Liquid Real Estate via Tokenization

A primary reason that real estate prices are so stable isn’t just the physical nature of the asset. It’s the barriers to entry and exit of the asset itself.

The costs of purchasing residential homes in Australia can be as much as 10 per cent for both parties once we factor into account taxes, selling fees and finance set-up costs. Most real estate is sold under a single title. Ownership is rarely fractionalised, unless it sits inside a REIT (real estate investment trust). Even then, access is limited to a share in a portfolio of real estate assets.

While this may sound like investor and cultural heresy in Australia, I’m not convinced it benefits our country that real estate, particularly residential, doesn’t rise and fall enough to reflect market sentiment due to its lack of liquidity.

This lack of liquidity is not related to the costs of acquisition and leasing that plague it. The real estate market is filled with extraneous inefficiencies. It is difficult to verify ownership, history of costs, revenue and maintenance. Much of the transaction data is opaque, obscured in paper trails requiring specialists to trace and share. There’s also a misaligned incentive structure of traditional financiers, brokers and agents to maintain the status quo. In addition, real estate transactions are often the result of non-economic decisions such as relocation, family size changes, death and divorce.

Tokenizing Real Estate

The idea that one day we’d be able to buy and sell shares of individual buildings has fascinated investors and property entrepreneurs alike for years. When cryptocurrency emerged, many believed that the technical solution had finally arrived. Leading cryptocurrency Ethereum is Turing-complete, meaning it has in-built ability for computation. Blockchains could provide the required infrastructure to create liquid markets for real estate, and potentially any other traditionally illiquid asset class. How this could be structured is through tokenizing assets.

What are Tokens?

For those unfamiliar with the term, "tokenizing" refers to the process where any asset and anything of economic value, be it property, a piece of art, a solar farm or a vintage car, can be split into smaller parts bearing equal rights. Similar to shares of a company, these tokens can perform many of the same functions without the need for a traditional corporate or operating structure underneath it. This act makes the financial asset ‘liquid’ through the use of such crypto tokens. The process can take typically static assets and allow multiple parties to own and trade smaller pieces of it. This can then create a more dynamic pricing and access to a multitude of asset classes.

Imagine we have a high-rise building worth $100 million. Normally, ownership would only be accessible to institutional investors and a REIT, or the building could be sold as floors and apartments. In a crypto economy, tokenization could come into play. While tokenization couldn’t work at an industry level, it could work at a single asset level. Essentially, the building could be ‘digitized’, by splitting it into smaller blocks that take the form of tokens.

The $100 million building could be split into 100 million tokens valued at one dollar each. The total token value would then represent the current market value of the asset – in the same way as a company’s market capitalisation. In a market like this, ownership of the building could be accessed by investors, speculators, or even its residents – all with minimal capital and transaction costs. The token holders would own a portion of the property. The asset would have a trading layer that represents a quasi-financial digital twin. In this case, the building would likely be owned by a DAO.

The tokens would then be recipients of the asset’s yield and capital growth, reflecting an accurate current market value, and invent a new form of asset liquidity. Acquiring enough tokens could also trigger mandatory ownership changes depending on the rules of the DAO. The process could significantly democratize traditionally illiquid markets and open opportunities for the next cohort of young investors.

Beyond Speculation

While seemingly biennial crypto booms and ‘winters’ tag the asset class as purely speculative, I’m a firm believer new markets will emerge that can reduce transaction costs and improve asset liquidity. That said, it could take a long time. Essentially, we’d need trusted, government-ratified exchanges, and a legal framework to facilitate this blockchain reality. While we have a way to go, it’s clear that many governments want to enable the blockchain economy, albeit while maintaining regulatory and protective boundaries. So far, the focus on distributed ledger technology has been directed at DeFi (decentralized finance) and NFTs. However, when bubbles burst and the speculators leave, the real work begins.

Token Gesture or New Reality?

The real estate example of tokenization is likely to occur, but it’s unlikely that we’ll see individuals en masse buying and selling tokenised shares of individual houses. Despite the legal and technical hurdles of small asset fractionalisation, finding the necessary market scope won’t be easy. To meet the definition of true liquidity, we need to be able to buy and sell an asset whenever we want, and without a single transaction moving market prices significantly. The technical ability to sell an asset doesn’t automatically provide ‘liquidity’. If there aren’t enough people looking to buy or sell a token of a building, we end up with an ineffective market. Transaction frequency is a necessary precondition for true liquidity.

This doesn’t mean tokenizing real estate is another crypto pipe dream. In fact, tokenization will invent entirely new types of business models. Some of the potential emergent market properties include:

• Fractionalised portfolios: Tokens would make small and direct-pooled investment possible, tailored to individuals’ insights and personal risk profiles. This is more challenging to achieve in a REIT. In a fractionalised portfolio, you could build a personal real estate portfolio comprising 20 per cent in New York City office space, 20 per cent in London residential, 30 per cent in Australian shopping centres and 30 per cent in Australian family homes.

• Tax policy: Tokens would make it possible to set and enforce new taxation policies that better align the long-term interest of investors, tenants and society at large. It could reduce barriers to entry and change the nature of property tax being largely regressive, as the major costs occur at acquisition stage.

• Better than reverse mortgages: Retirees could sell tokens that factor in future capital growth and a set price, so they could avoid reverse mortgages or the need to downsize during retirement. This also provides cashflow for living expenses and early access to people looking to enter the market. 

• Royalty streams: Another interesting case is inspired by the market for NFTs. In the same way an artist earns royalties every time their unique artwork is sold, why not a builder, architect, engineer or contractor receive royalties from their labour? This could allow people in the supply chain to benefit from capital upside just like speculators do.

Like all technologies, tokenized real estate could go either way. It could be a tool of emancipation for those locked out of the property market, or further exacerbate the advantage of those already in the system. However, as investors and people who care about access to housing and living standards for all Australians, it’s best to consider the potential now, so we have a chance at shaping possibilities before they arrive.