This post is intended to serve as an introduction and “pre-MIP” discussion, where the Maker Community and Risk teams can discuss and provide input on Blocksquare’s protocol as a proposed solution to start accepting real estate (and possibly even other RWA) as collateral, without the need for major updates to the Maker Protocol.
The main goal of this forum post is to gather feedback in preparation for the creation of a formal Maker Improvement Proposal (MIP), which will contain more implementation details.
The post serves as a “pre-MIP” discussion to gather feedback on the real estate tokenization protocol developed by Blocksquare;
In the context of real estate assets, debt or equity tokens do not seem to be the appropriate solution — while debt services are already very well covered traditionally (banks), equity tokens have no real on-chain settlement in most jurisdictions;
Revenue based asset tokenization is a far superior model for real estate assets as it is not only easier to understand for a token holder, but also solves challenges like on-chain settlement, valuation and transparency;
A description with examples form Blocksquare’s real estate tokenization protocol is included in the 2nd part of this post;
Adopting RWA tokenization protocols will expedite collateral onboarding as it becomes possible for Maker risk teams to compare real estate properties and analyse them more efficiently;
On-chain liquidations should be Maker’s primary concern, while off-chain liquidations of underlying RWA should be left for other participants to engage;
Real estate is the biggest asset class in the world. At the same time it’s also one of the most illiquid investments you can make. Generally investing in real estate is hard to access, time consuming and capital intensive. What’s more, real estate as an asset class is difficult to properly valuate, making investments predominantly regionally bound as the availability of reliable data is scarce.
In fact, when we look into Commercial Real Estate, a research by JLL shows that approximately 80% of all direct investments are made in just 60 cities around the globe, meaning that 1000s of urban areas are underserved, receiving only 20% of capital. This inequality of accessing funds for urban development furthers the inequality gap and the ability for communities to prosper.
With the acceptance of real estate backed collateral, Maker will not only address the sustainable growth of its protocol, but also open an immense opportunity to address these underserved markets providing a real financing solution for real world challenges.
With the publicly declared intention of onboarding RWA (Real World Assets), the Maker community will face numerous collateral onboarding requests by issuers of tokenized securities. This will in terms bring a myriad of tokens structured in various ways up for consideration and assessment by Maker’s risk teams and community.
As we have seen from some recent posts on this forum, these tokenized securities have more often than not a complex structure with various legal entities holding certain rights to the underlying asset(s). Individual due diligence on each and every structure will prove to be exhausting and consequently slow down the regular onboarding process for other crypto assets.
It is therefore important for the Maker community to first agree on tokenization protocols that will be accepted as a standard and that will help expedite collateral onboarding for RWAs adopting them. It is also important to note that it might not be possible to find a ‘one solution fits all RWA’ protocol and that different tokenization models might fit different requirements.
Who are we to comment?
Since 2017, Blocksquare and its team have dedicated their time and resources to find the most lean and effective method of bringing real estate assets on the Ethereum blockchain.
In the course of this journey Blocksquare has also received some awards and recognitions amongst both the PropTech and Blockchain communities:
- Best blockchain solution for real estate — 2019 winners at Crypto Valley Summit (first prize 100,000 USD)
- Builtworld PropTech competition finalists 2019
- One of the winners at 2020 Proptech Innovation Awards by German Tech & Union Investments
While developing the real estate tokenization protocol the team researched various tokenization models including debt and equity, concluding that neither of the two are currently suitable for the purpose of tokenizing real estate assets.
Debt vs Equity: Research and Findings
While tokenization of debt is easier to implement and also easy to understand, banks already serve this avenue very well. As long as the project is of a certain quality, the borrower has a good balance sheet and is able to provide 20-30% of the required capital to execute the real estate investment, banks will green light the senior loan. Tokenization of debt will thus predominantly attract projects that are unable to secure financing through traditional and well established routes — in short, projects that Maker shouldn’t onboard as collateral.
