Why now is the time to tokenize commercial real estate

April 21, 2020
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Louisa Bartozsek

In a pandemic environment it is difficult to view the longer-term repercussions with clear conviction. However, Mozaic Markets believes COVID-19’s legacy on commercial real estate investment will be transformational.

Wise commercial real estate (CRE) investors don’t bet on appreciation. They purchase properties on sound judgement that the building will generate more income than it costs to own.

However, the coronavirus has created material uncertainty over the value of property worldwide. Rent defaults, business closures and increased vacancy rates, pose a very real concern for over-stretched landlords and developers.

And those who have invested in many daily traded property funds have found themselves ‘locked out’ and unable to sell their positions after the economic fallout from the coronavirus pandemic cast doubt over the value of their underlying properties.

These are unprecedented times and whilst the immediate impact continues to unfurl, smart investors are already assessing the longer-term impact of the crisis.

I believe the pandemic is going to transform the commercial property industry in two stark ways:

1. Physical ‘Bricks and Mortar’– with the geographic landscape evolving in response to changing property requirements fuelled by e-commerce and flexible working (for example, from retail to industrial).

2. Financial — with the introduction of new financial instruments which remove barriers to investing and open the door to new types of investors, improve transparency, increase liquidity in this traditionally illiquid asset class, and, create a new valuable revenue stream for property asset owners.

Physical property transformation

The impact of the pandemic in the immediate term is clear, and whilst in exceptional circumstances, like the current environment, it is difficult to view the longer-term repercussions, its legacy could be transformational.

Let’s take offices, retail and industrial.

Offices

With most office workers working from home to help limit the spread of the infection, our offices have become our homes with our desks gathering dust.

In the short term, office growth plans are likely to be paused or slowed significantly as businesses rapidly assess their needs as the impact of the pandemic unfolds.

I’m interested to see second and third quarter business results for those who have been able to implement a working from home business model — both financial and productivity.

This could influence future operational business models and could ignite a reduction in office space requirements.

Retail

Plummeting values in the retail sector are a heightening concern. Retail was a tough environment before the pandemic of course, due to rising costs and changes in people’s shopping habits.

Notwithstanding a steady series of retailer failures (including restaurants and drinking establishments) which has seen an acceleration in recent weeks as non-essential shops around the world are forced to close indefinitely.

The only winners being those with strong digital platforms.

Industrial

Traditionally perhaps the least attractive of CRE sectors, comprising warehouses, manufacturing facilities, refrigeration, storage and data centres, industrial is now a growing sector.

It is reported to be one of the out-performers in the pandemic, specifically with e-commerce businesses as consumers shop online in their millions.

Demand for storage for these businesses will undoubtedly continue to grow. Particularly in more densely populated areas, also known as “last mile” delivery locations, and potentially even the high street.

Financial Transformation

Whilst generally high yielding, real estate suffers from illiquidity, lack of transparency, high transaction costs, execution time frames, and, in the case of commercial property, restricted investor access.

The performance of real estate, both commercial and residential, can be hard to gauge too with many transactions private and, as a consequence, trusted, reliable and easy to access financial information is scarce.

It’s therefore an ideal candidate for digital financial innovation.

Firstly, let’s quickly look at the ways you can invest in commercial real estate today.

Direct Investment

  • Acquisition — a physical building but need substantial capital (and or hybrid capital/mezzanine financing) up front (combined 30–40%) and the buying/selling process is long, slow and cost heavy.
  • Online Investment Platforms — connect investors who are looking to finance projects with developers

Indirect Investment

  • Real Estate Stocks — large developers and property advisers are listed on the main exchanges, but like any stock, they are impacted by falling equity prices.
  • REITs — Some invest directly in properties, earning rental income and management fees. Others invest in real estate debt, for example, mortgages and mortgage-backed securities. Some REITs trade on an exchange like a stock.
  • ETFs — In Europe, ETFs operate under UCITS regulation and can only make indirect investments. They are similar to individual stocks and trade on exchanges in the same manner and thus impacted by equity falls.
  • Open-Ended Funds — can provide stable long-term income and returns, but due to the illiquid nature of the assets there have been infrequent instances when the funds have had to suspend temporarily to preserve value.

Open-Ended Property Funds Concerns

Concerns around the latter are most prevalent at the time of writing with at least seven UK property funds suspending trading as a result of the pandemic, trapping at least £12.7 billion of investor money.

Because property is an illiquid asset and can be particularly hard to sell during times of market stress, funds are usually frozen over fears that the fund would not have enough cash to meet a sudden surge in outflows.

Commercial property funds are arguably much better prepared than they were in 2008 (global financial crisis), with many having built large cash holdings to meet redemption requests.

