How Blockchain Technology Will Transform Real Estate
Every day on CNBC and Bloomberg there seems to be a heated argument between two pundits debating whether cryptocurrencies are humanity’s greatest breakthrough since the controlled use of fire was pioneered in the early Stone Ages or whether they are the biggest scam since Enron. There is growing consensus that even if some cryptocurrencies go the way of Enron or Pets.com, the underlying technology is here to stay, and will transform how commerce is conducted over the coming decades.
The underlying record keeping technology behind the networks for cryptocurrencies like Bitcoin and Ethereum is called blockchain. At its core blockchain is a digital ledger. Blockchain makes it very difficult, or even impossible, for any nefarious actor to change, hack, or cheat the system due to its near real-time settlement, distributed ledger, irreversibility of transactions after they are completed, and trustless environment that allows any two parties to transact directly with each other without the need for a third party.
According to a World Economic Forum survey of 800 global executives and I.T. experts, 57.9% of respondents believe that 10% of global GDP information will be stored on blockchain technology by 2025. [1] Like many industries, real estate is ripe to be disrupted and improved by blockchain technology. Blockchain technology in real estate can create new opportunities while simultaneously alleviating some existing challenges.
Tokenization
Real estate investing is restrictive. It is not really accessible to the vast majority of small-time investors unless a person wants to buy into a specific REIT. The limitation with REITs are it is hard to get hyper-focused exposure when buying into one.
For example let’s say a small-time investor believes that warehouses outside of Louisville, Kentucky are undervalued and wants to take advantage of this underpriced opportunity in this specific market. This investor cannot afford to buy a warehouse on their own and even if they could, they do not know how to operate one. They do know of a real estate investing group that puts these types of deals together for investors, but the minimum investment size in these deals, like for many private real estate syndications, is $100,000. This person only has $1,000 to invest.
Right now, this investor’s only option would be to buy a warehouse REIT, like Prologis or Duke. The challenge is that Prologis and Duke have large national portfolios, spanning a number of markets. This investor only wants exposure to warehouses near Louisville, Kentucky, in-line with their investment thesis.
Using blockchain technology a real estate investing group can tokenize singular assets relatively easily. For the warehouse example, a real estate investing group can raise equity through a tokenization. A tokenization turns real-life assets-such as bonds, artwork, and real estate and secures them into digital assets.
One of the advantages of this is that these tokens take previously illiquid singular assets and allow them to be easily traded on exchanges. It is similar to buying and selling a share of Apple on E-TRADE.
The tokenization of real property opens up a previously restricted asset-class to small-time and retail investors. Instead of buying a REIT, a small-time investor can add exposure to a single-property through buying a token that represents a pro-rata share in the equity of that asset. Through blockchain technology, investors do not need to buy a whole token, but can buy a fraction of a token, opening real estate single asset investing up to even more retail investors and furthering the democratization of property investing.
When an investor receives a token, they are entitled to their pro-rata share of the free cash flow from a property and their pro-rata share of that property’s appreciation or depreciation. Not only does tokenizing properties allow investors to take more nuanced positions that only institutional investors could previously take in the property market, but it also provides additional liquidity for property operators.
Property operators can easily buy and sell tokens on an exchange to either increase or decrease their equity position in an asset. This is a much more capital and labor efficient way to transact on property interests than having to deal with listing agreements, letters of intent, offer sheets, and closing documents.
Smart Contracts
The process of transferring property ownership is unnecessarily tedious, stressful, and expensive. In the simplest terms, sellers are reticent to transfer property ownership before receiving funds and buyers do not want to send money before receiving ownership of a property.
The result of this counter-party risk is that third-parties, such as lawyers, closing agents, escrow agents, and title agents are hired to draft contracts and facilitate transactions to make-sure that both parties abide by the terms of their written agreement. This is costly and takes sale proceeds away from sellers and limits the amount that buyers can bid for a property as they need to reserve funds to finance these miscellaneous costs.
Smart contracts can help to solve these issues, make transactions more frictionless, and save buyers and sellers time and money. A smart contract is a piece of code programmed onto a blockchain, which defines the terms of a particular transaction. Upon the receipt of a given input, the smart contract will execute and preform its assigned tasks. Smart contracts are self-executing and automated, thereby they are not prone to human error.
Smart contracts are similar to traditional contracts, but what has been commonly conveyed in sentences is written into code. When two parties enter into a smart contract, they automatically agree to implement that the terms expressed in the contract are met. This takes out the need for an intermediary in many cases. If there is a breach by either party, smart contracts can be coded to automatically pay out a noncompliance penalty to the party that is owed that money. Smart contracts do an effective job of taking out the risk that a nefarious buyer or seller may not execute on the agreed upon terms of a contract and can help to avoid years of potentially expensive litigation.
Smart contracts are also a useful tool for managing leasing agreements, property operations, and cash flows. From the start of a lease there are a number of payment and service transactions that need to be executed by the tenant and landlord. For example, a tenant and landlord can sign a smart contract. This smart contract would contain the rental value, payment frequency, tenant details, and property details. Per the terms of the lease, the smart contract would periodically initiate lease payments from the tenant to the landlord. When the lease expires, the same smart contract would trigger the payment of the security deposit back to the tenant. The advantages of using a smart contract over traditional property management methods in this example is the instant settlement of cash flows and accountability that both parties are held to without the need for human oversight.
While blockchain technology is still nascent, an interesting comparison is to where the internet was in 1970s or 1980s, it has the potential and is likely to reshape how many industries conduct business on a daily basis, including real estate. Not all parts of real estate transactions and investing will be automated, if not implemented correctly blockchain can actually increase costs and friction, but this novel technology has the potential to save significant time and money.
At the beginning of the 20th Century I could imagine it was difficult for carriage manufacturers to envision that a majority of the population would be using cars to get around. In the 1960s, it was likely challenging to picture a world where everyone worked in front of screens all-day. While today it might be tough for real estate operators and investing firms to foresee an industry that is built on the blockchain in a few decades, that very well could be where the world is going.
[1] “Deep Shift: Technology Tipping Points and Societal Impact”, Global Agenda Council on the Future of Software & Society, World Economic Forum, September 2015