On the other side of the capital stack we have equity. The tokenization of equity was highly expected with the rise of STOs, however, it never really took off. The main challenge of tokenizing equity is transferability. While tokens can settle instantly on a blockchain, to actually transfer the ownership of private companies or real estate is a much more complex process that includes notaries and banking institutions to get involved. We thus conclude that as long as these core players do not become an integral part of Ethereum, the actual transferability of shares will remain limited and provide investors more uncertainty than traditional investment routes.
A third option: Revenue based asset tokenization
As mentioned above, tokenizing either debt or equity of the capital stack presents challenges — debt is already serviced very well traditionally, while equity tokens have no real on-chain settlement in most jurisdictions around the world.
Is there anything else out there? A solution that would offer both asset owners and investors something new?
In the real estate context it is fairly easy to estimate the revenue a particular property can generate. Most common revenue streams for real estate properties are:
- cash flows from lease contracts, and
- resale of the property to a 3rd party buyer.
In the context of commercial real estate, the revenues a property generates also highly impact the valuation of the property as investors look predominantly for a target return.
Revenue based investing is not by any means a new concept, and is mostly used for financing companies through royalties. A royalty is a defined share of the royalty issuer’s revenues. Royalties have been used for hundreds of years where one party wished to share revenues with another party who was doing something useful to the royalty payer or issuer. Royalties were traditionally used in commerce where the definition of profit was either difficult to determine or not chosen to be revealed.
To put it simply, the issuer is telling investors that every month they will receive X% of the issuer’s revenues until they receive Y times their cash back and the issuer expects it to be happening in a period of Z years.
The advantages over buying shares or lending a company money? An investor is not concerned with or impacted by the issuer’s profitability for so long as the issuer meets royalty payment obligations. The royalty owner also benefits when the revenues of an issuer increase, but on the flip side there is also the risk of revenues declining.
But don’t take our word for it — Investment banker, financier, management consultant, author, lecturer, and inventor of the Lipper Index, Dr. Arthur Lipper, is the main advocate for revenue based investing. Feel free to Google him.
Top-line revenues vs. bottom-line profits
Revenues are found on the top line of a balance sheet and are easier to understand and project than the profits we find on the bottom line of the balance sheet. Grasping one set of factors that affect revenues is easier than grasping the multi-dimensional factors that affect profit, so risk and reward of revenue investing can be quantified in a more straightforward manner.
This is the principle behind royalty finance and provides a greater degree of certainty to the investor; returns in the form of current income begin to flow immediately, and they grow as revenues grow. The investor’s natural skepticism is decreased because he has better information, though it can never be eliminated (nor should it be).
The company must still credibly justify its revenue projections, and provide a failsafe mechanism to report, sequester and pay a percentage of revenues to investors. But the investor is now on more solid ground in quantifying his risk, and his reward. Therefore, raising capital may become easier, and the decision to green-light the investment becomes more straightforward. Everyone benefits.
Real estate revenues & tokenization
Real estate is a specific asset class that offers an investor both steady cash flow and value appreciation over time. Although volatile for traditional markets, in comparison to the crypto market it looks like a safe and steady investment that appreciates in value over time. Additionally, the revenues from lease contracts offer a steady inflow of capital to the investor — in crypto terms it is much like rewards you receive while staking, but without the risk of holding an unstable asset.
By tokenizing the real estate asset’s revenues, investors are focused on the growth and performance of revenues. The rest of the balance sheet is less relevant to the investor’s direct interest, and unlocking its mysteries is less of an obstacle to making an informed investment decision.
Blocksquare’s real estate tokenization infrastructure
Blocksquare’s vision is to power 100s of platforms across the globe, connecting investors to real estate opportunities in their region. With our real estate tokenization protocol entrepreneurs can start digitising real estate assets at a fraction of the cost, while our white-label platform offers the quickest way to launch an online marketplace. DAI is at the heart of the platform already, and adding the ability for property tokens to be used as collateral within Maker would create great value to all participants — issuers, platform operators and end-users alike.
Blocksquare’s products include but are not limited to the following:
Blocksquare’s real estate tokenization Protocol provides our Client a standardized method of digitizing the value of a single real estate property, either partially or in full.
