Real Estate Tokenization for Dummies

What is tokenization and why is it relevant for the real estate industry? To understand this, we need to look at bitcoin and blockchain.

Tokenization refers to the process of digitizing securities and representing them as tokens on the blockchain. The most common types of securities to be tokenized are company equity and debt instruments such as bonds. Once the security has been digitized and rendered in the form of a blockchain token, the security can be managed in a fashion that is quite similar to bitcoin and other cryptocurrencies (tokenized securities are also called security tokens, digital shares and digital assets). This has wide-reaching implications, such as the ability to store shares and bonds in digital format on your own computer or mobile device and the ability to trade these in a peer-to-peer fashion directly with the counterparty (but with no counterparty risk).

The blockchain has been described as a trust and value-layer on top of the internet. It is similar to the internet because it is decentralized and not controlled by any single central entity. It is also the facilitator of an enormous amount of new business models based on the digitization of trust and value. With blockchain, there is a trusted and agreed upon understanding among participants in a single ecosystem. This agreement encompasses who owns certain amounts of bitcoin, and who owns certain amounts of shares in specific companies.  This agreement also includes their value in relation to each other as a huge decentralized and anonymous share cap table. This trusted and agreed upon understanding does not require any centralized middleman to function; it is a built-in property of the blockchain.

In addition, blockchain has for the first time enabled a digital representation of value in the form of cryptocurrencies such as Bitcoin and Ethereum, as well as “normal” currencies such as USD, EUR and GBP in digital form. Blockchain is the first technology to solve the fundamental problem of double spending where it must be impossible to spend a digital currency more than once.  Therefore, it has been possible for the first time to create digital currencies that people can hold in their own digital wallets on their computers or mobile devices without relying on a bank or other central authority to safeguard it.

Why does this matter? The digitization of currencies and assets has made them programmable.  It is now possible for software companies to develop financial business models that are self-contained and not hindered, slowed, or rendered uneconomical through bank integration and involvement.

On October 31, 2008, the famous research article “Bitcoin: A Peer-to-Peer Electronic Cash System” was published. This article presented the solution to the double spending problem and enabled the digital representation of assets on the blockchain. Since 2008, the blockchain industry has grown from zero to around $237.1 billion in new realized value due to (1) the ability to safeguard your own digital assets, (2) the ability to safely transfer these to others in a peer-to-peer fashion with no bank involvement, and (3) the ability to manage and manipulate these digital assets through software programs (also called smart contracts). The consensus among industry experts is that we are still in the early stages of realizing the value of blockchain.  Analyzing where we are in this process, we can compare the time frame to the introduction of the Netscape browser (1995).

The growth of internet users vs growth projection of cryptocurrency users in the world. Source: Internet vs Blockchain Revolution: Are we in 1994? What to expect next? (Remi Gai)

You are probably still wondering why blockchain – and indeed tokenization – is relevant for real estate. There are several reasons. Real estate properties can be tokenized and it is typically done in two ways. Either the equity of the company owning the property is tokenized, or loans provided by investors to finance the property are tokenized. In the first case, each token refers to one share with regular dividend payouts. In the second case, each token refers to a loan note held by the investor that provided a fraction of the loan. The loan note entitles the investor to regular interest payouts.  The digital share further entitles the investor to a share in a potential profit when the property is sold; a loan note often does not give that right.

Real estate represents the biggest single asset class that may be tokenized. Global real estate is around $228 trillion and only 7% of this is available to retail investors. Only 3% of the global population has invested in real estate, but more than 80% views real estate as a good investment. Efficient trading with real estate assets does not exist today and increased liquidity could potentially increase the existing market with a 20-25% liquidity premium.

The real estate industry is plagued by slow, expensive, cumbersome, and paper-based processes relating to the financing and management of projects. Financing is often done by a bank and a few trusted investors able to meet the EUR / USD 100,000 minimum ticket size. Investors are locked in for several years and there is no easy or inexpensive way to sell shares beforehand.

Tokenization of real estate assets solves all of the above problems. Most processes related to financing and ongoing management can be digitized and even automated. Due to the 100x more efficient processes, it becomes possible to manage thousands of investors in a single project and hence to reduce the minimum ticket size down to $1,000 or even $100. This gives the real estate developer access to new types of investors and new sources of capital.  With the growth of the total amount of capital, the financing of real estate projects should become easier and less expensive.

Having real estate assets in a tokenized form allows for peer-to-peer trading with instant settlements. Real estate investors will be able to trade their digital shares or loan notes directly with each other in a safe and secure manner. Since the only way a security can exist in digital form outside a bank is as a token on the blockchain, this is the first time direct trading between individuals becomes possible. It only works with blockchain technology.

Last but not least, retail investors can obtain access to real estate investments. Real estate investors can now   diversify their portfolios in a manner that is similar to the method    wealthy investors have used for hundreds of years. This is also known as the democratization of real estate investments.

Tokenization of real estate enables developers to reduce the cost of financing and ongoing management, to target new types of investors, to more easily finance new projects, and to increase the liquidity of assets.

This is slowly becoming reality in 2020. Some of the last barriers to adoption are being removed. Knowledge and comfort with crypto is becoming more widespread. Software platforms are becoming easier to use to the point where little knowledge of crypto is actually required. Platforms that are tailor-made for real estate tokenization such as the DigiShares white-label platform are becoming better. Pioneers among real estate developers are taking steps to become entrepreneurs in their local region or market segment.  All of the different puzzle pieces in the new tokenization ecosystem are slowly falling into place.