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fractional investment in commercial real estate
Commercial Real estate investment is undergoing a paradigm shift with fractional ownership

Commercial real estate has always been a popular asset class for investors. It holds a long term potential for generating stable, passive income and guaranteed steady returns. However, the illiquid nature of the commercial real estate market, combined with the big-ticket, size and cumbersome administrative tasks have always been barriers for investors. But thanks to the technological upsurge, the real estate arena is experiencing a paradigm shift with the new-age platform of Fractional ownership. With blockchain-based tokenization, crowdfunding and fractional ownership, institutional investors are now diversifying their portfolio and smaller investors are realizing their aspirations of purchasing premium real estate commercial assets.

Challenges in commercial real estate investing

  1. Huge Initial Capital Requirement

The purchase of commercial real estate property requires huge capital. This creates a difficult barrier to entry into the market for smaller investors. Ownership of Grade A commercial properties such as office spaces and industrial properties require outrageous investment. Hence, the commercial real estate market gets monopolized by bigger, wealthier investors. Such inflated rates make it tough for investors having small or moderate budgets to purchase a property.

  1. Time-consuming process

Investing in real estate is a time-consuming process. Loan against property approval, due diligence, multiple entities, property management and paperwork- all elongate the overall process of investment.

  1. Illiquidity

Real estate is widely considered to be an illiquid investment. This implies that the money invested is usually tied up for a considerable amount of time. Further, the asset cannot be easily sold or exchanged. Even if the investor sells or exchanges the property, without a solid exit strategy, they incur a substantial loss in value.

What is Fractional Ownership?

Fractional ownership is the process where several unrelated investors purchase fractions of shares in a real estate property. This type of investment is common for expensive real estates assets like hotels, apartments, stadiums or others.

How does it work?

In this arrangement, a Commercial real estate property is listed online or advertised as open for sale and purchasing. Based on the total investment required, each property share is allocated a minimum ticket size. Here, investors can purchase just a percentage share or multiples of the same ticket instead of the whole property. This depends entirely on the budget of the investor or how much is he/she willing to invest. The investor then legally becomes co-owner of the property depending on the investment amount. Thus, they can own fractions of any high-value assets previously unaffordable for them due to multi-million dollars of down payment. 

The fractional owners can make personal use of their space and earn revenue when it is rented out. The amount of returns the investors are entitled to receive in the form of monthly rental payments or interest on the tenant’s security deposit again depends on the investor’s percentage of ownership. Therefore, fractional ownership paves the way for average/small investors to purchase a physical real estate asset. It helps them to enter the market alongside wealthy accredited investors.

Responsibilities of the Fractional owners

Usually, the pool of the fractional investors is managed by a property management company, or a central board or association. This ensures a coherent centralization of the property management and oversees that the unrelated owners operate without any dispute. The management is responsible for several tasks related to property management. This includes construction/renovation and brokering an eventual sale. However, in the absence of central management, the co-owners of the property are responsible for sharing property management tasks. These include bill payments, record-keeping, preparing an annual budget for maintenance and repairs, taxation and decision making.

In case of the presence of a larger number of fractional owners, there arises a greater need for electing a board of directors that holds most of the decision making powers. The presence of a central board prevents the cumbersome process of convening every co-owner for decision-making in the case of any emergency. Such fractional owners’ groups elect one or more entities who are responsible for signing and acting on behalf of the entire owner groups. These entities generally include a president, a secretary and a treasurer. The board is also responsible for ensuring all the co-owners abide by the terms met in the legal agreement. It also penalizes or charges the co-owner with monetary fines, if he/she violates the rules.

Options for Fractional Ownership

In the United States, there are predominantly two options for fractional ownership in real estate. These are Tenancy-In-Common (TIC) and Delaware Statutory Trust (DST). These two types of fractional ownership options are gaining immense popularity for being inexpensive ways of acquiring commercial real estate properties that generate higher returns than residential properties. 

Tenancy-in-Common (TIC)

Tenancy-in-common is an investment property structure where two or more parties share the ownership rights of a commercial or residential property. The independent tenants-in-common each own separate interests in the property, which may be of equal or different percentage. Also, the tenancy in common owners can leave their share of the property to any beneficiary of their choice. Further, they can also independently buy or sell their portion of the property. Hence, this arrangement is a classic example of purchasing a real estate property with limited capital.

