How Blockchain Securities Enable Real Estate Owners to Optimize Their Liquidity
The commercial real estate industry faces a number of challenges, which are further intensified by COVID-19, particularly affecting institutional investors. RTX21, partner of the Frankfurt School Blockchain Center, offers a transaction platform providing a unique ecosystem for real estate on the basis of blockchain technology and the concept of tokenization. They key goal is to provide infrastructure and standards to tokenize existing real estate objects. The goal is not to provide a crowdinvesting platform for real estate objects. This is an interesting perspective as the focus then lies on standardizing processes and infrastructure and not so much on fundraising. With the help of blockchain technology, intermediaries, intransparency and fees can be reduced to create a fair market environment that meets the dynamic environmental requirements of the industry. — Authors: Ekaterina Bozoukova, Philipp Sandner
The world is in motion — and so is the commercial property market. In addition to market shifts and unclear future forecasts, questions about procedural and technical alternatives for project management and financing are becoming louder. Apart from topics such as crowdfunding, suburbanization and rent securitization, during COVID-19 many process-related questions play into the hands of the tokenization movement for commercial real estate with the help of blockchain technology. This article not only discusses the current situation as well as problems, but also introduces a leading provider and partner of the Frankfurt School Blockchain Center. With its innovative “tokenization as a service” concept, this should be of particular interest to institutional investors and property managers. We start by taking a look of the industry and its problems, before explaining the concept of tokenization in conjunction with commercial real estate as well as solution.
Current problems of the real estate industry and for investors
The commercial real estate industry is facing a number of problems, which will become even more pronounced in times of COVID-19. To begin with, there are procedural difficulties due to the high level of project-related financial movements and risky objects, leading to problem areas, which can be mitigated and improved with the help of blockchain technology. As is almost always the case, the larger the project, the greater the risk. Therefore, the perception of tokenized, platform-based liquidity management tools is particularly relevant within the institutional project scope.
First and foremost, many intermediaries are required for a real estate transaction or administration process. Amongst others, these include lawyers, brokers, financial institutions and asset managers. This can result in high costs for the owner and the tenant or buyer. With the number of intermediaries involved, the amount of time required for these processes as well as the organizational and processual frictions increase. It is also not guaranteed per se that the intermediaries trust each other, so that for many process steps additional tasks such as internal checks and audits are required to reduce the corresponding mistrust. Inefficiencies are therefore high on the agenda. This is where blockchain technology offers the greatest potential, because it is an efficient solution for creating trust and a world of transactions without friction.
In addition, there are difficulties resulting from the immovable condition and local dependency of commercial real estate properties. Natural disasters or construction delays for example, or even construction errors can have a direct impact on the liquidity of the project, especially if the above-mentioned procedural inefficiencies are added. Blockchain technology cannot help to mitigate the physical risks, but it can help to make the problem-solving process more efficient and effective from a cost perspective.
The third major weak spot of commercial real estate is directly related to the liquidity problem in atypical situations as mentioned before. Commercial real estate is inherently illiquid, which means that, for example, partial sales are economically unprofitable due to procedural or organizational hurdles alone, and in certain cases liquidation is not even possible. This is a major problem for asset managers who deal with commercial real estate. The concept of tokenization, one of the most basic mechanisms in the area of blockchain, can help here. We will look at how exactly this works exactly in the next section.
Blockchain-based tokenization of real estate
Blockchain technology enables the trading of digital assets, including tokenized shares of commercial real estate, on the corresponding markets, with the potential to turn traditional real estate financing and the processing of the associated payments and liquidity management upside down. Responsible for this: the concept of tokenization.
The concept of tokenization is used to convert rights to an asset (and this can be an analogue asset such as a property or a solely digital right) into a digital token. A Distributed Ledger Technology (DLT), mainly blockchain, is used for this purpose. In principle, rights of all kinds can be tokenized. These can be means of payment or securities, but also vouchers and guarantees as well as physical objects (e.g. real estate). The token embodies the corresponding right on the blockchain. It highlights ownership and the legal effect of the transaction so that objects, people and services can interact with each other efficiently and without friction in the token economy, as shown in Figure 1 below.
In the special case of real estate tokenization, the form of this token is a security token called asset token according to its real estate application.