Blocksquare’s Platform provides the Client with a white-label solution to create, list, issue, sell, distribute, manage, track and trade properties tokenized through the Protocol. The Platform is composed of two web applications:
- Investor dashboard (for end-users)
- Admin panel (for platform administrators)
The Protocol is the process of creating a ‘PropToken’ smart contract - a standard Ethereum ERC-20 smart contract with a defined maximum issuance of 100,000 digital tokens, extended with unique information identifying a specific real estate property, and additionally limiting transactional rules according to the issuer’s requirements (which users can transact with the tokens is defined within a separate ‘DataHolder’ smart contract).
To link a real estate property and its revenues to the ‘PropToken’ smart contract, a Public Corporate Resolution is generated and subsequently signed by the legal representative (e.g. GM, director, CEO) who is mandated by shareholders of the issuing legal entity which in terms also holds title to the property. The signed resolution is made public through IPFS - a distributed file system that ensures the legal document has a fixed online address, while the file itself can not be tampered with after it has been uploaded and becomes public. The location of the file is defined as a unique IPFS hash and recorded within the PropToken smart contract, while the Corporate Resolution holds the information of the ‘PropToken’ contract address. The ‘PropToken’ now points towards the Corporate Resolution and vice-versa, so the legal effects of the corporate resolution work in conjunction with the tokens managed by the ‘PropToken’ smart contract.
Consequently, investors holding tokens can use this corporate resolution to appeal in court should the issuer stop their payments. As payments are conducted via smart contract, they are recorded on the ethereum Blockchain and shall be used as proof, should a legal dispute start.
Traditionally, corporate resolutions are used by boards of directors in private and public companies to sign on important corporate decisions, like change of leadership and then reported to the companies house or similar government institution. In the context of tokenization, however, the corporate resolution is used to make a public decision on a specific asset and its revenues.
The corporate resolution is used to transfer any and all revenues (NAT — Net After Taxes) that the issuing legal entity generates within the scope of its commercial and trading activity with the specified real estate property to the individual digital token holder of the PropToken smart contract, where 100,000 digital tokens represents a predefined ‘Royalties Percentage’ of any and all net revenues, including revenues generated by a sale of the property to a 3rd party.
The ‘Royalties Percentage’ is defined at issuance according to the real estate property’s business model and the cost structure that the issuer will use to generate revenues. For instance, renting out an apartment might append all costs to the tenant and thus the issuer could direct 90-100% of revenues towards token holders, while an office building could have a more complex cost structure with legal, maintenance, financing and other costs stacking up and thus only 60% of revenues would be directed to the token holders.
The above method of tokenizing a real estate property or multiple properties forms the Protocol developed by Blocksquare.
A property owner has invested in an office building valued at 10,000,000 USD. The equity stake is 2,000,000 USD, a REIT (real estate investment trust) partner has also invested 2,000,000 USD, while a bank loan is in place to finance the remaining 6,000,000 USD over a period of 10 years. All combined lease contracts are projected to generate 2,000,000 USD per year if fully occupied, and the issuer is willing to give up 60% of these projected revenues, as they project 40% need to be reserved for direct and indirect costs.
The property owner and REIT partner decide to tokenize 20% of the property to decrease their exposure and use funds for a new investment. The previously described tokenization protocol is used, meaning 20,000 tokens are minted from the PropToken contract (out of a maximum possible supply of 100,000 tokens). If revenues perform as projected, token holders will receive 2,000,000 USD ✕ 60% ✕ 20,000 tokens / 100,000 tokens = 240,000 USD, converted into DAI and distributed to token holders each month. Simply put, if you hold 1,000 tokens on your wallet, you receive 1% of the agreed upon royalties.
The sale price of property tokens is determined by the issuer. While it will not change the amount of royalties token holders will receive, it will affect the profitability for investors.
“FactoryContract” is the main smart contract to generate a “PropTokenContract” — an ERC-20 backwards compatible token standard developed by Blocksquare designed to tokenize a specific real estate property and the revenues it generates.