Delaware Statutory Trust (DST)

Delaware Statutory Trust (DST) are legal entities that are created as trusts that allow each investor to own a “beneficial interest’ in the DST. This does not necessarily restrict itself to the state of Delaware. Investors in a Delaware Statutory Trust own a pro-rata interest in the trust. As a result, the investors become entitled to receive rental incomes or a share from the eventual sale of the property.  In this co-ownership system, investors enjoy the returns but are free from the responsibility of management. Hence, in a Delaware Statutory Trust. Investors can enjoy the benefits of a securitized real estate property with lesser investment amount, limited personal liability and no management responsibilities.

Why Fractional Ownership is the future of commercial real estate investment?

  1. Low Acquisition Cost

Commercial real estate is essentially a capital-intensive market, and often affluent investors dominate the market through crowdfunding or peer-to-peer lending. Mid-sized investors cannot afford real estate properties due to the high costs of purchasing.

However, fractional ownership changes this scenario. When a buyer purchases only a fraction of a property, he/she also has to pay just a fraction of the cost of the entire property.  This allows the entry of average-sized investors to purchase great properties with minimal investment.

  1. Lower Operating Costs

Maintaining a commercial real estate property involves complex operating costs such as property tax, utilities and maintenance. This consumes a lump-sum amount of expenses and effort on the part of the owner.

In a fractional ownership arrangement, the fractional owners share the cost of renovating, furnishing, landscaping and outfitting the property. Mostly, there are also property managers to supervise the maintenance operations.  Hence, this significantly reduces the cost and time of operating.

  1. Portfolio Diversification

The commercial real estate market is considered to be restricted to wealthy investors due to the involvement of a significant amount of capital and the risk of undergoing losses.  However, the fractional investment allows investors to expand their portfolio with diverse property types and asset classes, across multiple geographies with minimal effort and capital. This implies that, if a specific investment fails, other investments in the portfolio could still be performing well and secure great returns. As a result, such diversification reduces portfolio risks significantly.

  1. Passive Income Opportunities

Fractional investments enable investors to access higher-yield investments. In this model, the fractional owners can invest in a lucrative commercial property and then rent it out. Thus, they can amass wealth in the long run by procuring high rental returns every month based on their percentage of ownership. It is noteworthy that the regular rental income from commercial real estate properties is almost 2-3 times higher than the rental income from residential properties. According to Colliers International’s new Global Capital Markets 2021 Investor Outlook, 98% of investors aim to expand their portfolios in 2021, with 60% aiming to expand more than 10%, including 23% who want to expand by 20% or more.

  1. Enhanced Liquidity

Due to its highly illiquid nature, a large number of investors consider commercial real estate a bad investment. The money invested in the property usually gets tied up for a considerable amount of time, with no tangible returns. However, fractional ownership has no lock-in period. Therefore, investors can sell their percentage of the asset in a secondary resale market, at any point needed. This reverses the illiquid nature of commercial real estate properties and makes it an all-time advantageous investment for investors.

Blockchain-based tokenization for fractional ownership

Blockchain has been disrupting traditional business models for years now. Its distributed nature conveniently restores transparency, security and decentralisation back in any transaction. In the commercial real estate industry, it’s no different. Blockchain-based tokenization is disrupting the commercial real estate ecosystem by tokening real estate property assets. Further, it eliminates various procedural difficulties such as the presence of intermediaries, illiquidity and high costs of entry.

What is Tokenization?

Asset tokenization refers to the process of converting physical real estate properties to blockchain-based digital tokens. These tokens represent a particular number of shares os a property. The investors can then purchase these tokens, with minimal capital and be direct fractional owners of the property without involving in asset appreciation or cash flow. The investors, as fractional owners also get the full authority to sell these tokenized shares further, as per their convenience.

