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8 min read

Reimagining the Capital Stack for Tokenized Real Estate

Published on
October 11, 2023
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In the ever-evolving landscape of tokenized real estate, there are two stacks that need to be addressed. There is the traditional capital stack, which serves as a sort of operating system defining the mechanics by which capital is invested into a real estate project and the priority by which investors are paid back. At a different, more technical level, there is also an operating system by which all the components for a specific tokenized real estate deal are pieced together. For each of these operating systems, it is equally important to ensure that the goals for the system are harmonized by the design choices that lead to their ultimate structure.

The capital stack refers to the various types and sources of financing that are used to fund a real estate project. The typical components of a capital stack can vary depending on the specific project and its financing structure. Usually, there is a combination of different flavors of debt and equity. Each flavor is used in a slightly different context to facilitate (or attempt to facilitate) some preferred set of outcomes.

The benefit of tokenization within the context of the capital stack for a real estate project comes from the configurability that is enabled.

"By setting up access control lists and designating, at a granular level, which groups in a real estate deal receive stated benefits (such as dividend distributions or repayment priority in the event of default), it is now easier than ever to ensure a project is aligned to the preferred outcomes of the project."

Debt Tokens: Unlock New Access

Debt instruments, such as senior debt, mezzanine debt, and subordinated debt, play a vital role in real estate financing. Tokenization allows for the representation of these debt components using the core features baked into ERC1404 tokens. For instance, senior debt tokens can be designed with priority repayment rights and access to cash flow distributions. Mezzanine debt tokens can carry higher interest rates and include features like payment-in-kind (PIK) interest or equity conversion options. Subordinated debt tokens, on the other hand, can have a subordinate claim to senior debt but seniority over equity. These debt tokens provide investors with the ability to diversify their portfolios and participate in real estate projects at different risk levels.

Equity Tokens: Own a Piece of the Property

Equity is a fundamental component of a real estate capital stack, representing ownership in a property or project. Through tokenization, equity can be represented by a specific type of security token. These equity tokens are issued to investors, providing them with proportional ownership rights and voting power. By leveraging blockchain technology, investors can now have direct, tamper-proof proof of ownership and participate in the project's decision-making processes. Furthermore, smart contracts associated with these tokens can facilitate automatic dividend distributions, profit sharing, and even opportunities for fractional ownership.

Preferred Equity Tokens: Balancing Risk and Return

Preferred equity represents a hybrid form of financing, sitting between debt and common equity. Tokenization enables the representation of preferred equity through security tokens with predefined terms and features. These tokens can grant investors priority rights over common equity, fixed dividend distributions, and other preferred equity characteristics. The smart contracts associated with preferred equity tokens can automate dividend payments and provide investors with a clear and transparent mechanism to participate in project profits.

Common Equity Tokens: Share the Success

Common equity represents the residual ownership interest in a real estate project, carrying the highest risk but also the potential for higher returns. Tokenizing common equity allows investors to have direct ownership of the project and participate in its success. Common equity tokens provide holders with the ability to vote on major decisions and receive a share of the project's profits and appreciation. By digitizing common equity, investors can easily transfer their ownership interests, increasing liquidity in traditionally illiquid real estate markets.

Unlocking New Opportunities in the Capital Stack

To integrate these real estate capital stack components into a security token framework, tokenization providers often leverage standards like ERC1404. This standard defines a set of rules and functionalities for compliant token transfers, ensuring regulatory compliance, and investor protection.

By adhering to ERC1404, tokenization providers can implement:

  • Transfer restrictions
  • Enforce investor accreditation requirements
  • Incorporate necessary compliance features into the smart contracts governing the tokens.

This happens using the previously referenced access control lists and specifying a set of administrators responsible for the needs of a given project, including automated dividend distribution, coordination with Transfer Agents, and in certain cases the use of mint(), burn(), freeze(), and forceTransfer() functions.

While it is still early in the era of real estate tokenization, the custom configuration of real estate capital stack components into the ERC1404 security token framework shows signs of great promise. As we continue to evolve more effective, transparent, and usable financial vehicles for an ever-evolving real estate market, security tokens will be a key driver of this evolution.

Reconfiguring Debt

Debt for real estate projects typically comes in two flavors: senior debt and mezzanine debt. Banks have a long history of providing senior debt to projects. This is because senior debt holders have the first claim on the project's cash flow and assets in the event of default. This type of debt typically has a lower interest rate but requires collateral and has stricter repayment terms.

