How Blockchain Technology can make Commercial Real Estate Markets more Liquid

Commercial Real Estate has a liquidity problem.?

Illiquid investments tend to carry more risk than liquid investments. This is because holding a single security for a long period of time exposes the investor to several risk factors, such as market volatility, potential default, economic downturns, interest rate fluctuations, risk free rate fluctuations, etc. When investors tie up capital in a single security, they also incur opportunity costs of investing in other, more liquid investments.

Because of the added risk, lenders in the CRE industry have to charge a liquidity premium on the loans.?Furthermore, landlords are required to keep additional reserves in escrow to offset this liquidity challenge. Landlords therefore have capital tied up on their balance sheets which could otherwise be deployed into the market, earning additional returns.?

The root of this problem is access to data and the asymmetry of information between buyers and sellers of commercial real estate.??

To visualize this, let's think about how public equities trade vs commercial real estate assets.?Public equities trade on highly liquid public markets and exchanges. Price discovery of shares of stock is happening in real time amongst market participants.?This is because companies with publicly traded shares are required to report to the public on a quarterly basis and disclose all pertinent information related to their business.??

There is a much smaller gap in terms of the of information between market participants. Data is more abundant. Data leads to more shared information. More information allows for trust to be established.?Trusted data means buyers and sellers are able to draw conclusions about fair value faster. As such, public assets can trade much more frequently.

Real estate markets are not nearly as liquid because of these gaps in data and therefore information and trust amongst market participants.?

Blockchain technology can help solve this.??

Some background on Blockchain Technology?

We need to start with a little background on blockchain technology - I'll try to keep this brief and high level. Blockchain technology was invented when Bitcoin came onto the scene in 2009. Bitcoin was, and still is, the first proven use case for Blockchain technology.?It has achieved 100 million users faster than the internet and mobile phones. It also garnered a $1T market cap in half the time that Apple did it. Not too shabby.

Bitcoin has proven that blockchains work.

So how do Blockchains work and what does this have to do with Commercial Real Estate??

Let’s dig in.?

When Satoshi Nakamoto created Bitcoin, he solved one of the most difficult problems for mankind: The Byzantine Generals problem.?That is, the problem of establishing trust (so we can transfer value) between two parties that do not know each other, without a middleman or intermediary. Wait, what??

That’s right. I’ll say it again: Blockchain is a revolutionary innovation that allows for trust to be established between two unknown parties, without a middleman, so that value can be transferred.?The technology does this by utilizing computer code to execute smart contracts. The computer code enforces the law or a rule set.?Blockchains also gather, validate, and index data on a trusted, open and transparent ledger.?The blockchain itself is really just a distributed, transparent scorecard that stores and validates data. I may be a recovering accountant, but this still tickles my fancy. It’s a beautiful thing for those that appreciate clean, orderly, reliable data.?

The ability to execute smart contracts and store the data related to those contracts in a trusted, transparent way ultimately cuts out the unnecessary middleman.?The fee takers and paper pushers. It also reduces friction around gathering, validating, and indexing important data.?

Smart contracts are at the core of blockchain technology. A smart contract is just computer code that automatically executes and documents legally relevant events related to the terms of the agreement or contract. Again, smart contracts are computer code that enforce the law.?Smart contracts are not the law themselves.?

A nice way to visualize a smart contract is to think of a vending machine.?Vending machines do not require operators. No middleman. The consumer simply enters a code on the machine, pays the fee, and receives the desired drink or snack. B9 + $1.00 = Snickers Bar. If the vending machine was connected to a blockchain, the owner would have a transparent, trusted ledger of all transactions that have occurred. And we would trust the ledger because each transaction would have been approved by a network of decentralized computers. The network of computers would all agree that B9 + $1.00 = Snickers Bar. This is the power of blockchains.?

Let’s talk about trust.??

I went to the grocery store yesterday and I picked up some organic vegetables.?I trusted that they were organic because the label said so.?But how can I verify that??I can’t.?I have to trust that the farm they came from is true to their word.??

