Professor Andrew Baum, Saïd Business School, University of Oxford
Tags: Proptech, tokenisation, fractionalisation, blockchain
Output type: Think piece
Target stakeholders: Institutional investors, retail investors, proptech entrepreneurs, property lawyers, government
"Classical opera cake slices" by PetitPlat - Stephanie Kilgast is marked with CC BY-NC-ND 2.0.
What’s the issue?
Hardly a day goes by without someone sending me a proposal for a tokenisation start-up. So far I have seen Bricklane, Bricklet, Bricknest, Brickvest and many, many others, focussed on the UK, the US, Latin America, Asia and elsewhere. There is clearly something highly compelling about a tech-supported proposal to split a property into smaller pieces so that anyone could get on the property ladder with £1,000 - and then using apps to trade that £1,000 for £1,100, instantly, for a tiny fee. This, and more, is the promise of tokenisation – defined by many insiders as the process of representing fractional ownership interest in an asset with a blockchain-based token. The combination of lumpy old real estate with defi and blockchain is just irresistible, especially if you are based in a country where the property ladder is hard to jump on and the legal processes involved are slow, arcane and (in extremis) corrupt.
In January 2020 Placetech publicised the flotation of IPSX’s first asset, The Mailbox in Birmingham, UK, the home of Harvey Nichols and the BBC’s Birmingham’s home, and one of the largest mixed-use property assets outside London, with 700,000 sq ft of shops, restaurants and offices. In the same month, it was reported that BrickMark purchased a prime commercial building from RFR Holding in Zurich in a share deal in which a significant part of the purchase price of around €120m was paid in BrickMark tokens. Are we on the front edge of a real revolution and the democratisation of real property?
Real estate suffers from illiquidity and lumpiness. If real estate assets were to be easily unitised, or fractionalised, this would surely improve the risk-return characteristics of typical real estate portfolios, while at the same time the liquidity of a typical asset would increase. However, it is not clear that all market participants see improved liquidity as a positive benefit without a price.
There are several ways in which a real estate asset can be (or has been) split into component parts, or fractionalised. These include splitting the freehold ownership between several legal persons; sub-dividing the building physically (vertically, horizontally or both, including strata title); creating a time share structure; creating leasehold and sub-leasehold interests; tranching, splitting the entitlement to income receipts from an asset between different people; and syndication.
However, there are several examples in history of failed real estate fractionalisation schemes, including modern crowdfunding platforms.
The key issue influencing or limiting fractionalisation is control of the entire non-divided asset. If a property is divided into 1,000 parts, who pays for repairing the roof? Who pays for maintenance of the elevator – does that include those on lower floors? What happens when the value of the whole is bigger than the sum of the parts and one person refuses to sell?
Intermediate ownership can in principle cope with any of these problems. This type of solution (using companies, limited partnerships, trusts and, in Germany, the KAGB law) is used in real estate syndications, debt and funds. It is claimed that tokenisation would be a better solution. It is hoped that by moving to the digital world promoters can avoid regulations; avoid tax; reduce fees; achieve disintermediation; speed up transactions; avoid public information being made available; exploit the efficiencies of blockchain; and enable crypto currency trades.
Connecting blockchain and real estate is by no means fanciful. However, the work needed to justify the digitalisation of data requires velocity of transactions, so that the use of a building – security passes, use of power, meeting rooms and so on, which is already fractionalised – is more likely to be tokenised than ownership. We already see utility tokens; but security tokens denoting fractional asset ownership are where the main action is happening.
The acid test lies, as ever, in economics. What capital investment is required to establish an efficient tokenisation platform? What will be the running and transaction costs compared to conventional fractionalisation? What demand will there be for the product, and will there be enough transactional velocity to amortise the development costs?
Security tokens will be regulated. There is room for regulatory arbitrage as Singapore, Switzerland, Lichtenstein, Luxembourg and many other smaller regimes make it as easy as possible to attract new business, but the major regulatory limitations will remain in place. Nonetheless, there has been a small number of single asset tokenisations.
The data implications of this for data availability are enormous. Imagine the Shard, 22 Bishopsgate, the Walkie Talk and the Cheesegrater each split into 100,000 units of £10,000 each. If those units were all traded in the primary and secondary market, we would begin to see real time pricing in the property market at last.
But to spread ownership more widely requires an intermediate structure – a company, a partnership, or a trust. This is likely to put the investment (a security token) into the regulated world, and it will limit the appeal of a small token. Market experts expect these instruments to have a significant bid offer spread, greatly limiting their liquidity, and to trade below par value. Is there really enough effective demand to buy units in buildings to justify this expense and overcome the risk of an untried platform?
The tokenisation of real estate funds, on the other hand, is the most natural of all real estate tokenisation endeavours. The property fund is already in an appropriate legal form and the investor base is already fractionalised; and the legal entitlements of the fund investors have already been established through a corporate structure or REIT, a trust, or a limited partnership, which is already regulated.
There are many committed evangelists and several examples showing the potential of the technology. To grow faster, the market needs broader adoption and understanding of the benefits and challenges of these new products, and the continued monitoring and reporting of new developments. It is better, in my opinion, to invest in blockchain-supported solutions to inefficiencies with a proven demand (such as funds) than to risk undermining the appeal of the technology by mis-applying it. Time will tell.