By Julio Gonzalez, Founder and CEO, Engineered Tax Services
In the Middle Ages, medieval alchemists dreamed of a magical object called the Philosopher’s Stone, which could change lead into gold. Well, today, we in the realm of real estate have at our disposal just as miraculous a tool—tokenization, which can transform an illiquid asset (like a real estate holding) into a liquid asset!
It’s Time for a Change: Brick & Mortar Goes Blockchain
Last year I came up with an innovative idea. Blockchain technology is disrupting capital markets through cryptocurrency—what if we harnessed blockchain technology to promote liquidity in real estate markets? As the founder and CEO of Engineered Tax Services, the nation’s leading specialty tax advisory firm that weds modern accounting methods with sophisticated engineering studies, I have over 20 years of experience in commercial real estate, and I believe in looking ahead.
To bring my dream into reality, I partnered with tZERO, a leader in blockchain technology for capital markets, which works to tokenize and trade digitally-enhanced securities securely. Its stated goal is “democratizing access to private market investments.” I collaborated with tZERO to bring tokenization to the accounting industry and its real estate clients so I could make next-generation real estate services available to the nation, just as I’ve done with cost segregation studies, 179D energy tax deductions, and R&D tax credits for a wide variety of industries.
Disrupting Real Estate Markets Through Digitalization
To understand how tokenization works, let’s first take a look at the traditional real estate landscape. Real estate’s status as a relatively safe investment has remained pretty much unchallenged. There’s a famous Mark Twain quote: “Buy land, they aren’t making it anymore.” The stock market might rise or fall, but real estate is eternal—people will always need a physical place to live and work. However, real estate transactions also tend to be some of the most complex and expensive, which makes real estate itself relatively illiquid.
In recent decades, securitization has been somewhat successful in making real-property interests easier to transact. But there’s a new method of engaging in such transactions that promises to go even further in transforming the purchase, holding, and sale of real property. It’s called tokenization.
Exactly what is tokenization? When you tokenize real estate, you create a digital securities ownership interest in the entity that holds and/or operates the underlying real estate assets. These securities use blockchain technology to make trading easier and safer for investors. (In the future, with regulatory reform, we could see an expanded role for blockchain in the lifecycle, including real time or near-real time settlement.) To make their holdings available to the public, an issuer can utilize a variety of blockchain networks, such as Ethereum or Telos. Digital securities are typically governed by a smart contract that’s programmed to be compliant with securities regulations.
Tokenization and blockchain have numerous advantages over traditional methods of dealing in real estate. Among these technological innovations are:
- Increased liquidity and transparency;
- Materially faster transaction settlement speeds;
- Reduced settlement costs;
- Enhanced security; and
- Simplified management.
How Does Tokenization Work?
By tokenizing real estate, you issue digital equity securities in a holding company that owns the real estate asset. You can easily structure digital securities to represent a variety of ownership and economic interests in an underlying asset. These interests can be:
- Equity in a company that owns the asset;
- An interest in debt secured by the real estate;
- A stream of income based on cash flows from the asset; or
- An interest in the capital growth of an off-plan project.
You can apply tokenization to a wide variety of types of the real property, including single-family homes, multifamily structures, office buildings, warehouses, retail spaces, timeshares, and everything else imaginable.
Several models of real-estate tokenization are already being actively developed, such as:
- Ownership of real estate through a special purpose vehicle;
- Shares in real estate funds;
- Investments in and loans to development projects; and
- Tokenized REITs.
Why Tokenization Is a Good Idea: Its Benefits
Here are some of tokenization’s outstanding advantages:
- Access to capital: Because property developers can fractionalize a property efficiently, more investors can participate, so more capital can flow into a project.
- More accurate pricing: The price of the asset will closely match its real market value, since illiquidity discounts will be significantly decreased. In the secondary market, potential investors can easily trade many assets at low fees.
- Real-time pricing information from the order books: Because you’ve eliminated paper-based systems that share data asymmetrically, investors can uncover better trading deals more swiftly.
- Elevated transparency: Since the blockchain-based system is regularly updated, investors can be informed of the underlying property’s value in advance.
- Reduced overhead expenses, faster settlement of funds: With tokenization, there’s no need for intermediaries such as brokers and agents, since you’ve converted the platform’s entire operations digitally and automated them.
- Portfolio diversification: Market participants can invest in multiple properties internationally and enjoy higher returns.
- Decreased opportunity for fraud: Investors can have greater confidence in the process, since no one can change a transaction recorded on the blockchain network.
- A collateral-backed investment: Since real estate tokens are financially supported by real-world assets (tangible property), they’re less risky than unstable cryptocurrencies or potentially questionable Initial Coin Offerings (ICOs).
- Constant oversight: With regular checks and balances that ensure stability, the security token’s value doesn’t fall below the real estate asset’s net asset value (NAV).
tZERO’s Real-Life Examples of Real Estate Tokenization
Now I’d like to discuss why my tokenization partner, tZERO, has been so successful in introducing digital liquidity to real estate markets.
First, tZERO digitizes securities by creating a digital capitalization table can be efficiently managed with an innovative smart contract. Then it offers a regulated trading platform through its regulated broker-dealer subsidiaries, where issuers can make their assets available for trading. (These securities aren’t purchased with or quoted in Bitcoin or another exotic cryptocurrency—only in traditional cash, although tZERO is working on regulatorily-compliant mechanisms so investors can convert their crypto into cash that the broker-dealer would then accept.)
Tokenizing real estate has many advantages. One is controlling liquidity. If you don’t want a certain party to own more than 10% of your security, for example, through set contracts, you can obtain tailored liquidity. You can also create a “sandbox” where only a certain set of investors are allowed to trade your security.
If you’re a real estate owner, you can digitize your building or real estate portfolio and sell shares in it as if you were a large public REIT on the NYSE. Recently tZERO has been seeing on its platform 30 times the historically balkanized and opaque liquidity of traditional private markets.
Here’s a useful case study. Last year, tZERO was approached by a luxury ski resort in the western United States that was interested in tokenizing its real estate assets. Last summer, it took tZERO less than two months to completely digitize the capitalization table for the holding company owning the real estate asset and onboard the holding company’s securities for trading. During the pandemic, this resort continued to maintain continuous automated liquidity, with market-driven pricing that was untouched by the dislocation some other publicly traded hospitality companies suffered.
Tokenization: The Future of Real Estate
Tokenization is yet another sign of how technology is revolutionizing the real estate profession. I see it as the democratization of access to asset classes. Now anyone with substantial assets—even collectibles!—can convert those illiquid assets into liquid ones and trade them on a regulated trading platform as if they were shares of Apple or Amazon. It’s a potential game-changer for capital markets — and I think it’s a startling new development that could introduce substantial liquidity to U.S. and international real estate markets.
