The St Regis Aspen hotel boasts 179 rooms, a 15,000 square foot luxury spa, and terrific views of the Rocky Mountains on all sides. It’s a prestige venue by any measure, and apparently an attractive investment as well. Recently, a New York asset management group closed an $18 million digital token offering for a small share of the property, working with investors recruited through Indiegogo, a platform that usually funds projects like this fitness robot for pets.
The ICO gold rush has been dominated by utility tokens marketed as advance purchases of services and products from the sponsoring business. These sales were often labeled to avoid being treated as securities and thus regulated by the SEC (though the SEC is seeing through the spin and cracking down anyway). By contrast, security tokens are sold as equity or debt securities, and sometimes as rights to share in future profits or revenues. They are issued in compliance with securities laws and are more like traditional stocks. Compliant platforms have to satisfy know-your-customer and anti-money laundering rules. Issuers need to know whether buyers are qualified investors and may limit the number of investors involved.
“If you can create the financial infrastructure anyone can access through the internet, it is a massive equalizing force for the world."
Evangelists for security tokens believe they will open up financing for illiquid assets, from luxury hotels to fine art. Eventually, they imagine democratizing finance and brokering an open network for peer-to-peer securities trading across the globe. “If you can create the financial infrastructure anyone can access through the internet, it is a massive equalizing force for the world,” says Will Warren, co-founder and CEO of 0x, a protocol for trading tokens on the Ethereum blockchain.
For now, the pace of new tokenized security issues is slow. But real estate is a promising early area of activity, not least because the idea of fractionalizing property ownership is not new. REITs, which are like mutual funds for property investments, have been attracting investors since the 1960s.
“All property is a potential target,” says Josh Stein, CEO of Harbor, a San Francisco startup that claims to have several real estate deals in the pipeline. Harbor is also exploring deals in art owned by museums and shares in privately-owned sports franchises. Other startups are looking to tokenize future movie ticket sales. Harbor is one of more than 20 platforms launching security token offerings (STOs), according to Issuance, which helps market digital securities to investors.
Harbor has big name backing, including David Sacks, a cofounder of PayPal, who has invested via his Craft Ventures fund. “When we started Craft, we asked the question, ‘Can we raise our funds through an ICO?,’” Sacks, who is also chairman of Harbor, says. “The short answer was ‘no’ because of compliance. That sparked the next question: ‘What if you could solve the compliance challenge and do a legal ICO on the blockchain? That’s when the idea for Harbor was born.” (Harbor gets its name from the legal term “safe harbor”—which means an exemption from laws or regulations.)
Stein, a former federal prosecutor, has plenty of legal expertise. He was general counsel for several companies in defense and aerospace, health care, and insurance, all highly regulated industries. He also led the legal team at Zenefits as the HR startup was fined by the SEC for misselling insurance (Stein came in after the scandal broke).
Companies that raise capital from security tokens can unlock liquidity and keep their new capital even when investors sell their tokens.
Stein argues that security tokenization can unlock new capital for real estate, even as investors sell on their token holdings in secondary markets. “Our mantra is lock up the capital—not the investor. Real estate is a great example of that,” he says.
Stephen McKeon, assistant professor of finance at the University of Oregon, thinks tokenization also can lower the cost of capital for real estate because it reduces the so-called “illiquidity discount.” Instead of a small number of investors charging a premium as a price for locking up their dollars in a project, developers can go to hundreds of investors who are likely to charge proportionally less for their money.
If a property company is looking to raise $100 million, four investors usually might put in $25 million each and negotiate a private stake in the business, Stein says. Each of those investors is likely to extract a premium on their money, not only because of the size of their investment, but because it is locked up in the transaction. If, on the other hand, the same $100 million real estate project tokenizes a portion of its real estate capital through a REIT, it can have a maximum of 2,000 investors. That means each investor puts up $50,000, reducing the leverage of individual investors to demand bonuses on their money.
Harbor works with up-and-coming real estate stars who have not yet made a name for themselves. “Everybody starts somewhere. Barry Sternlicht was not Barry Sternlicht early in his career,” says Stein. Hotel magnate Sternlicht is the founder, CEO and chairman of Starwood Capital Group and chairman of Starwood Property Trust, the nation’s largest mortgage REIT.
REITs are a popular way of investing in real estate. At the end of 2017, there were 222 REITs in the US with a market cap of $1.13 trillion, according to the National Association of Real Estate Investment Trusts. NAREIT estimates 80 million Americans own REIT shares through their retirement savings or other investment funds. REITS for commercial real estate are particularly attractive.
Given all the bad publicity around ICOs, potential issuers and investors are likely to be skittish about STOs until deals have delivered promised returns. McKeon reckons investors who made money in crypto, and are looking to diversify their portfolios, are most likely to move into tokenized real estate.
“Family offices and institutions that were buying bitcoin two years ago are buying into some of these offerings. The technology doesn’t daunt them. They’re just going to evaluate it as to whether or not it is a good investment. If they don’t see an opportunity, they won’t come in just because it’s tokenized,” he says.
“They are not fully in the wild. 2019 will be the year for token exchange launches,” Reiss says.
Fintech entrepreneur Tory Reiss, founder of the TrustToken Platform reckons the industry will see liftoff next year. “These [platforms] are not fully in the wild. 2019 will be the year for token exchange launches,” he says. More platforms will attract more investors and more demand, which, in turn, will lead to more security token issuance, he says.
A year from now, McKeon expects 10-20 compliance platforms with some degree of secondary market trading (where original purchasers of security tokens sell on to other investors). As time goes on, more mandatory holding periods for tokens will expire, allowing more tokens to reach the market.
“The 800 ton gorilla in the room is the SEC,” says Stan Pearson, who heads North America blockchain consulting for Heyi Advisors in Greenwich, Connecticut. “Once the SEC makes a ruling and issues some regulations around this new asset class, people will feel like we’ve taken out the wild, wild west. That’s when the market will grow—and grow quickly.”
Main image: Wolfgang Moroder
Update: We clarified Stein’s role at Zenefits.