Process of tokenization

Real estate tokenization follows a five-part procedure by the seller:

  1. Asset identification- identification of the commercial real estate asset which involves the processes of its acquisition, financing and appraisal. The owner can choose to tokenize the property itself, or a mortgage of the property or a right to share in the revenue generated by the property. The nature of the interest directly applies to the type of regulations that will apply to the token;
  1. Smart Contract formulation- the formulation of a smart contract that defines the token’s characteristics and the process of its sale. Further, these smart contracts should comply with securities laws;
  1. Token creation- determining the number and size of the issuable tokens. This step also includes the selection of the blockchain for the token creation and the nature of the data and transfer restrictions in the token;
  1. Token Distribution- confirming the investor accreditation and advertising of the offering by listing of the digital token on primary issuance platform through security token offering (STO);
  1. Post-listing support- ongoing support for investors and distributing profits or other rights to payment. 

Benefits of Tokenization

  1.  Increases Liquidity

Tokenization not only permits sellers to sell the assets directly to the investors through security token offerings but also enables the investors to trade the assets on a peer-to-peer basis on a secondary market. This reduces the illiquidity of an asset and also brings its executable price closer to its actual value. 

  1. Improves Speed

Blockchain-based tokenization improves the speed of investment transactions for all parties. This is due to the formulation of smart contracts that increasingly automates the primary aspects of the exchange and distributions. As a result, this reduces the cumbersome administrative costs and improves the speed of the settlement. 

  1. Eliminates intermediaries

Commercial real estate property trading involves multiple external entities in the form of intermediaries. These third-party intermediaries take care of multiple aspects of the settlement, ranging from validating the transaction documents to identifying the eligibility of the investor. Hence, the transaction process transpires an additional significant expense of intermediary charges and also elongates the process unnecessarily.  However, with tokenization, there remains no need for such intermediaries, which accelerates the deal settlement at a much-reduced cost.

  1. Enhances Transparency

The use of blockchain in a commercial real estate transaction stores all the data ranging from the rights of the fractional owners, limitations and property information.

All the transactional parties can access this information in real-time. As a result, there is little room for asymmetric information from neither parties. Further, the distributed nature and immutability of the blockchain records every transaction. Therefore, it becomes impossible for a token holder to “double-sell” a token or accept a transfer for the same token from different parties. Blockchain also embeds a token with both the smart contract terms algorithm and an immutable record of each token’s ownership. Hence, the property transaction becomes increasingly transparent from every aspect.

  1. Cost-effective

With the use of smart contracts, blockchain reduces the need of various costs generally incurred in a real estate transaction, ranging from intermediary charges to due-diligence costs. Also, smart contracts automate the property transference without the need of any intermediary. The self-executing software algorithms of smart contracts implement the terms automatically, thereby eliminating the need for individual negotiation and reducing the cost of the transaction. Further, tokenization-based fractional ownership also helps investors to purchase fractions of a real estate asset within a confined budget. It also helps the investors to trade and transfer the rights of their share of the property on the blockchain platform. Since, the property is represented digitally on the blockchain, the transfer and reselling of the tokens become easier. Therefore, it helps investors in getting quicker returns on investment.

  1.  Expands the Investor Base

Tokenization enables commercial real estate property owners to fractionalize their asset through a blockchain-based platform and offer smaller investment denominations to interested investors. This, in turn,  maximizes the market access for a wider range of investors. By facilitating purchasing a commercial real estate asset with minimum investment amounts, tokenization reduces the barriers of high entry cost in the real estate market and allows smaller and medium-sized investors to enter the market with a real asset. Further, the digital representation of a property on a blockchain platform allows a diverse range of global investors to purchase, hold and trade cross-border properties more seamlessly. This also helps the property owners to expand their base of trading partners and increase the overall trading volume.

Conclusion

With rising costs and diminishing incomes, investing in commercial real estate properties is a far reaching dream for average investors. However, with the fractional ownership and blockchain-based tokenisation, the chances to own a commercial property with minimal amount is no longer a dream for mid-sized investors. Fractional ownership also allows owners to unlock crowdfunding opportunities for their property. Hence, fractional ownership is a revolutionary step in the commercial real estate investment arena, which is expanding the boundaries of the market and increasing the trading volumes significantly.

References

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Prabali Chattoraj
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