Why tokenized funds is the next frontier of real estate investing

Why tokenized funds are the next frontier in real estate investing

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Real estate has long been considered an asset class well-positioned to benefit from tokenization. The question is: What is the best way to do it? Answering this question leads us to examine problems traditionally faced by those buying and selling real estate investments.

Consider why many investors are drawn to real estate in the first place. Among the key reasons: well, it is real. When you visit a property physically, you can see and feel the underlying asset. There is a kind of solid simplicity that comes with this physicality.

But physicality can be a double-edged sword. It limits the potential pool of buyers and lengthens the process of entering an investment. For a start, you must be interested in the property’s location. You or a proxy must then be willing and able to pay a visit, as part of the decision-making and due diligence process. This takes time and effort. 

In addition, a valuer also has to visit the property in many cases, before a deal can be closed, which, again, prolongs the timeline of the transaction.

A second barrier to entry, one that reduces the number of prospective buyers significantly, is the minimum investment. You can typically buy into a publicly-listed company for a few thousand dollars. But in many urban areas, even a small apartment will set you back to the tune of hundreds of thousands of dollars. Lowering this threshold is no easy task. 

For these reasons, real estate has always been somewhat hampered by slow, difficult and expensive transactions. Of course, this hasn’t stopped investors from loving and buying properties. In land-scarce, well-developed cities like Hong Kong and Singapore, real estate remains popular among individual investors who view the asset as a robust store of value that appreciates reliably over time as the economy grows. This is in spite of the transactional challenges they face.

The promise of tokenization

When tokenization — or the digitization of an asset using blockchain technology — entered the picture, there was excitement within the real estate sector. The benefits of tokenization seemed capable of resolving pain points that had long plagued property transactions. Tokenization generally makes trading an asset faster and cheaper — qualities the real estate industry sorely needs.

With the dust starting to settle after the initial buzz, it still isn’t clear if tokenization can indeed meet the high expectations of those who saw it as game-changing for the real estate sector. Can we really tokenize every house and apartment?

A key problem that tokenization solves for real estate is high minimum thresholds. The issuance of digital securities or tokens enhances the ease of servicing an asset, by automating actions such as yield distribution or ownership tracking. The technology therefore enables fractionalization, as it can serve a large number of investors who each hold a small share in the property or the portfolio of properties. 

However, the other quality that makes real estate transactions difficult — its physicality — is less easy to mitigate through tokenization. The fact that a property is located in a specific neighborhood of a specific city, and that visiting the property will take some effort, will continue to increase transaction time and limit the pool of interested investors.

Furthermore, fractionalization gives rise to another issue — that of collective action among the investors. When an individual sets out to buy an apartment, for example, he is by default the asset manager. He makes decisions on all issues, including the subsequent maintenance and tenancy of the property, as well as whether to sell it later on. 

If a hundred people buy fractions of the same apartment, the same decisions will have to be made, but that is now harder because decisions must be made collectively.

How tokenizing real estate funds would work

Having a fund structure instead would resolve many of the challenges confronting real estate tokenization because funds are designed to overcome collective action problems among investors.

With a fund, investors are delegating to the fund manager important decisions connected to the assets, such as maintenance and rent. Depending on the fund’s tenure and mandate, the fund manager may also be empowered to make bigger decisions around when and at what price to buy and sell properties as part of a portfolio in order to maximize the returns to token holders. 

A fund manager can also visit the properties physically to assess them on behalf of investors, which is an efficient way of mitigating difficulties tied to the physical nature of real estate.

In addition, funds tend to be designed with a more robust governance structure. If they are regulated, they will likely have to be audited and have to make disclosures regularly. Fund managers also have to demonstrate a good track record in order to attract capital.

Real estate funds are, of course, already being offered in smaller lots to individual investors — in the form of public REITs. This has been possible without tokenization because public exchanges do have the infrastructure to serve many investors. 

But tokenization can still play a meaningful role in fractionalizing private real estate funds, which are not easily available to individuals today. They are typically offered at a minimum size of US$1 million or more because of inefficiencies in the private markets. 

Private real estate funds tend to have a higher risk-reward profile compared to public REITs, and taking them on in the appropriate, fractional size can help investors build a more diversified real estate portfolio.

For the fund structure to work, though, there does need to be a minimum scale. Questions will therefore remain on whether tokenizing individual apartments or houses can be commercially viable. The fund structure only starts to make sense if many apartments or houses come together to form a portfolio of properties.

As more projects and ideas are experimented with, real estate tokenization will no doubt evolve further, and we may yet find innovative ways to bring the benefits of tokenization down to individual properties in a standalone yet efficient way. Until then, real estate funds are likely to be seen as more sensible targets for tokenization.

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