Real estate tokens are equipped with register-like features that can map corresponding liquidity and ownership relations in the digital world and can thus support efficient day-to-day liquidity management of commercial property projects. With the help of these tokens, existing real estate objects or the financing structure of planned projects can be converted into digital tokens (“tokenization”). Classical real estate parameters are then recorded in an unchangeable data structure and managed on blockchain by an algorithm based on cryptographic mechanisms. In this way, it is possible to have the entire range of commercial real estate “dematerialized” into digital assets using blockchain technology — i.e. without a deed or analogue land register entry. Payments to the owners, e.g. rent payments from the tenants, could also be mapped in this way. Real estate tokens thus represent a further development of classic share forms (voucher-like deeds, land register entries, etc.). Tokens do not always have to be based on their own blockchain, but can, like the best-known example ERC20, be built as a token standard on an existing blockchain — in this case the Ethereum blockchain. An exemplary real estate tokenization process is shown in figure 2.
Exemplary process of a commercial real estate transaction
To make the concept of tokenization described above more tangible, Figure 2 shows an exemplary process of a real estate tokenization in a commercial context. To illustrate this, we showcase the process of the RTX21 platform, partner of the Frankfurt School Blockchain Center, one company among others which is tokenizing real estate.
First, the project is listed by the owner on the RTX21 token platform. These are typically pre-vetted portfolio properties with an entity value of at least 10 million euros. This does not necessarily have to be accompanied by the intrinsic motivation to cover the project exclusively with third-party capital in the future, but can also be taken as a preparatory measure to digitalize the project for the future. RTX21 securitizes the ownership for the real estate asset and conducts the transformation in tokens technically and organizationally. The project can now be divided and (re-) financed accordingly. With the help of the platform, it is made possible for primarily institutional investors to buy security tokens for different investments and to quickly liquidate commercial real estates. These security tokens are issued as Security Token Offerings (STOs) and are equipped with security-related features. With the help of security tokens, real assets can be converted into digital tokens. By tokenizing these assets, it is possible to transform tradable financial instruments such as real estate into fungible, digital assets on the blockchain. RTX21’s security tokens represent pro rata ownership of a certain property and/or concrete profit participations. The investors receive their pro rata profit share on a regular basis. Concluding, a holistic process without frictions and unnecessary transaction costs can be established with the help of RTX21 in a fully legally compliant environment.
Advantages of blockchain-based tokenization for asset management
Especially the current crisis painfully demonstrates the illiquid character of real estate to asset managers. The above-mentioned current problems in the real estate industry prevent the immediate and efficient creation of liquidity for institutional investors. Above all, it is important to significantly reduce the cost side and exploit all opportunities to generate liquidity and remain flexible. The experiences from the 2008 crisis show that liquidity is the decisive criterion for successfully getting through a crisis of this extent.
This is precisely where the tokenization of real estate creates the appropriate instrument for asset managers to create liquidity efficiently and cost-effectively, enabling institutional investors to access previously tied-up capital. The securitization of properties on a blockchain-based system enables tradability of partial ownership which in turn enhances the degree of liquidity of the asset itself whilst reducing associated direct and indirect marginal costs (e.g. transfer tax, brokerage and legal costs). The transformation of the previously non-fungible property into a liquid security de-risks the property’s capital structure by preventing real estate transfer tax previously resulting from partial exit sales. This also has an impact on the valuation of the property itself as the previously immanent high liquidity premiums on real estate are significantly lowered. Therefore, real estate is enabled to efficiently be liquidated, withdrawn without a penalty, or actively traded on a secondary market for the assets’ fair market value without liquidity discounts on the property. In particular, the emerging blockchain-based secondary market for real estate offers easy and cost-efficient ways to invest in real estate, holds the opportunity to enter and exit an investment at any given time and place without frictions, whilst offering an adjusted user interface for asset managers and their institutional investors to fully comply with their investment requirements. Consequently, institutional investors, but also financial institutions, will gain access to traditional and completely new asset classes in the form of tokens. Inevitably, regulatory compliance and technical security are of paramount importance for these products. Therefore, the custody of blockchain-based digital assets plays an essential role. This activity involves storing private keys necessary for the transfer, storage, and safekeeping of tokens. The third-party custody integration on the RTX21 platform offers institutional and retail investors solutions that meet their regulatory standards and technical requirements.
