More than A Token Gesture – Tokenisation of Real Estate, Debt and PERE Funds
Being able to buy and sell land is a relatively recent phenomenon. In medieval times monarchs owned all land and granted it and took it back as they pleased (or as power politics at the time permitted). Real estate has improved as an investment class since then, but vestiges of old problems remain – real estate remains relatively illiquid, it takes several months to conclude transactions, large transaction sizes limits the pool of buyers (and buyers may be dependent on debt, which may suddenly not be available in a downturn) and transaction costs and transaction taxes remain high. Real estate investment trusts (REITs) is one approach the markets took to solve some of these problems, they allow fractional ownership and in Asia are tradable on stock markets. However a more radical solution is here – tokenisation.
Issuing ownership rights in a building in the form of digital tokens creates the possibility of fractional ownership in a building. It is a more focused asset than an interest in a REIT, which may be a share of ownership in several buildings and also a share of the debt taken on by the REIT. Tokenisation also offers the prospect of using technology to lower transaction costs. Direct fractional ownership and lower transaction costs will, if it becomes popular, improve liquidity and therefore asset values. There is value to be created by tokens.
How It Works
A typical approach is for an investor to be issued with a token embedded with ownership rights in the underlying real estate asset. The token is in digital form and the register of owners of the tokens are maintained by using distributed ledger (or block chain) technology. Block chain (famous for being the technology supporting Bitcoin) is well suited to this purpose as it does not require a central authority to manage the register of owners. The register will update automatically upon any transfer of ownership of the tokens and the transaction will be transparently recorded in the block chain. The tokens can then be freely traded on a secondary market.
The technology also allows other useful features. Tokens with different ownership rights can be issued. For example some “senior” tokens may grant the holders a priority right to receive income from the property and the other “junior” token holders will only receive income once the senior tokens have received the agreed amounts. These senior tokens, being much less volatile, will attract a different type of investor compared to the junior tokens. Attracting different types of investors will automatically widen the pool of potential investors and, other things being equal, increase liquidity and increase asset values. With embedded smart contracts these tokens will automatically pay out in accordance with the agreed set of rights, reducing long-term administration costs. This feature is also attractive to real estate funds, of which more later
Real estate tokens offer several distinct advantages over more established methods of investment in real estate:
- The ability to significantly lower the barrier of entry for investors.
By using tokens to fractionalise shares in individual properties, property owners can offer smaller investment denominations in real estate. This allows access to a much wider investor base, including retail investors, and by issuing tokens with different bundles of rights they can attract institutional investors who may not have been interested in buying the entire building but who may be interested in less volatile “senior” tokens or more volatile “junior” tokens. Embedded weighted voting rights or “golden” tokens can also allow property owners to retain control over a building despite having sold off the majority of the ownership (although there are accounting hurdles in getting the building off balance sheet if control is retained).
- The ability to drive down transaction costs and speed of execution.
Unlike traditional transactions, transactions in real estate tokens can be settled almost instantly, and in keeping with its securities-like nature, can be easily traded (assuming an active market) and do not lock investors into long-term commitments.
- Cost savings in the operation and administration of the fractional ownership model.
Tokens of different classes can easily be programmed with unique characteristics to identify the asset and rights afforded (e.g., priority to income, priority on disposal of entire asset and special voting rights). Transactions and payments can be made using embedded smart contracts which self-execute, reducing the long-term cost of maintaining the register of owners and managing fund flows and dividend distribution to each token holder. The use of block chain also provides for greater security and transparency – ownership and transaction records are recorded on a distributed ledger, protecting against fraud by the hacking of any particular ledger.
The most obvious use is to tokenise a single high-value building. This is a direct interest in the real estate so a purer investment than via a REIT or private equity real estate fund as there is no extra entity involved, so no debt or other assets at the entity level. It is just a slice of the real estate asset. And by varying the rights of different types of tokens more or less risky slices of that real estate can be created to cater for different investor appetites.
It is not just equity interests in real estate that can be tokenised. Tokens can also be used to represent an interest in a loan secured on real estate. Many of the same advantages apply, in particular the ability to offer smaller transaction sizes (the minimum bond purchase in Asian debt markets is typically US$100,000 to US$200,000). The nature of tokens lends itself particularly well to reducing the administrative and operational burden of managing multiple owners of assets, including real estate loans. The bond can be issued through the use of tokens, each representing an interest in the bond, and smart contracts can be programmed with information and terms. These smart contracts allow for automation of post-issuance events such as transfers and interest payments.
Private Equity Real Estate (PERE) Funds
PERE funds offer an interesting use case. Investments in them are notoriously illiquid due to their long lock-up periods (often several years) and lack of a liquid transparent secondaries market. By tokenising interests in the fund, it will, in theory, make it easier for limited partners (LPs) to trade interests in the fund. However, in practice, there may still be contractual limitations on disposals by LPs and tokenisation itself will not be enough to make the secondaries market more liquid given the nature of the underlying asset. However tokenisation may make it easier to administer funds with the relevant rights of LPs and the general partner to dividends and carried interest embedded in the relevant tokens.
As tokens are effectively a digital version of traditional securities they are governed by the existing securities frameworks in different jurisdictions. As such, security tokens are subject to securities laws and regulations in Hong Kong – in particular, a Type 1 (dealing in securities) licence will be required to market and distribute security tokens in Hong Kong or to Hong Kong investors. The Hong Kong Securities and Futures Commission (SFC) has classified security tokens as a “complex product” and restricted its offering to professional investors. New issues of tokens will require a formal prospectus to be issued, unless an exemption applies (for example, where the offering is restricted to professional investors).
Those that wish to encourage liquidity by setting up trading platforms for secondary trading of tokens will also require relevant securities licences, and, in addition comply with the SFC’s Terms and Conditions for Virtual Asset Trading Platform Operators, which stipulate operational requirements that such operators must meet (including, among other things, financial soundness, due diligence on assets to be traded and internal policies on the handling of client assets).
Other Risks and Barriers to Adoption
In any project involving tokenisation the technology itself creates a layer of risk. It will be essential to ensure that an appropriate technology partner is involved and that the infrastructure is in place to ensure that technology support will be available to ensure it all runs smoothly throughout the life of the tokens – which could be indefinite depending on the use case.
If smart contracts are used it will be important to verify that they implement the agreed terms accurately (for example, dividend payments) and that the technology service provider is obliged to fix any errors and, if necessary, enable others to do so, in particular in circumstances where the technology partner ceases or changes business.
A bigger barrier to the success of tokenisation is the classic chicken and egg situation with any new product that relies on the network effect to create the largest benefit. In this case the holy grail of increased liquidity will only come about if there is an active market for buying and selling real-estate-related tokens, and this will only happen if there are a large number of real estate projects, loans or funds tokenised. Progress may be slow until a critical mass is reached, and it will require support from the relevant regulators. Ultimately, new technology will drive new ways of trading and packaging real estate investments, but time will tell whether this form of security tokens will be one that takes off.