Investment real estate can be an incredible asset class. Rental income properties offer steady income streams, long term appreciation (in most markets over the long term, though growth rates vary), and access to debt capital markets (i.e. refinancing). Additionally, and most importantly, it offers consistent passive income to supplement traditional salaries and a relative safe haven from the volatile equity capital markets. However, for all of the benefits that come with real estate investing, it does have its challenges. For example, high transaction fees given many intermediaries, high minimum investment requirements, and long lock up periods create illiquidity. Simply, real estate investing requires a significant amount of capital that most people, particularly millennials, just do not have.
As a result, real estate investing has historically been almost exclusively reserved for high net worth individuals who have the cash on hand necessary to purchase rental income properties. Of course, unaccredited investors do have access to publicly traded REITs that offer exposure to underlying investment real estate assets and cash flows, but dividends tend to be low and fees tend to be high. Additionally, most retail investors don’t understand REITs because people who are foreign to the finance world can be intimidated by more sophisticated structures. So there has to be a better option. Here at Nine Four Ventures, we believe there should be better alternatives other than REITs and believe in democratizing access to rental income properties for retail investors to benefit from all of the advantages that come from it.
If retail investors do not have the necessary capital on hand to buy rental income properties, how do we solve this problem? One solution is fractionalization. Fractionalization allows investment property managers to sell small minority equity stakes in their assets to smaller retail investors for more manageable investment amounts (hundreds or thousands and not millions of dollars).
How do you offer fractional shares to retail investors? The exact structure has yet to be determined, but founders are working to bring this to market at scale. One solution is to create a new security to hold the underlying assets. For example, Compound has created a new instrument called a ReTF. It provides exposure to city and property specific real estate that offers the benefit of both a REIT and an ETF, including lower taxes and more liquidity, respectfully. Another solution is tokenization. Security tokens can be used to automate the KYC/AML process and enforce tax rules and regulations, whereby making transactions seamless between parties from pre-approved pools of global investors. For example, Harbor has created the R-Token standard offering a building block backbone for crypto security compliance.
What is the benefit of selling minority equity stakes in properties owned by institutional investors? First, debt capital could become more expensive as we enter a rising interest rate environment and may not be as readily available. In addition, debt changes the capital structure of the property and sometimes includes lockout periods or pre-payment penalties that prohibit or make selling a property expensive and thus is not always the best alternative for the owner. As a result, the ability to sell a minority stake allows institutional investors to harvest gains and reinvest that capital in new geographies, assets, etc. Second, some Limited Partners (“LPs”) might want to liquidate holdings when the General Partner (“GP”) might want to hold on to the position. Thus, fractionalization provides greater flexibility to both GPs and LPs, saving the GPs the headache of identifying a buyer and allowing LPs to liquidate easier, earlier, and faster than what was previously possible. Third, fractionalization allows larger institutional investors to raise capital from the “long tail” of the market comprised of retail investors, whereby automating a previously very difficult and tedious process.
What new revenue generating opportunities are available through fractionalization? The most exciting opportunity, I believe, is the ability to sit in between the property owners and retail investors to facilitate the trading of fractional share buying and selling. Prime brokerage, market making, and asset management represent some of the biggest centralized opportunities. Protocols and security tokenization represent some of the biggest decentralized opportunities. As a result, companies working to solve this issue and taking any of those approaches stand to gain the most from creating this new market.
If you are a Founder or CEO interested in democratizing access to real estate for retail investors, please get in touch. It would be a privilege to learn about your business.