How Digital Securities Are Disrupting Private Real Estate Marketplaces
Author : Vladimir Estoup
Date : Sept 2020
A Bird’s Eye View: Real Estate as an Asset Class
On a global scale, real estate has historically performed similarly to public equities (7.05% vs 6.89%) (1). Not only does this asset class offer consistent returns with lower volatility, but in recent years, it has become relatively common to see real estate investments returning above 10%. Real estate as a whole tends to be quite cyclical — it goes up when times are good, and down when times are bad. On a more granular level, however, multifamily real estate is often seen as a defensive investment as opposed to the more volatile commercial real estate segment. The current low interest rate environment also creates the perfect landscape for the steady fixed income-like cashflow features of this investment. Historically, this asset class was reserved for property developers, wealthy individuals and institutional investors. But as fund managers and property developers look to pool capital from a larger group of investors, and individual investor platforms and options open up, real estate marketplaces are becoming increasingly prevalent in the private investments sphere.
The biggest barriers to entry in the real estate investment world are large ticket sizes and high legal and transaction costs. Investing in physical real estate can be extremely exclusive, especially in today’s economy. Individuals who want to finance their investments often need to undergo extensive credit checks and demonstrate material earnings or wealth. Further, the real estate market is relatively opaque, and information asymmetry can often lead to significant mispricing.
Real estate investment trusts were the very first iteration of a “solution” to the aforementioned issues. These funds essentially pool capital from public markets, and distribute the properties’ revenue to investors in the form of dividends. Investors can also profit from the assets’ appreciation. But investors are unable to pick and choose which properties and projects they want to invest in — their returns and risk appetite are left to the discretion of fund managers. In essence, REITs limit investors’ options.
Private real estate marketplaces, however, allow individuals to take a more selective approach to building their own portfolio, having more power over the way in which they allocate funds and vet property. Over the past decade, the most prominent private real estate marketplaces have produced an average yearly return of 12.16% (2), while the S&P 500 has averaged 10.88% (3). In terms of risk level, real estate is known for producing reliable, consistent cash flows, since most of the dividends come from properties’ rental revenue. Development deals can be slightly riskier, but usually yield higher returns. Debt issuings are also common in the real estate crowdfunding space, although more than two thirds of the offerings are classified as equity or revenue sharing.
Some of the top US real estate marketplaces have raised more than $1 billion and have distributed sizable cash returns to investors. See below:
The total real estate online marketplaceis estimated to be worth close to $90 billion, up from $80 billion in mid-2018 (4).
Benefits for Investors
With lower minimum requirements and greater granularity, real estate marketplaces are changing the way the average investor is able to allocate funds towards property. This is leading to a democratization of the real estate market. By choosing individual properties, investors are able to better accommodate their risk appetite. Since individuals directly control which properties are included in their portfolios, risk-averse investors can pick low-risk deals while risk-seeking investors have the option to look for higher risk profiles in exchange for higher returns. See below:
For each incremental unit of return, a risk-averse investor’s utility will increase less and less (diminishing utility). For a risk-seeking investor, it goes up incrementally. Since a public REIT is somewhere in between the two, both investors will be dissatisfied with the fund’s risk level. A risk-averse investor will not be compensated enough for the amount of risk they are taking, while a risk-seeking one will want higher returns than the fund can provide.
With private real estate marketplaces, investors are given a menu of projects, and they can pick the ones they find attractive at their own discretion. This allows for a more efficient distribution of risk tolerance, since investors can choose which deals they are most comfortable with, depending on their particular circumstances.
Although real estate marketplaces allow participants to invest in individual deals, investors may face single-asset risk (i.e. their investment is overly reliant on a single project). In order to successfully address this concern, marketplaces must encourage investors to build highly diversified portfolios. Crowdstreet, for instance, offers investors the option to buy into a custom-built portfolio tailored to their risk appetite. It is also important to curate deals as thoroughly as possible in order to minimize counterparty risk for investors.
There are challenges, however, when it comes to finding the most efficient way to streamline this particular investment process. Real estate marketplaces have to vet participants from various jurisdictions, as well as ensure that their deals offer full disclosure to investors. Furthermore, dividend distributions and transaction settlements are almost always manual, as they are generally done through outdated financial routes. Hence, there are tremendous opportunities for real estate marketplaces to leverage digital securities.
A New Market: Real Estate Marketplaces using Digital Securities
There is no doubt that a real estate investment platform of the future must leverage distributed ledger technology. These platforms have the ability to offer investors the same benefits as traditional real estate marketplaces, with the added value of digital securities. To date, there are around 16 real estate investment platforms using digital securities around the world. They are concentrated in the United States and Europe, but very few have their assets listed on secondary exchanges.
Some of these marketplaces (particularly in the Middle East and Europe) are multipurpose digital security issuance platforms that also feature real estate offerings. Some are solely dedicated to the issuance of real estate backed digital securities. As more issuers begin to tokenize multifamily properties, adoption of digital securities in the real estate market is likely to increase substantially over the coming year.
Digital securities provide an innovative solution to an outdated mechanism. By digitizing real estate, issuers are able to streamline the process for viewing holdings and analyzing asset performance. The concept of an online platform where transferable digital assets can be safely stored is set to transform the way people own fractionalized equity.
Broker-dealer networks are at the core of what makes digitization so important. Blockchain and distributed ledger technology provide the underlying infrastructure for transferability of digital securities. By creating a system that allows for the seamless flow of securities across platforms, broker-dealers are able to connect with each other and offer investors a wider array of assets. This enhances deal distribution by removing opacity in the market and eradicating the barriers between entities. Since investments are sourced online, the overall amount of opportunities available to investors is much higher than with traditional private securities.
Moreover, higher levels of transparency can result in lower barriers to entry for investors, due to more accurate security pricing and risk assessment as well as lower middlemen costs. In the future, Investors can gain liquidity by accessing licensed trading venues, significantly increasing the speed at which these private securities circulate and become accessible to investors.
Real estate marketplaces are at the centre of a trend in increased access to real estate investing and digital securities are the perfect vehicle to expand and accelerate that trend.
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- Source: Bundesministerium für Bildung und Forschung (BMBF) & Institute for New Economic Thinking (INET), The Rate of Return on Everything, 1870–2015, page 13, https://economics.harvard.edu/files/economics/files/ms28533.pdf
- Source: Investopedia, Real Estate Crowdfunding Sites, https://www.investopedia.com/best-real-estate-crowdfunding-sites-5070790
- Source: Macrotrends, S&P 500 Historical Annual Returns, https://www.macrotrends.net/2526/sp-500-historical-annual-returns
- Source: EY, Real Estate Crowdfunding, https://www.ey.com/Publication/vwLUAssets/Real_Estate_Crowdfunding/%24FILE/EY-Real%20Estate%20Crowdfunding-March%202019.pdf