Tokenization Of CRE In The U.S. Has Been Slow. The Pandemic Could Speed It Up
This year has been defined by economic disruption and volatility, shaking up the financial sector. Amid a global pandemic, a U.S. election year and an energy downturn, the U.S. dollar has depreciated in value since March, while investors have flocked to place their money in low-risk commodities like gold and diamonds.
Pressure has been mounting on U.S. banks, and more bank failures in the near term could put the brakes on traditional lending.
All of this could create more incentive for property owners to consider a different way of raising capital: offering digital securities in their real estate assets.
“It's no coincidence that Bitcoin was initially created during the last economic crisis, where the investment banks failed,” said Alexandra Levin, YK Law partner and co-head of the firm’s Emerging Growth & Technology Practice. "Now, I think it'll be interesting to see what happens with the real estate market."
Real estate is traditionally considered one of the most illiquid asset classes, requiring significant capital commitments and entailing long, expensive transaction processes. REITs were initially founded to address that problem, allowing more investors to gain access to the sector at a lower price point.
With the invention of blockchain technology and cryptocurrency, that concept can be pushed even further. Real estate tokenization involves creating a digital asset that represents a single property, or even a portfolio of properties, where investors can purchase a fractional ownership stake.
Security tokens have multiple benefits. Aside from making commercial real estate more accessible to retail investors, the process removes intermediaries, which shortens clearing and settlement times, reduces administrative costs and frees up collateral. Higher transaction security and transparency of ownership are additional benefits that make tokenization an attractive concept in theory.
But despite the positives, commercial real estate has remained relatively slow to adopt the technology. Levin said that for companies that are already established and have secure sources of financing, tokenization is less attractive because of the expense involved. Aside from the costs involved in mining and creating tokens in the first place, there are also significant due diligence costs on the legal side.
“If you compare where the industry was a few years ago, you're seeing a lot more institutions adopting this technology. It seems like all of the major financial institutions are on board. [But] I think that on the real estate side, it is a little bit slower,” Levin said.
“The issue is that the bigger players are more risk-averse. So why bother ... doing this pilot or testing the waters, which is not going to be a cheap process, when they're fine as it is?”
Though some CRE firms remain wary, other industry players see plenty of opportunity, particularly as blockchain technology becomes more normalized. Ed Nwokedi is the CEO of RedSwan, a commercial real estate tokenization platform. This year, the company launched $300M in security tokens for several Class-A multifamily properties and plans to eventually expand into offering other asset types on the platform.
Nwokedi, who worked as a commercial real estate broker for several years before founding RedSwan, said he got completely on board with the concept of security tokenization when the Securities and Exchange Commission issued an investigative report in July 2017, finding that digital tokens issued in the context of an initial coin offering may be securities, thereby falling under its jurisdiction.
“That was it for me because now I knew that the green light was in place for this technology to take off,” Nwokedi said.
Sabina Kalyan, the global chief economist and global head of real assets research at CBRE Global Investors, told Bisnow that at the margin, people in the sector are trying to explore the underlying technology and what it could do. But for the most part, her company and many other players are waiting to see if it does get adopted by the industry.
“To my knowledge, it's not hugely widespread, so it's hard to know how it behaves in practice. And I think, until it is a little bit more common, I'm sure there will be unintended benefits and negatives that we don't really know about yet,” Kalyan said.
So far, most examples of tokenization in the U.S. have involved single properties coming onto the market. While an investor would receive cash flow from that one property, they would also be very exposed to the performance of the asset, according to Kalyan.
She said that she could see tokenization taking off if people find ways to use the technology to provide access to a pool of properties, similar to a REIT, which would offer more diversification and therefore lower the risk attached to the return.
The regulatory environment in the U.S. is frustrating for many investors because it can be more stringent and restrictive than other countries, and regulators have not made it easy for innovation in the space, according to Levin. In addition, local governments largely regulate commercial real estate, and there is often little to no understanding of how tokenization works at that level.
“As long as there needs to be any kind of government involvement, whether they be at the county level or the federal level, I think it's going to be a bit of a struggle in the U.S. We are not traditionally quick to respond to innovation, as opposed to some other countries, frankly,” Levin said.
Levin said that the biggest challenge facing CRE tokenization in the U.S. is educating local regulators and authorities, particularly at the county level, where there can be very little interest in learning new kinds of technology.
“Unless there's a real budget for retraining, I don't really see a push, certainly from the county's role, for governments to adopt anything new,” Levin said. "And again, that's not just blockchain, that's really anything technologically new."
Kalyan noted that regulators need to devote more time and attention to understanding and clarifying how security tokens for CRE work, especially when it comes to tax treatment, because without that knowledge investors are less interested.
“That really does determine whether it becomes attractive for an investor in their portfolio, depending on [the] particular circumstances,” Kalyan said.
The other challenge is the risk that some private stakeholders see to their own professions, according to Levin. That could apply to commercial real estate brokers, who may be concerned that if tokenization removes all intermediaries, they would be out of a job.
As long as the U.S. continues to move slowly on adopting blockchain technology, Levin said it is likely that investors will continue to go overseas to other markets where the environment is less stringent.
“I just don't think the U.S. is as hungry for blockchain business, to be frank, as other jurisdictions,” Levin said. "And so until that happens, I think this is not for the faint of heart. I think we will continue to see an exodus to other jurisdictions."
Commercial real estate activity saw a major slowdown in 2020 as many investors and lenders opted for caution. Activity has begun to pick back up, but in some markets, significant damage has already been done.
Many prime office and hotel properties are sitting mostly empty in highly coveted markets like New York, Chicago and San Francisco as people continue to work remotely and avoid travel. More CMBS loans are distressed than ever, with many being sent to special servicing to mitigate the damage.
It's an uncertain time, and like the last recession, there may be new opportunities to arise from the fallout.
“Maybe tokenizing real estate may become more popular because people are having a harder time selling their properties or finding investors in their properties. The values have gone down,” Levin said.
Kalyan said that in the future, it could be possible for tokenization to start being used by conventional fund management institutions as a way of giving people efficient access to their products.
"I still suspect that there will be an aggregation of those investments into funds because they'll just be straightforward governance, and people will understand what it means for tax," Kalyan said. "But we're at the very, very beginnings of this. It's an exciting time."