The Emerging Defi Capital Stack for Real Estate

The Emerging DeFi Capital Stack for Real Estate

Todd Miller - VP, Business and Partnership Development at ChromaWay

Note that this is a reprint of an article that appeared in the 2023 FIBREE Industry Report. The full report can be downloaded at https://fibree.org.

Introduction

Decentralized Finance (DeFi) is considered one of the key engines of the growth of blockchain networks over the past 5 years. Despite the bear market, today DeFi protocols boast more than $50 billion1 in total locked value (TLV). Decentralized Finance offers financial instruments for borrowers and lenders without relying on intermediaries such as brokerages, centralized exchanges, or banks and instead using smart contracts on a blockchain.

A new segment of DeFi has emerged referred to as Real-World Asset (RWA) protocols. Instead of providing liquidity to holders (typically via staking) of crypto-native tokens, these new generations of protocols provide liquidity for alternative assets like real estate, commercial lending, and invoice receivables. The revenue streams of these assets provide a source of return to debt and equity for investors. In addition, they may collaborate with decentralized lending protocols (e.g., Aave) to source additional capital for real-world asset projects. Maple, Goldfinch, Centrifuge, and Bloqhouse are examples of credit and SaaS marketplaces that serve as a source of alternative capital for real estate (and other asset types) projects through on- chain, transparent processes that combine tokenization and liquidity sourcing through DeFi protocols.

The paper will introduce readers to the mechanics of these RWA protocols and focus on profiles of projects in this space as well as use cases.

Industry Evolution or Revolution?

Perhaps one of the first real estate transactions “on record” can be traced to the Hebrew Bible (The Torah) where Abraham negotiates with Ephron the Hittite to acquire the Cave of Machpelah to bury his wife, Sarah. Ephron offers to simply “give” the field and the property, but Abraham insists on purchasing for the mutually agreed upon amount of 400 shekels2. While it is doubtful whether there was a Hittite Land Registry, commentators have noted that Abraham preferred to purchase the land to ensure it would remain in the hands of his family in perpetuity.

Today, there are a variety of methods for individuals to invest in real estate including owning property directly, participating in a property investment syndication as a limited partner, investing in a real estate fund or trust (e.g., a Real Estate Investment Trust or REIT), or purchasing shares in a real estate fund or project through a crowdfunding platform. Still, with only 10% of US households qualified as accredited investors (a requirement for most private offerings), investing in real estate is out of reach for most citizens. For borrowers (e.g., real estate funds or developers) looking for equity or debt to develop investable offerings, the search for funding can be arduous, time-consuming, and highly unpredictable.

Traditionally, real estate has been considered a highly illiquid asset due to restrictions on trading (via a lock-up period) and the lack of a secondary market. Illiquidity also stems from a lack of transparency and reporting around asset performance, particularly in private equity real estate. The fact that most private real estate investments are available primarily to accredited (i.e., wealthy individuals) investors further limits market participation and liquidity.

From the perspective of borrowers in search of funds, accessing the capital supply chain presents its own unique set of challenges. This is particularly true in the middle tiers where borrowers (e.g., real estate developers or funds) are looking for $50 million or less for projects. They typically must rely on structured syndicates, family offices, regional banks, and specialty lenders to secure debt or equity commitments. Particularly in today’s market with rising interest rates and post-COVID commercial real estate vacancy rates, these are typically hard-to- access fund sources – difficult to identify, stringent requirements attached, lengthy application and due diligence processes, and burdensome reporting.

So, can the tokenization of real estate – particularly in the private markets – solve the access, liquidity, and transparency problem for investors and the range of burdensome processes for borrowers? It’s still very early in the development of these capabilities, but initial prospects appear encouraging. Below we discuss some of the key mechanics behind these protocols.

1. The Blockchain:The Cap Table Goes Public

The high degree of “dematerialization” across all securities classes (including real estate) has led to “book entries” once managed by third-party intermediaries with physical paper certificates being replaced by digital registries. In fact, this “book entry” process is one of the legal foundations for storing digital shares on a blockchain or distributed ledger registry instead of, for example, in an issuer's private database with a broker or central securities repository.

To illustrate this, Figure 1 highlights how the Goldfinch protocol (developed by Warbler Labs) facilitated a $10 million raise from Addem Capital, a fund manager for asset-backed investments including real estate in Latin America. Investors in the raise could earn 17% using their USDC (stablecoin). Investors to the pool can easily check, in this case the Ethereum blockchain, to view settled transactions including transfers, withdrawals, repayments, etc.

2. NFTs: From Bored Apes to Representing Identity and Share Ownership

The use of Non-Fungible Tokens or NFTs has matured well beyond their initial use for digital collectible projects like Crypto Kitties and Bored Apes. A Non-Fungible Token is a unique digital identifier that is recorded on a blockchain and is used to certify ownership and authenticity. It cannot be copied, substituted, or subdivided. The ownership of an NFT is recorded in the blockchain and can be transferred by the owner, allowing NFTs to be sold and traded.

In the context of RWA protocols, NFTs are issued for investors and borrowers to represent their digital identity in on-chain financial transactions. In a standard workflow, once the user – whether an investor or borrower – passes KYC/AML or other business checks a token is minted (users of the Ethereum network may use the ERC-721 or ERC-1155 standard) enabling the holder (protocols can check user wallets to validate the presence of the identity token) the ability to participate in the borrowing or investing of funds for RWAs. As the ecosystem for RWAs grows, these NFTs should enable more frictionless issuance and exchange as identity tokens become potentially portable across projects.