However, this can take a long time and is typically expensive. Mezzanine debt, on the other hand, is more flexible than senior debt. Mezzanine debt is a form of subordinate debt that sits between senior debt and equity in the capital stack. It is typically provided by specialized lenders or investment funds. Mezzanine debt carries a higher interest rate than senior debt and may have additional features such as payment-in-kind (PIK) interest or equity participation. In case of default, mezzanine debt holders have a secondary claim on the project's assets. 

The first step to tokenize senior debt and mezzanine debt investors is to 1) determine a desired ratio of debt by classification (e.g., more traditional or senior debt if the deal has a likelihood to be financed by a bank or more mezzanine debt if a project has a lower likelihood of being financed by a bank) and 2) determine the payment mechanics that make a deal viable.

"Because tokenizations are infinitely configurable, it is possible to represent any financial framework in a tokenized form."

For example, if a capital stack for an apartment building is set up as being allocated as 34% Equity, 33% Senior Debt, and 33% Mezzanine Debt, the payment mechanics of the deal could be set up so that the Senior Debt is being paid back at a lower interest rate than the Mezzanine Debt but have a higher priority claim to the project's assets in the event of default.

Tokenization, however, provides an additional number of benefits. For example, different restrictions are able to be implemented for the transfer of different types of debt tokens or equity tokens to provide stability to the project. Tokens allocated to the Senior Debt holders can be programmatically designed with priority repayment rights, access to cash flow distributions, and other associated features.

Mezzanine debt tokens, on the other hand, can offer higher interest rates, payment-in-kind (PIK) interest options, or equity conversion provisions. Because of their association with higher interest rates, Mezzanine debt attracts risk-tolerant investors seeking potentially larger returns, while the PIK interest options and equity conversion provisions provide flexibility in terms of repayment and opportunity for ownership.

Consequently, these distinct features often make mezzanine debt tokens an attractive financing option for businesses that may not have access to traditional lending channels or those looking to minimize dilution of equity. They also provide additional flexibility compared with the traditional finance stack. As such, these tokens will be governed by smart contracts that enforce the specific terms and conditions of the debt, ensuring transparency, security, and automation of relevant processes.

The specifics around how to tokenize different types of debt will always be contingent on the factors unique to any given project. As such, they ought to be analyzed on a case-by-case basis.

Reconfiguring Equity

Unlike debt, equity has a lower repayment priority in the event of liquidation or failure of the business. The lower repayment priority carries with it both a potentially greater risk, but potentially higher payout. As mentioned in the previous sections, within this category, there are two subcategories of equity. Where Common Equity is more of a pure form of equity, there is a more diluted hybrid between debt and equity called Preferred Equity. Preferred Equity has both a repayment priority and a payout priority that are between equity and debt. This invites a lot of new opportunities in the context of tokenized real estate.

The biggest potential for tokenized equity is to create offerings that meet the market where it is at a specific moment in time and under certain conditions. As mentioned previously, some of these benefits come in the form of custom products for both entrepreneurs and issuers of securities, as well as for investors. Presently, as we are in the early stages of transitioning from the legacy financial operating system to this new, token-enabled tokenized operating system, there is much that remains to be explored.

Opportunities to specifically configure payment priorities based on the occurrence of a stated set of conditions, or reconfigure exit opportunities based on price indices are two key areas where tokenization offers more efficient and trustworthy configurability than conventional options.

The steps to tokenizing equity depend heavily on an analysis of each project's token economy or tokenomics. The tokenomics for any given project will typically involve an analysis of the utilities of a given token. What is the token intended to do and who is it intended to be completed for? From there, it is possible to begin mapping out the mechanism design.

Mechanism design is a field in economics and game theory that works to create systems that achieve a desired set of outcomes. These incentives are designed in a way that leads rational participants to choose actions that end with the desired outcome. Typically, a so-called "happy path" will be identified with a numbered list of actors and actions that encapsulates all the behavior of a given system.

For tokenomics design in real estate this will frequently involve identifying

  • The participants in the transaction
  • The pressures they face
  • And then engineering a system that ensures the long term health of the project

It is important to call out that many conventional real estate projects have a similar mechanism design that achieves a relatively linear goal of making money for a limited number of participants.

With tokenized real estate there is an opportunity to evolve these mechanisms to a larger number of investors and participants in order to achieve a broader set of desired outcomes, whether that be maximizing profit or occupancy, minimizing the negative effects of gentrification or minimizing negative impact on the environment. This list is by no means exhaustive. Exploring more granular and configurable options for tokenized equity is a necessity for the future of tokenized real estate.

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