Now imagine if there was a trusted, immutable ledger of data underpinning my organic vegetables? The data would validate that the farm used proper seeds, clean water, and avoided the use of pesticides. Hmm.

This may not seem like a big deal to you.?But let’s try to think about the major trends we are seeing today. The big moves. The move to digital.?Data will be absolutely critical in a world where ownership of physical assets is represented by a tokenized, digital twin. Trust is key. Blockchains establish trust in the digital world. They can do this by gathering, validating, and indexing data underpinning real assets over a decentralized network of computers.?

Let’s talk about friction.

Let’s say you want to send a wire from a US bank to a bank in Italy.?It will likely take 2-3 weeks for your funds to arrive. Why? Because your bank doesn’t interact directly with the bank in Italy. The funds will have to travel through 15 intermediaries on their way to the Italian bank before the transaction is settled and cleared. Because these payment rails between banks are not interoperable, the wire will take weeks to settle, and will incur high transaction fees.

Enter blockchain technology.?

What if you could just send the funds directly from a digital wallet address on a blockchain directly to the recipient? Peer to peer. No middleman. Instant and final settlement. Cheaper, faster, more secure.?

How does that sound??

With blockchain technology, we can transfer value peer to peer. We can do it with instant and final settlement. With no middleman siphoning fees and slowing down the transaction. No friction. And we can store the data related to the transactions on a distributed, transparent, validated ledger. Hmm.???

But how do I know the value was received and the transaction is secure? Again, because we can validate it ourselves on the blockchain. I don’t have to trust anyone or anything.?I can simply look up my wallet address and see that the Bitcoin left my wallet and was received in my counterparties wallet address across the world. I also know that thousands of computers around the world validated that the transaction met the requirements of the protocol and recorded it on their ledgers. That’s how we establish trust. Hmm.

This is getting interesting.??

We’ve established that blockchains execute smart contracts while storing and validating data in a trusted, transparent, immutable ledger. This happens via a network of computer nodes validating the data and where it came from.?

In summary, blockchains allow for:

• Trust to be established for the transfer of value between two parties that do not know each other, without a middleman or intermediary
• Data to be gathered, validated, and indexed in a transparent, immutable manner
• Instant and final global payment/transaction settlement at low fees
• Frictionless transactions and data capture
• Increased network security since there is no central point of failure

Let’s talk about Commercial Real Estate.?

As we’ve noted, commercial real estate is an illiquid asset. That is, a building cannot be easily sold and converted into something more liquid and tradeable (like cash). For this reason, most commercial real estate assets fall under FASB 157 as a level 3 asset. Level 3 assets are financial assets and liabilities that are considered to be the most illiquid and hardest to value. There is a fundamental information asymmetry between the owner of a commercial real estate asset and a potential buyer of the asset. Real estate assets are not traded frequently, so it is difficult to give them a reliable and accurate market price.?We can contrast this with highly liquid public markets - information asymmetry is much tighter due to the disclosure and reporting requirements of public companies.?

When an asset is illiquid, a bank that has a loan collateralized by the asset must require a certain level of reserves held by the owner to compensate/hedge risk for the liquidity premium on the asset.?This means that many commercial real estate landlords have capital locked up as reserves on their balance sheet that could otherwise be deployed - to generate further returns, add liquidity to markets, and increase the velocity of money in the economy.

By utilizing blockchain technology, landlords can tokenize their assets (a digital representation of a physical asset), and use technology to gather, validate, and index all related property information underpinning the asset: Title to the property. Energy use of the property. Foot traffic at the property. Environmental data. The number of work orders requested by tenants. Audited financial statements. Security data. Capital improvement data. Building operating systems data. Leasing & occupancy data. This data will be validated and time stamped because the blockchain will record where it came from - for example, a financial statement from Yardi that has been audited by PwC.?

I think you get the point - the data establishes trust and reduces information asymmetry. When we reduce information asymmetry, we expedite price discovery amongst market participants. When we expedite price discovery, we make assets more tradeable.?We make markets more liquid.