But with today’s market shock, it is not a case of unmanageable outflows, but the inability to accurately assess the value of a fund’s property holdings.

Financial Conduct Authority (FCA) rules require a fund stops trading if more than 20% of their portfolio cannot be assessed accurately.

Investors therefore now have no choice but to sit tight on their property fund investments during a very uncertain time for the global economy.

If they need urgent access to their capital — they simply cannot access it.

Property Tokens — a new Liquid Alternative

Asset values aside, one of the main issues today is the lack of control an investor has over their real estate assets in times of urgency.

What if there was a digital twin available as an alternative?

A digital twin which, whilst not immune to price fluctuations in a period of market distress, would always be liquid.

Tokenization uses distributed ledger technology (DLT) to turn a real-word asset, such as real estate, gold or even forestry, into a verifiably digital asset (Digital Twin) called a Security Token.

A Property Token is structured as a security or is deemed to be an investment contract that sits on a distributed ledger and is run by a smart contract.

It represents the tangible assets that can be traded in a security token exchange anytime and anywhere in the world, in a fully regulated environment.

Security Tokens can represent an underlying real asset and pay dividends, share profits, pay interest, or invest in other Tokens or Assets to generate profits for the Security Token holders.

A property token would be a digital twin of the real asset and would allow for an investor to request ownership of a property, in the event of a default. With the property acting as a form of collateral.

A digital ‘twin’ is exactly that — one to one. One physical and one digital. They are effectively the same in a sense.

A smart contract, imbedded into the token, can specify that it cannot be leveraged or that senior debt is limited to 65%, for example.

Thus, preventing the over-leveraging issues of subprime mortgage-backed securities which ultimately caused the 2008/09 global financial crisis.

Why Property Tokens are Attractive

The biggest opportunities for property tokens are that they:

  • Open up the market to fractional ownership. A new investor base that previously could not access the asset due to high ticket requirements of commercial real estate. Creating a new revenue stream for real asset property owners.
  • Can be included in institutional and pension funds. If the tokens are regulated, institutional investors and pension funds can incorporate property tokens into their asset allocation strategies. The liquidity of property tokens, vis-a-vis physical bricks and mortar, is attractive from an active portfolio management perspective. It is also a viable alternative to investing in Open-Ended Property Funds.
  • Provide dynamic data. The token will be continuously updated with the latest information from the asset that is relevant for the investor to know. This severs the dual purpose of keeping the investor up to date with their asset’s performance — directly from the source, and secondly, having an asset with a much better state of information relevance and history when it comes to being sold. This will allow for faster execution and lower legal fees.
  • Communities could play an active role in saving their High Street. The decline of our high streets is not just a material economic issue, it is a societal self-esteem issue. Boarded (often graffitied and left to decay) shops possess deep symbolism in a community. It impacts the mood and atmosphere of where we live, work and play. Local people generally want a thriving high street — would they invest to save it if they could? Research indicates yes. If a high street had a ‘digital twin’ local residents could choose to invest and influence the demographic make-up of the shops, bars and restaurants which serve their local community.
  • Low cost opportunity for individual retirees. If the tokens are regulated, they can be an alternative for the average individual retiree who may want to hold commercial real estate in their personal retirement account and is not able to easily do so today. As the population ages and we demand more accountability and direct control over our investments, particularly with more people on Defined Contribution pension schemes, the property digital twin can provide a low-cost opportunity to balance a typical equity/debt portfolio.
  • Substantially increase liquidity. Unlocking value from illiquid real assets and effectively doubling the market if every asset has a digital twin in the form of a token.
  • Enable faster, simpler and cheaper trading. Clearing and settlement of traded tokens are faster as they are fully digital with less intermediaries; costs are therefore reduced as intermediaries (brokers, bankers etc) are not required, and trading is able to take place 24/7 anywhere in the world by anyone.
  • Single Source of Truth. Trust is vital for markets to function and through using distributed ledger technology, such as blockchain and decentralised identity, transactions have immutable proof of ownership as a verified digital ledger cannot be altered. Both of the physical property asset and that of its digital twin. Securing transactions, verifying that a token is a twin and not leveraged and facilitating trust between buyers and sellers.
  • ESG Identity Scorecard and Certification. DLT will also provide an immutable record of the developer/construction company, history, and health and safety of a building. This is increasingly important in our ESG friendly world where environmental factors, such as building sustainability, energy consumption and carbon emissions, are increasingly a factor in the decision-making of investors.

The pandemic is unprecedented in many ways and the outcome remains unknown.

But for capital markets and real estate, it could be considered by financial historians a watershed moment with 2020 the year the true potential of tokenization was realised, and a new token economy born.

“An office is a place where dreams come true,” said Michael Scott in The Office (US).

Maybe for investors, that office is digital.

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