The process of structuring an offering, arranging financing, and gathering necessary due diligence items often take weeks or months.
● Large minimum capital requirements — Transactions move more slowly given that many CRE transactions require significant pooling of capital, in the form of both equity and debt. Additionally, during the operational phase, while equity owners may have difficulty finding a buyer for their respective interest, lenders may put covenants on how the property is managed financially.
Real estate transparency is a gauge of how accessible and reliable real estate information is in a city or country. Lack of transparency causes tensions and across the industry. Banks fear that incomplete or outdated information about properties will cause them to overvalue a property meant to serve as collateral for a loan. Wary investors who are unable or unwilling to perform deep due diligence on real estate portfolios may significantly under- or over-value asset values.
Equity investors in a development project may demand costly and time-consuming financial controls, reporting, auditing. These tensions, which exist in part due to the difficulty to obtaining timely information about the state of a real estate asset, persist throughout the lifecycle of a property from construction (architectural designs are often difficult to obtain) to sales and leasing (portfolio managers at a real estate mutual fund, for example, may find out that a major tenant has defaulted as long as 30–60 days after its occurrence).
Mortgage servicing market and costs
Mortgage servicers are individuals or companies who are hired to collect payments from borrowers, remit principal and interest to investors for securitized loans, remit property tax and insurance premiums from escrow funds, and perform collection. The mortgage servicing industry in the United States has seen dramatic changes since the financial crisis in 2008. Servicers are under new regulations for operational, capital, and liquidity requirements.
The typical costs of mortgage servicing are as follows:
● Customer Service: Statements and Billings
● New Loan Set-Up and Transfers
● Payoff/Lien Release
● Investor Reporting
● Loss Mitigation
Benefits of Tokenization to the real estate market.
Fractionalization — Assets such as real estate have a high barrier to entry due to large upfront capital required. Fractionalizing such assets democratize its access for smaller investors
Customizability — Tokenization enables exposure to individual real estate assets. Thus, instead of investing in the whole sector, portfolios can be customized down to single buildings.
Liquidity — Fractionalization increases the pool of potential investors and can unlock global investor base Secondary markets also facilitate additional liquidity. Liquid assets command a premium and can increase asset value
Automation — Smart contracts can automate steps such as compliance, document verification, trading, an escrow. Dividends and other cash flows can be programmatically paid when due
Cost Efficiency — By removing certain intermediaries and increasing efficiency of processes, costs can be lowered
Settlement Time — Tokens can settle in minutes or hours (depending on the underlying blockchain). This unlocks the capital that is tied in the market which currently settles
Data Transparency — Secure and visible recordkeeping on the blockchain can increase transparency to the underlying data. Especially for complex derivative products, the ability to link a security to its underlying value drivers
Structured Products — Additional value can be realized once assets are tokenized and that enables the creation of additional layered financial products such as a basket of assets and derivatives. Since the underlying is tokenized, creating complex products becomes simpler through coded smart contracts.
Example of Commercial Real Estate Tokenization: C Estates Utility Token (XCET)
C Estates, the Philippines’ first smart digital investment platform for real estate, offers a complete ecosystem solution that includes listing, tokenization of real estate properties and a marketplace for real estate property investors, brokers, buyers and sellers.
The company through the use of the Nem blockchain will issue a native utility token that will be used for transactions within the C Estates platform. Similar to the digital trading of stocks and financial instruments, users may buy and sell verified property completely online, closing deals instantly with lower cost compared to the traditional process.
Two residential condominium properties in Makati City have become the first successfully tokenized C Estates properties in the Philippines.
Through the use of digital ledgers, transactions are recorded together with their activities and all the changes that happen can be transparently traced through digital footprints. With the use of utility tokens (XCET) to facilitate and validate online transactions in the platform, C Estates gives users the option to trade real estate-backed tokens as fractions of its price, or as a whole. This is made possible through blockchain technology to provide fast, low-cost and secure transactions that will greatly contribute to the liquidity of the Philippine real estate industry.
The project seeks to raise about 189 000 Ethereum coins for its operations and is currently on its Initial Exchange Offering (IEO) fundraising stage that is being held on the Latoken Exchange IEO Launchpad platform.
The IEO route is more secure for both the startup and the investors as compared to the less palatable Initial Coin Offering(ICO) model as an IEO is administered by a crypto exchange on behalf of the startup that seeks to raise funds with its newly issued tokens.
The use of an exchange mitigates onboarding and KYC issues for the startup while for investors assurance that the project has been thoroughly vetted and checked is granted. In the case of C Estates, Latoken has given the project a rating of 3/5 which is fair.
The article above is written from an independent perspective as an entry into C Estates’ bounty program. The above does not constitute financial advice and independent financial advice should be sought before deciding whether to invest in any financial product.