Blockchains can allow real estate landlords to gather, validate, and index all related property data underpinning the asset. It also allows them to fetch relevant real world market data (via oracles used in conjunction with the blockchain). They can do this using zero knowledge proof - only giving away the permissioned, relevant property data for price discovery. No landlord would want sensitive, proprietary data on the market - but that data would be indexed, validated, and stored on the blockchain. Ready for due diligence and deal review.?

So what??

This allows landlords to not only record all of the relevant data on their property in a trusted, validated manner, but they can price their assets in real time. This means that we can now make an illiquid asset liquid. And that means that banks no longer have to worry about the liquidity premium. Landlords can free up capital that was previously locked on their balance sheets and get more favorable lending terms.?

Let’s use a real world example to explore how this solves real problems.?

Covid-19 was an absolute shock to commercial real estate. Practically overnight, businesses everywhere had to pivot to remote work. Imagine if you were in the middle of marketing a property for sale? The bid/ask spread on your property would immediately become quite wide. Price discovery would be lost. Buyers would not know how to price your asset. Too much uncertainty.?

But what if your asset had some feature that allowed for more foot traffic and in person work during Covid? What if it didn’t have as much retail exposure as other assets? What if it has high quality lab space instead of just offices? What if it’s energy use is much more efficient then other similar properties?

And what if you were able to easily commute these facts to the market? Blockchains can allow a landlord to do this.?

It’s all about verifiable data and trust. The data is trusted because it has been validated and indexed. The blockchain keeps an immutable record of where the data came from.?

So what does this really mean? What do future Commercial Real Estate markets look like??

The landlords that adopt blockchain technology will be able to move their assets from level 3 illiquid properties to level 2, liquid properties.?

This means that price discovery is more immediate. It means they don’t have to carry excess reserves in escrow to compensate the lender for the liquidity premium. Which means they can deploy that capital and increase their returns.?

It means that the “deal room” data is on the blockchain, and it has already been validated. It means you don’t need a war room of 10 attorneys earning $800/hour combing through documents during due diligence. You’ll still have attorneys, the process will just be streamlined and more efficient. It means that the transaction can happen much faster. Less friction. More efficiency. More trust.

And if securities laws follow this innovation, it means that you’ll see commercial real estate assets trading on liquid exchanges & marketplaces (and not only between accredited investors). It means LP’s will have a direct line of sight into what is happening at the asset and GP level. Waterfalls can be automated with smart contracts while fund administration costs are reduced. More trust. In a world of liquid, tokenized private real estate, we may see a basket of real estate assets in the Northeast trade as an ETF. Imagine traders being able to place bets (go long/short) on a basket of real estate in the Northeast vs the Southwest? Liquid markets. Financial innovation.?

When securities laws follow the innovation, it means that individual investors will be able to purchase small equity stakes in individual commercial real estate assets that they were previously walled off from.?This opens up additional liquidity for real estate development. It democratizes access for small investors.

Additionally, this allows developers to certify information related to a proposed project. For example, say a developer is collecting data regarding traffic counts at a proposed site, and they are able to certify and validate that data on a blockchain, in a non arbitrary way.?This allows the developer to go to a city or municipality with strong, validated data. If a proposal is rejected on the grounds of politics or some other capricious reason, the developer will have the data to make a legal case for their project. This speeds up the development process. It allows for construction lending to happen faster. It allows developments to be completed faster.?

It means that blockchain will help commercial real estate owners, developers, and investors win more.?

Conclusion

This is really just the beginning. We’re in the first inning, if that.?Companies like Inveniam.io are visionaries that are at the forefront of this innovation - helping landlords gather, validate, and index their data on a blockchain while creating a digital twin (token) of the asset. Landlords should take notice. Landlords with sophisticated tech stacks and smart building operating systems should especially take notice. Leverage your data. Use a blockchain. Tokenize your asset. Establish price discovery. Make your asset liquid. Deploy more capital.

And set yourself up to win.?

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