The protocol features a standardized token symbol BSPT-XXX-###, where BSPT stand for BlockSquare Property Token, XXX is a defined unique alphanumeric symbol, and ### is an automatically incremented number.
Each PropToken contract is registered in the “PropertyRegistry” — a smart contract where “Identification data” of all real estate properties is publicly available.
The “maximum amount” of tokens that can be issued is 100,000, where 100,000 tokens represents a predefined percentage of royalties of any and all net revenues, including revenues generated by a sale of the property to a 3rd party. The Royalties percentage is stored and sealed in the PropToken contract.
“Corporate resolution” is the legal binding document uploaded and stored on IPFS that works in conjunction with a PropToken smart contract and creates a financial obligation by the issuer towards any and all holders of a property token.
Due to AML regulations, to hold property tokens, a user is required to first complete KYC using Blocksquare’s platform. This is a one-time process. As opposed to ERC-20 where transferability is not limited, PropToken contract’s “transfer function” uses wallet information stored in the “WhitelistingContract” limiting token transferability according to an issuer’s predefined requirements. For instance, it is possible to limit token ownership to wallets whose owners are US residents only, or exclude residents of certain countries, or even define custom parameters for eligibility — the more limitations, the less liquidity potential a tokenized property will have.
Each PropToken contract also has a “Capital stack” parameter that needs to be defined by at issuance. Besides the tokenization percentage, the capital stack provisions for 1. Senior equity, 2. Preferred equity, 3. Mezzanine, 4. Junior debt, 5. Senior debt to be defined. This information adds transparency to token investors and the ability for protocols like Maker to create a custom valuation and risk assessment model based on this information. Important to note, that the capital stack can be updated by issuers as time passes, for instance, the debt portion should diminish in time in favour of the equity side.
Each PropToken also has the ability to store information about its valuation, split into two categories: 1. Property valuation, and 2. Token valuation. Both values can be updated through oracles. Blocksquare has developed a token valuation model that listens to transactions that occur via DEX protocols like 0x or Uniswap, and takes into account volume, price, property valuation and circulating supply.
Property valuation vs. Token valuation
A property’s valuation is traditionally created by qualified valuers, for instance, RICS (rics.org) is the most recognized international organization of valuers. On the other hand, big data and AI, has opened the world of “instant valuation” based on available market data. Additionally, companies like RCAnalytics (rcanalytics.com) offer access to accurate property valuation data by partnering with large corporations and investors.
Assessment of a property valuation is therefore well established and can be relied upon, although many professionals and RICS members will also tell you that there are cases where valuations made by different valuers with the same tools and qualifications might differ by as much as 10-20%. That being said, banking institutions usually update valuations of their portfolios (properties they have taken as collateral for debt issuance) on a yearly basis, depending on the regional standards of course.
A tokenized property’s valuation, on the other hand, is much more dynamic and can’t solely rely on the basis of a rather static traditional valuation model. For this reason, Blocksquare has developed a valuation model for properties based on the share of the tokenized portion in a property’s capital stack. For example, a property where 10,000 tokens have been issued, the token’s secondary market activity will have a lower impact on valuation, then for a property where 70,000 tokens have been issued.
RWA valuation and liquidation events
Defining a safe model to properly value tokenized RWA is important for mitigating risks associated with possibilities of manipulating prices on secondary markets that would trigger liquidation events.
As Maker works with oracles feeding token price information to the protocol, it also relies on multiple data sources to establish accurate prices. With RWA, relying solely on token pricing might prove to be challenging as the amount of data sources is very limited and perhaps even insufficient to establish a reliable pricing point. It can therefore be dangerous as a RWA token price could easily be manipulated.
Blocksquare’s protocol mitigates the previously mentioned challenge. Real estate properties hold their real world valuation within the PropToken smart contract itself. Maker oracles could use the rather static “propertyValuation” as an orientational point to prevent manipulated liquidations when the token prices become volatile on secondary markets.
Off-chain vs on-chain liquidations for RWA
RWA token collateral is essentially not much different than crypto collateral. While the latter has a much more complex valuation model, where network effects and token velocity impact greatly on its value, RWA are usually valued based on more traditional financial models.
