Tokenization of real estate: evaluating the promise of securitization

Disclosure: The views and opinions expressed herein are solely those of the author and do not necessarily represent the views and opinions of crypto.news editorial.

As it gains traction in the crypto industry, real estate tokenization is classified as a security in most jurisdictions with advanced financial regulations, such as the United States, European Union, United Kingdom, Australia, and others. In this article, I focus on the limitations of tokenization-securitization and explore why the concept of tokenization should aim to digitize property rights rather than penetrating the very heart of land records. In my previous article, I outlined the idea of ​​“land registry token” and the concept of a new generation land registry – blockchain real estate registry. Now let’s examine the promise of securitization to show why the digital economy will not advance without redesigning the system.

Traditionally, real estate was viewed as a valuable asset class but created challenges for small investors due to its illiquid nature and significant upfront investment requirements. It is widely believed that blockchain technology offers a promising solution through the tokenization of real estate. This common interpretation involves turning real-world assets into digital tokens that can be traded on a blockchain, thus breaking the asset into smaller, more manageable units. This approach is claimed to make investment more accessible and increase the liquidity of real estate as these tokens can be easily bought and sold in secondary markets.

However, although this type of tokenization has attracted attention, it is important to critically examine its limitations. The following review reveals the inadequacies of this model and underlines why a comprehensive redesign of the land system is essential to achieve meaningful progress.

Essentially, this tokenization represents securitization. A typical scheme authorized by a financial regulator involves the creation of a special purpose vehicle (SPV), such as a company or a trust, where tokens represent shares or units respectively. In rare cases, when tokens represent neither of these, such a security may fall within the broader category of “investment product” or “managed investment plan” that has been found in the regulations of many countries since the SEC v. Howey case in the US in 1946.

In economic terms, such a security is generally understood as someone’s promise to engage in some economic venture that may result in profit in exchange for cash. Therefore, there are two sides to this agreement: The side that promises something and the side that invests. To complete this picture, there may be a secondary market in which such securities are bought and sold between those who hold them and those who wish to purchase them.

When it comes to real estate economics, traditionally securitized properties represent a small portion of the overall real estate market. For example, as of 2023, the market value of publicly traded real estate investment trusts (REITs) in the United States was approximately $1.4 trillion; This equates to 1.3% of the entire US real estate value, estimated at $113 trillion.

Source: NAREIT, Statista, courtesy of the author

This disparity highlights that securitized real estate makes up only a small portion of the broader real estate market. The limitation arises from the legal nature of such relationships. Security is an economic interest in a person’s property (a promise secured by a legal instrument). The person holding the collateral is not the owner of the property. The security holder cannot benefit from all legal rights; hence its economic application is limited.

Security token etc. Title token: A real estate security token represents the owner’s economic interest in another person’s property. The title deed is the actual record of the title to property.

Starting with the first wave of tokenization in 2016-2017 (also known as the initial coin offering boom), there was irrational excitement around real estate tokenization, which was in line with the hype generally present in the crypto industry. Tokenization is associated with high profit potential from market bubbles.

Tokenization of real estate is advocated as a way to increase the liquidity of real estate. It is often explained that digital technology, along with fractionalization, will reduce barriers and make this investment more attractive. There is no doubt that having real estate as an underlying asset reflects the behavior of the underlying asset.

Real estate prices are not the same as corporate stock markets, where business expansion and innovation can skyrocket company shares. Generally, real estate does not fluctuate dramatically; Moreover, it is unlikely that the price of a building will increase quickly and other buildings around it will remain the same. Normally, the real estate market moves in a single trend with some minor differences from region to region.

The addition of publicly traded real estate investment trusts (REITs) makes sense. Investment trusts democratize real estate investments by reducing barriers, as they are shares of companies that own real estate that are traded on stock exchanges.

It is obvious that daily dollar volumes in REIT markets are much lower than in major stock exchanges. The average daily trading volume (ADTV) of the U.S. stock market is expected to exceed $500 billion in 2023, while publicly traded REITs generally see volumes in the $10 billion range.

Source: NAREIT, Russell Instruments, courtesy of the author

Additionally, REIT markets exhibit lower volatility compared to broader stock markets. This stability is due to the nature of its underlying assets (real estate), which generally do not experience dramatic short-term price fluctuations. Most importantly, public REITs move in line with the general trend in the real estate market. The performance of REITs often reflects broader trends in the real estate market because both are affected by similar economic factors such as interest rates, economic growth and property values.

So the general excitement around real estate tokenization seems more irrational. For example, it is unreasonable to expect tokenized properties to generate significant returns while the rest of the real estate market stagnates. However, it is reasonable to expect transaction costs to decrease with the digitalization of finance. Web3 and other digital technologies can make security markets more transparent and accountable, making some bureaucratic procedures unnecessary and obsolete. Therefore, the emergence of innovations can make the REIT market more efficient, provided the government reduces bureaucratic processes to unlock the potential of digital technologies.

Finally, let’s examine some empirical evidence that supports this argument. STM (Stomarket.com) is a popular resource in the world of tokenized real-world assets (RWAs). Similar to Coinmarketcap.com, it aggregates tokens, their capitalization, volumes and other important market data.

A closer look reveals how small the tokenized RWA market is compared to the cryptocurrency market. The capitalization of STM’s 465 listed ‘Real Estate’ tokens is $226 million, with a daily trading volume of only $1.7 million. For comparison, Coinmarketcap’s listing capitalization is $2.3 trillion, and the more than 8,000 coins and tokens listed on the website have a daily trading volume of $72.6 billion (as of May 14, 2024). Deloitte analysis points to more optimistic figures: According to their research, capitalization of $16.4 billion in 2022 is still 140 times smaller than Coinmarketcap’s list.

In summary, securitization is not a revolution and the speculative excitement around tokenizing real estate markets is far from over. Blockchain and other web3 technologies could make securitization of real estate more efficient if implemented with more progressive regulations. But since securitized properties make up only a small fraction of the entire real estate market, bringing efficiency to this small segment doesn’t make much of a difference.

In fact, all property rights, title deeds and legal interests are locked in state registries, that is, old-fashioned land registries with paper-based transactions and bureaucratic registration and title services. With Web3 technologies, economic relationships can become cross-border, online, instantaneous and peer-to-peer. Programmable relationships reduce the need for intermediaries—agents, lawyers, notaries, conveyancers, and other registrars.

The outdated system of registration is a bottleneck for the future of the digital economy, as all this potential efficiency collides with the old-fashioned stagnant system. The government’s inertia to improve the system, that is, to automate and digitalize, hinders the further development of the economy. In fact, the emergence of traditionally securitized and tokenized real estate is a kind of response to this inefficiency. However, as shown, it has a marginal effect that does not change the whole picture.