Blockchain technology offers the potential to address the sources of illiquidity discounts by accelerating efficient markets and price discovery, streamlining the transaction process, and facilitating instantaneous payments. The effects of these benefits will likely be further accelerated when it comes to commercial real estate, as the traditional formation of syndicates and other capital structures can be laborious.
The concept of illiquidity discounts, how it relates to markets like commercial real estate, and the benefits that tokenization could bring to the industry are topics that I have already discussed in previous articles. In this article, I am taking a closer look at the relationship between liquidity preference and the future demand for tokenized real estate investments.
Illiquidity discounts reflect the reduction in price that gets applied to an asset due to a shallow market and are particularly pronounced in real estate, sometimes reaching 30% to 50% of the asset’s true value. This occurrence is due to a number of factors, such as burdensome regulatory oversight, the unique nature of many assets, as well as the fact that most transactions take place in shallow private markets and that properties are often priced on an as-needed basis.
If this indeed becomes the case, then the next question is, how will demand for real estate – especially at the commercial level – change based on these more liquid markets?
In 1936, famed English economist John Maynard Keynes articulated his quantity theory of money in his book “The General Theory of Employment, Interest and Money”, whereby he divided the demand drivers for liquid assets into three primary categories:
In common vernacular, Keynes described how people need access to liquid funds to cover their daily expenses, fill a rainy-day fund, and keep some left over strictly to see if it may appreciate in value.
From this framework, Keynes theorized that governments could adjust the level of monetary demand based on interest rates in an effort to manage inflation and support broader economic goals. This is an interesting insight, and perhaps worthy of future study as blockchains seek to construct more sophisticated monetary policies.
It would be interesting to consider how Keynes’s quantity theory of money could impact the real estate industry and corporate finance in general.
At a very basic level, the job of chief financial officers is to ensure that their organizations have enough liquidity to cover daily and monthly expenses and invest whatever funds are left over to maximize returns.
In fact, this requirement neatly breaks down into three demand categories that align very closely with Keynes’s 1936 theory. Specifically, corporate entities need access to liquidity for:
The specific term often utilized to describe this balance is working capital management. Working capital typically consists of assets that can be converted into cash within a 12-month period. It is described in both gross and net terms – gross being the total value of all relevant assets and net being the remainder left after subtracting short-term liabilities, such as a firm’s accounts payable.
Typical short-term assets that qualify as working capital include cash on hand, accounts receivable, inventory (provided it is not too unique or illiquid), and certain highly liquid short-term investments. It is important to focus on what I mean by short-term investments, as these are considered to be “marketable securities” that can be directly converted into cash over a time frame of 3 to 12 months. These investments are typically listed on public exchanges and their sale does not have a major effect on the underlying asset’s spot price.
Today, there are many types of real estate investment ventures and funds looking to take advantage of tokenization, and one of the most relevant use cases are real estate investment trusts (REITs), some of which are listed on the biggest exchanges in the world, while others are public but nonlisted or private.
In general, a REIT is an entity that combines the capital of many investors to acquire or provide financing for a diversified portfolio of real estate investments under professional management. REITs are able to qualify as a real estate investment trust under the United States Internal Revenue Code for federal income tax purposes. REITs are therefore generally entitled to deductions for the dividends they pay and are usually not subject to U.S. federal corporate income taxes on their net income that is distributed to their unitholders. This treatment substantially eliminates the “double taxation” (taxation at both the corporate and unitholder levels) that generally results from investment in a corporation. REITs generally pay distributions to investors of at least 90% of their annual ordinary taxable income, making some types of REITs an ideal short-term investment. Furthermore, they focus on a wide variety of industries that pertain to real estate (commercial, residential, health care, timberland, malls, etc.).
According to the National Association of Real Estate Investment Trusts (NAREIT), there are about 1,100 REITs that have filed tax returns in the U.S., and collectively own more than $3 trillion in gross real estate assets across the country. About 20% of these are public REITs, which have registered with the SEC and trade on one of the major stock exchanges – the majority are on the New York Stock Exchange (NYSE). The remaining 80% is represented by public but nonlisted REITs, which are not traded on any national stock exchange but are registered with the SEC, and private REITs, which are not traded on a national stock exchange or registered with the SEC and often can be sold only to institutional investors.
The fundamental difference between nonlisted REITs and listed REITs is the daily liquidity available with a listed REIT. While some nonlisted REITs do traditionally offer limited redemption plans, for investors with a short-term investment horizon, listed REITs have historically been considered a better alternative.
On the other hand, nonlisted REITs can serve as a way for investors to deploy capital into a diversified pool of real estate assets, with a lower correlation to the general stock market than listed REITs. Additionally, listed REITs are subject to more demanding public disclosure and corporate governance requirements than nonlisted REITs.
The overall listed-REIT sector has been trading at all-time highs, with the FTSE NAREIT All REIT Index yielding less than 5% from Jan. 1, 2015 to Dec. 30, 2018. Such pricing suggests that a substantial portion of the price of listed REITs is attributable to a built-in liquidity premium, as recent unlevered capitalization rates on real estate transactions in the private sector have averaged 4% to 6%, according to the most recent publicly available report from CBRE, the U.S. Cap Rate Survey H1 2019 Advance Review.
While REITs are just one of many types of investment vehicles, and there is an entire galaxy of real estate ventures and investment funds looking to take advantage of distributed ledger technology, in my opinion, specifically nonlisted and private REITs may stand to reap the greatest benefits of tokenization.
So, what does tokenization potentially mean for the real estate sector? This industry, more than most, falls victim to the illiquidity discount, which can invalidate the sector from investment companies that need a certain degree of liquidity in their investments.
There are two general reasons why blockchain technology could be a key enabler that unlocks a new set of opportunities for investment firms looking to maximize the upside potential on their working capital.
Firstly, through the utilization of blockchain technology, conventional and highly regulated real estate investment vehicles (like REITs) can operate at unprecedented levels of efficiency by making programmable governance and built-in regulatory compliance possible on the platform and/or the security token levels, as well as by automating cap table and investor management processes. This will, at least in theory, lower management expenses and increase the profits that get returned to investors.
Secondly, the symbiotic emergence of digital security issuance and secondary trading platforms brings with it not only the possibility to significantly reduce (if not eliminate) the traditional counterparty risk and transactional friction, but to also make the underlying assets more liquid. This suggests that, in the future, nonlisted and private real estate investment vehicles (like private REITs) – which once represented a highly illiquid section of the market – may no longer have that unfortunate distinction.
It remains to be seen when – or if – tokenization will help traditional types of private real estate investment vehicles to qualify as viable short-term investments, but there is a good chance that they could receive this distinction, especially in local economies, thereby bolstering the overall demand for real estate investments.
One thing is for certain: The timing for this opportunity is auspicious. The outlook for the real estate industry in the U.S., Europe and other regions abroad remains positive. As long as the demand for residential and commercial real estate assets stays strong, it is fair to speculate that, at least at a macro-level, demand for tokenized real estate investments will only increase compared to other types of private equities.
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