This is precisely where blockchain technology can show its full potential. In addition to the possibility of tokenization, there are a number of other advantages that will change the real estate market sustainably whilst making it more cost efficient and fungible. The decentralized approach of blockchain technology facilitates matching real estate owners and investors without the involvement of an intermediary. This is particularly beneficial for the purchase and sale of real estate assets, as the costs for e.g. the legal structuring and brokerage fees account for a significant proportion of the total transaction amount. Especially for partial sales, this is the fundamental prerequisite for their economically meaningful realization. Apart from the often high direct and indirect costs of a commercial real estate transaction, the participation of institutional intermediaries requires a considerable time to process. Through blockchain technology, real estate transactions can be securely executed within minutes — instead of several weeks or even months as is currently the case. This, in turn, is beneficial for the property’s degree of liquidity, as properties can be sold in their entirety or in part both swiftly and with minimum bureaucracy. The blockchain also creates greater transparency while at the same time removing costly intermediaries who currently facilitate a reliant market environment. Ownership and transaction data are accessible to all peers digitally on the network and are updated on a regular basis. It is stored in the distributed web and hashes are recorded to the blockchain. Property owners and investors are empowered with control of their information and have more confidence in conducting transactions.
Innovative companies such as RTX21 take a pioneering role in the creation of a digital marketplace for real estate investments, bringing together property owners, institutional investors and asset managers. With digital real estate trading platforms, these firms connect global investors with local real estate operators on a single-asset investment basis by enabling investors to move from top down portfolio-based strategies towards direct investment opportunities as well as personalized lot sizes and risk strategies. The application of blockchain technology creates the potential to digitize the entire value chain of the real estate industry, enabling all workflows to become more transparent, efficient and cost-saving. At the heart of this commitment is the tokenization of real estate ownership to create high liquidity of real estate investments and to create information symmetry within its primary and secondary market. Digital marketplaces for real estate facilitate transactions without recurring transaction costs (i.e. transfer tax and legal costs)and consequently create a fair and efficient transaction environment for owners and investors — associated with a high degree of automation, concurrent execution and low transaction fees.
The technological basis of the blockchain technology as well as the tokenization framework for commercial real estate of companies such as RTX21, have great potential to fundamentally change the real estate industry and to advance real estate investments for institutional investors. Particularly at this time, blockchain technology offers itself as a useful instrument for asset managers, in order to digitize asset managers’ portfolios and create liquidity quickly if needed, whilst still being able to actively participate successfully in the profitable real estate market. Besides solving the liquidity issue of the real estate industry, the tokenization framework for commercial real estate creates a fully transparent market environment for its stakeholders, reduces overall market and transaction cost as well as complexity and enables investors to move from top down portfolio-based strategies towards direct investment opportunities whilst offering investors the right management interface as well as supportive services.
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About the authors
Ekaterina Bozoukova is Chief of Operations at RTX21 since 2018 and has already gathered experience in two other startups she founded — one healthy system gastronomy and one real estate brokerage company. Before her entrepreneurial journey began in 2014, she worked at the Investment Banking Division of Deutsche Bank in Frankfurt for four years dealing with large cap mergers and acquisitions as well as capital market transactions. With years of entrepreneurial, corporate strategy as well as corporate finance experience, Ekaterina is one of the driving forces behind RTX21 becoming a one stop shop platform for the real estate investment industry. You can contact Ekaterina via mail (firstname.lastname@example.org) and LinkedIn.
Prof. Dr. Philipp Sandner has founded the Frankfurt School Blockchain Center (FSBC). In 2018 and in 2019, he was ranked as one of the “top 30” economists by the Frankfurter Allgemeine Zeitung (FAZ), a major newspaper in Germany. Further, he belonged to the “Top 40 under 40” — a ranking by the German business magazine Capital. Since 2017, he is member of the FinTech Council of the Federal Ministry of Finance in Germany. The expertise of Prof. Sandner includes blockchain technology in general, crypto assets such as Bitcoin and Ethereum, the digital programmable Euro, tokenization of assets and rights and digital identity. You can contact him via mail (email@example.com), via LinkedIn or follow him on Twitter (@philippsandner).