Any ERC-20 token that is already being accepted as collateral on Maker can lose its value — for instance, a better solution could come to the market and the project’s token could stop to serve its purpose, significantly dropping in value. This process would trigger liquidation events along the way, but on the other side, keepers would not be interested in bidding for these tokens as they would know the project has no future.
In the context of RWA like real estate, the assets backing a token are much more tangible and are expected to hold value even in case an off-chain liquidation occurs. However, their capital stack might prove to be more complex, with traditional institutions like banks being involved and having priority to recoup their investment.
It is thus required to distinguish between off- and on-chain liquidation events.
On-chain liquidations are similar for both crypto and RWA collaterals. A holder has locked a token to get a loan — the RWA tokens might get liquidated, but this does not mean the collateral itself is not performing, thus keepers will gladly engage in auctions to bid for the tokens and profit on the spreads.
On the other side, off-chain liquidations are different. While a crypto project’s failure is permanent, a real estate backed token could still offer the token holder an off-chain process via legal dispute that will enable them to recoup at least the underlying asset’s nominal value, at least in part. For instance, commercial banks usually sell portfolios of NLPs (Non Performing Loans) to investors at discounted rates of 70-90%. That’s correct. You could go to a bank to buy a portfolio of real estate assets for a fraction of their valuation. Why? Because getting your investment back on these properties is not by any means an easy job.
We believe that off-chain liquidations of RWA should not be Maker’s primary focus. Maker is a decentralized organisation without a legal entity recognised within the real world economy and thus can not take part in legal procedures that take place for off-chain liquidations. On the other hand, certain keepers could operate as legal entities and thus have the ability to engage in RWA legal proceedings. Just like commercial banks sell off their NLPs to outside investors to “deal with them”, Maker should auction NPTs (Non Performing Tokens) to those who are able to turn a profit with them.
Why should Maker care?
Adopting a tokenization standard for a specific class of real world assets like real estate should be an important step towards standardisation for RWA collateral onboarding.
But, at the same time, Maker’s position as a decentralized organization challenging traditional banking institutions should be carefully safeguarded. Opening to RWA collateralization is important, but so is the notion of keeping Maker decentralized and without a central touch point in the “real world” — as long as Maker can not be regulated by governments, institutions and lobbyists, its position as a challenger to central banks will remain intact and hard to stop. It is therefore important, in our opinion, that any proposed solution for onboarding RWA as collateral should not push Maker to create any legal entity of any kind, as such steps could jeopardise the very essence of Maker.
Blocksquare’s protocol does not require Maker to create any legal entity to onboard real estate assets as collateral. Maker governors are solely responsible to assess the risks of onboarding a PropToken as collateral via information that can be easily retrieved either directly from PropToken contracts or indirectly via Blocksquare’s API. As most relevant information is publicly available for assessment, Maker risk teams will be able to efficiently analyse different real estate assets not only by looking at each asset individually, but also by comparing them one to another. Information readily available includes:
- Real estate property identification data (Ethereum)
- Real estate property legal ownership (IPFS)
- Signed corporate resolution (IPFS)
- Property and token valuation (Ethereum)
- Property capital stack (Ethereum)
- Revenues distribution history (Ethereum)
As the identities of issuers are known and linked to Ethereum wallets/accounts, an on-chain “credit scoring” system could be further developed for Maker to automate collateral evaluations based on an issuer’s past performance. What’s more, Blocksquare’s PropToken protocol creates ERC-20 compatible token contracts and implementation to work with Maker should not be an issue, and most importantly, there would not be a need to make major adaptations to the current liquidation system.
At Blocksquare we would like to start a conversation within the Maker community to assess if moving towards a Declaration of Intent and subsequently starting an official MIP on this topic is within the interest of the community. From our point of view, the acceptance of tokenized real estate properties issued through Blocksquare’s protocol should be perceived as a potential model that could expedite if not even automate RWA collateral onboarding on the mid-to-long term. On the other side, the adoption of the protocol by Maker would result for more traditional investors to engage as their tokenized real estate holdings could be further used as collateral.