Commercial Real Estate is the New Liquid Asset
The blockchain and “tokenization” of CRE are taking off, bringing new liquidity to a traditionally illiquid asset class.
By Aaron Lohmann
As every seasoned CRE investor or lender knows, getting into a CRE investment requires significant due diligence and paperwork. Exiting an investment can be difficult if a recession strikes or if a property is outdated, poorly located, oddly configured or has other issues that limit cashflow and marketability. In fact, the illiquidity of investment real estate is why some investors stick to stocks and bonds.
With the potential to digitize and accelerate the CRE investment process, blockchain technology is poised to transform CRE finance. The blockchain not only stores transaction data in an immutable secure digital environment, but it can also support securities regulatory compliance.
Blockchain Comes of Age
Blockchain technology has been available for nearly a decade, but it is only now beginning to emerge as a major CRE industry disruptor. It originated as a means of backing cryptocurrencies by providing an indisputable record of ownership, which happens to be a very valuable capability for CRE financing too.
As the name suggests, a “blockchain” is a database of digital blocks of transaction data, each block timestamped and connected to the previous block via secure programming. Each data block is highly secure and impossible to alter or erase, making blockchain an efficient way to store transaction documents such as property deeds, mortgages and shareholder agreements.
Think of blockchain as a digital ledger. But instead of the digital ledger belonging to a single server and a single owner, it is replicated and stored on multiple servers all networked together. When a new data block is added to the chain, all the server nodes automatically update themselves to maintain identical copies of the ledger.
For example, if you used the blockchain and cryptocurrency to sell a CRE investment to a different owner, all the transaction data would be recorded in the blockchain ledger. So, there’s no human argument about who owns what share of a property or who has the final version of paperwork. All the transaction information is securely recorded and can’t be altered.
How is This Possible?
From its earliest days, blockchain technology has been advanced by software developers around the world. One important advance was the development of the digital security token, in which the token is programmed to represent a share of a debt or equity instrument. In recent years, software developers using the Ethereum blockchain platform created standards for a new kind of token that can be used to execute investment transactions in compliance with securities regulations—a major advantage for the CRE industry.
While many advocates of the blockchain have recognized its potential for different kinds of financing and investment, securities requirements have been an obstacle in the past. Today, technological advances make it possible to use a blockchain-powered platform to buy shares in CRE debt and equity instruments and trade them just as you trade stocks and bonds—and completely in compliance with securities regulations.
Specifically, Ethereum or possibly other blockchain platforms can be used to create security tokens that represent ownership in some kind of asset or interest. In the case of CRE investment, a security token could represent a 100% or fractional ownership interest in a CRE debt or equity investment instrument and would replace paper documentation of the ownership interest. And a token can have a built-in smart contract that will accurately execute the terms of the ownership stake.
Tokenization in Action
Imagine a partnership wants to raise $7 million in equity to build a senior housing community. It lists the project—and its associated market volume, current price, project location, market cap and more—on a digital platform backed by a blockchain. As an investor, you use U.S. dollars to buy digital tokens representing shares of equity in the senior housing project.
The token assigns ownership to you, just as a paper certificate represents the shares of stock that belong to the owner of the certificate. That is, your legal rights and responsibilities are embedded in the token in the form of data. Then, all information about the transaction is recorded on the blockchain. Since the blockchain is an immutable public ledger, no one can ever argue with you about your equity stake in the senior housing project.
And your digital tokens are programmed to include “smart” contract functionality that automatically distributes funds from the partnership building the senior housing community to you, a token holder, as the project advances.
Over time, you may decide you’d like to exit the senior housing investment. The beauty of security tokens is that, being digital, they can be easily bought, sold and exchanged—just like stocks. No more waiting around for the lawyers, appraisers, notaries, lenders and everyone else to do their part. Tokens with built-in smart contract capabilities will take care of all that and generate real-time auditable records that reinforce trust.
In Contrast…
Tokenization creates something that has never existed before: a secondary market for CRE investments. Traditionally, an investor receives a partnership or membership interest in the entity that owns or is developing a commercial property. Assuming the property produces rental income, you receive monthly or quarterly distributions. If you have an equity interest, you receive—ideally—a return on your investment when the asset is sold or refinanced with a permanent mortgage.
Either way, in traditional CRE investing, the investment is extremely illiquid. If you want to exit the deal, you need another investor or the project sponsor to buy out your shares by negotiating terms and entering into a contract. You may need permission from the managing partner of the ownership entity, and you need to submit paperwork to a transfer agent. It’s a lengthy process that can take weeks or months, involving endless emails, conference calls, documentation and constant confirmations.
Streamlining Across the Middle
While CRE will always have actual humans performing some transactional roles, investors trading tokens on a blockchain-based trading platform will have fewer reasons to call a lawyer or a broker. Instead, the trading platform will automate the critical tasks and record the results in the secure digital ledger.
The role of banks also will change on both the front and back ends of CRE investments. On the front end, a token-based trading platform would be a boon to banks and other institutional lenders and investors in search of CRE investments worthy of a loan or equity placement. Financial professionals can simply look at the array of tokens on a blockchain trading platform and purchase those that meet their lending or investment goals.
Soon, a CRE investor will be able to use a blockchain-based trading platform to access a range of CRE debt and equity opportunities involving nearly any type of commercial property. Investors will be able to use the platform to quickly trade tokens directly with each other, assured that their tokens will accurately allocate and distribute rental income and dividends on equity, direct payments to lenders, and execute any number of other financial tasks. Meanwhile, the company operating the trading platform can assume responsibility for certifying investors, vetting projects and ensuring that project information is available to prospective investors. While the technology working behind the scenes is complex, the front-end experience for project sponsors, lenders and investors alike is poised to become much more enjoyable—and empowering.