NFTs are also being used to represent RWA ownership shares in specific properties. For example, let’s say that 650,000 shares (representing $650,000) are minted to represent fractional ownership in an investment property. The minted shares are recorded on the blockchain (i.e., the book entry) and allocated to the issuer’s wallet. As investments are made, the tokenized shares are transmitted to either the wallet of the investor or a desired custody agent.

3. DeFi Protocols: A New Source of Capital for RWA

DeFi protocols use smart contracts, which is code to automate the borrowing process, by calculating the loan terms, collecting the deposited collateral, and distributing the cryptocurrency being borrowed. Protocols like Curve and Aave specialize in overcollateralized loans, meaning that users will need to deposit collateral in the form of crypto worth more than the amount that they wish to borrow. This protects lenders from losing money due to loan defaults and allows a protocol to liquidate the collateral if it drops too much in value3.

Figure 2 illustrates how a RWA project establishes “pools” (i.e., investment funds) comprising real-world assets like real estate loans or SME lending to provide to asset originators. For example, the RWA protocol Centrifuge partnered with New Silver, a non-bank lender primarily focused on providing real estate-backed financing. The protocol allows New Silver to tokenize revenue from their real estate portfolio. An NFT representation of each of RWA assets is then committed to the blockchain, making both its authenticity and ownership verifiable. These tokenized assets can then be used as collateral for loans funded by the liquidity of investors that have deposited stable coins within the investment fund pools.

Lenders are participants who lock stablecoins (such as USDT, USDC, or DAI) in the investment pools to provide capital to businesses as loans. In return, investors earn a yield on the capital that has been provided to the asset originator’s projects. In addition, Aave Defi protocol users can also stake to the “RWA Market” (considered a “permissioned refinancing facility”). This provides additional yield for the collateral deposited via Aave by holders and greater liquidity to issuers of the RWA products. The permissioned facility is aimed towards institutional investors who must pass KYC, but can earn a return (~2%-3%) for providing an additional backstop in the event the RWA value drops and has to be liquidated. The yield is embedded in the protocol borrowing costs for issuers.

4. Bridging the Real and Digital Worlds:Programmed Compliance into RWA Tokens

A key benefit of RWA tokenization is the capability of issuers to design program compliance requirements into the smart contracts of the token themselves. This is an important feature; particularly given the real and digital asset worlds these protocols are seeking to bridge. Real- world property and financial investment products are accompanied by strict laws and regulations around ownership rights, investor qualifications, and reporting. The degree to which these requirements are ported into RWA protocols and processes will reflect directly on perceived risk, digital asset quality, and ultimate market value. The differential value of some “wrapped” equities on blockchain-based exchanges and their conventionally offered twins is a good example of the potential pitfalls of poorly executed offerings.

Unlike pure crypto assets, RWA purchases generally require KYC and AML checks on investors. Once these screens are completed, the “approval” can be associated with the investor identity NFT stored in meta-data fields. The approval can travel with the investor allowing other protocols to potentially interact with this investor without performing additional lengthy and costly checks. The digital investor management and issuance platform Bloqhouse has implemented a Real World Asset Token Protocol (RWATP) with ChromaWay which prevents token holders from exchanging the protocol with non-white listed secondary investors. The protocol also allows the “clawback” of tokens from, for example, unqualified or illegal holders. In addition, multisig wallets are used to ensure that issuers are protected from cyber hacks.

One additional note. Because the shares in these protocols are in the form of NFTs, they will invariably be presented on decentralized peer-to-peer marketplaces like Open Sea and Blur as illustrated in Figure 3. Because the token smart contracts enable the sale of the token to only approved white-listed investors, these exchanges provide additional visibility for the investment opportunity while allowing the issuer to maintain compliance with regard to only exchanges with qualifying eligible investors. Note that white-listed investor names are not stored on the blockchain, only their pseudonymous public wallet hash so privacy can be maintained.

Conclusion

DeFi protocols from developers like Aave, Curve, MakerDAO, and Compound have primarily focused on crypto native assets like Ethereum and the use of stablecoins like DAI, USDC or USDT. Typically, borrowers will lock their crypto as collateral in the protocol. In exchange, lenders will provide liquidity to the protocol in return for an offered interest rate. As described in this paper, a new wave of DeFi protocols backed by real-world assets is now emerging. Riding on the same public infrastructure as DeFi projects that have focused exclusively on cryptocurrencies and introducing scaled technologies from other blockchain verticals (e.g., games and digital art) like NFTs, these initiatives are working to close the gap between completely on-chain assets and those which exist in the “real world.”

There remain many challenges. Can securities like real estate investments be offered, recorded, settled, and traded on the blockchain within existing and emerging regulation? Will highly speculative crypto investors looking for high Annual Percentage Rates (APR) be willing to accept lower returns in return for less volatility? Will conventional investors in these traditional assets “crossover” to these digital assets given the still unfamiliar Web3 infrastructure (e.g., wallets, on-chain ledgers, etc.)? Will greater asset transparency, accelerated settlement, and the removal of intermediaries result in adoption by institutional investors? Though still in the very early stages of this innovation, the levels of investment, the sophistication of participants, and the quality of projects in this space point to continued purposeful and steady growth.

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1 Redman, James (February 2023), “Total Value Locked in Defi Surpasses $50 Billion Mark for First Time Since FTX Collapse.” Available at Bitcoin.com (Accessed May 31, 2023).

2 Francis A. Betten S.J., A Real Estate Deal of Four Thousand Years Ago, 21 Marq. L. Rev. 132 (1937). Available at: https://scholarship.law.marquette.edu/mulr/vol21/iss3/3

3 https://www.investopedia.com/what-is-aave-68361