Investment in commercial real estate, and specifically the pooling of capital to acquire property has been around for thousands of years. In the United States, it became less popular because the Securities Act of 1933 made public solicitation of investments illegal unless registered and restricted under the Securities and Exchange Commission (SEC).

President Franklin D. Roosevelt Signs The Securities Act of 1933

With a much smaller network of potential investors to fund deals, syndicators relied on tax benefits to convince high-net-worth individuals (HNWI) and institutions to participate. For decades, U.S. tax laws allowed investors to depreciate properties over a very short period, resulting in high amounts of negative taxable income. This major benefit was sold to investors on a forward-basis, which made raising capital easy.

However, lawmakers passed the Tax Reform Act of 1986, which extended depreciation schedules and once again reduced a major source of equity for real estate projects. Additionally, lenders reduced available leverage, which further increased the need for equity financing.

President Ronald Reagan Signs the Tax Reform Act of 1986

Smart entrepreneurs like Sam Zell formed private equity funds to raise capital for commercial transactions, and in 2012, the Jumpstart Our Business Startups (JOBS) Act introduced multiple changes to SEC regulations that allowed public solicitation to specific investors.

Samuel Zell, Founder and Chairman of Equity Group Investments

Yet, access to most commercial real estate investment is still dominated by large institutional investors and UHNW individuals with the capital and connections needed to participate in these opportunities. U.S. Real Estate Investment Trusts (REITS) have been around since 1960 to give public market investors access to income-producing real estate, but these vehicles only give exposure to real estate without depreciation benefits or direct ownership.

Fractional Ownership at Scale

The latest development in the industry is the tokenization of equity in real estate deals, a process that is revolutionizing the way real estate assets are bought, sold, and managed. Fractional ownership, made possible by tokenization, allows investors to purchase and own small portions of a real estate asset in the form of digital tokens stored on the blockchain. These tokens are governed by smart contracts, which automate the management and distribution of revenue generated by the asset. Companies like InvestaX and RealT offer services for this.

The tokenization of equity in real estate deals is ushering in a new era of democratization and decentralization in the commercial real estate world. With the ability to break down real estate assets into smaller, more accessible units and sell them as tokens on blockchain platforms, true public ownership is now possible. This not only provides a more efficient and cost-effective way to raise capital, but it also increases accessibility to real estate investment for the average person.

Decentralization is an Illusion

The shift toward fractional ownership in the real estate industry has brought about the potential for decentralization through the tokenization of equity. However, this decentralization may not necessarily result in a more equitable distribution of ownership:

-Large institutional investors now have access to the market and can accumulate significant control, potentially diminishing the democratization that tokenization aimed to achieve.

-Due to the impracticality of giving every small shareholder a seat at the decision-making table, only a limited number of decisions will be available to shareholders. The power of decision-making will rest with the deal manager, typically a large institution.

-As equity liquidity increases, the negotiating power of shareholders will decrease. Management fees and profit splits favoring the manager will increase, which will reduce investor returns.

-Increased liquidity will make real estate markets more efficient, which will significantly reduce the potential for acquiring assets below intrinsic value. Shareholders will get to participate in cash flows, but may see less probability of equity upside.

-The best deals will not be tokenized. They will be quickly acquired by larger and more sophisticated investors and not offered to the public.

The decentralization of ownership through tokenization may paradoxically lead to a concentration of ownership, control, and profits in the hands of large institutional investors, and will lower return rates for shareholders.

My Prediction

BlackRock headquarters - the world's largest asset manager, with $10 trillion in assets under management

Final Thoughts

While tokenization is not inherently flawed, it is important to acknowledge the potential unintended consequences of adding liquidity to real estate. To avoid undermining the democratization of real estate ownership, a combination of technological solutions (smart contracts, decentralized autonomous organizations (DAOs), and regulatory frameworks that ensure a level playing field for all participants) would be necessary.

However, I don’t think even the most restrictive of regulations could stop the concentration of ownership by large entities. As we navigate this new paradigm, it's important to be aware of the possibility that the "decentralization" may not necessarily lead to a more equitable distribution of ownership.

Phoenix, Arizona

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