Feb 14, 2019
Henry Elder joins us today to talk about how real estate, one of the oldest forms of investing – around since practically the dawn of human civilization – is getting a fresh coat of paint through the application of blockchain technology and cryptocurrency.
Topics Covered in this Conversation with Henry
– Real estate as the ultimate imperishable good
– Real estate has built in scarcity
– What does it mean to tokenize real estate
– Why does real estate need blockchain technology and cryptocurrency
– Pain points and friction in the system
– Real estate is rooted in the past
– How real estate differentiates between haves and have-nots
– How tokenization creates liquidity in the market
– Initial customers will be institutional investors
– Tokenization of a real estate property in New York
– Complexity of global market and tax implications for overseas investors
– Crossing the educational hurdle
– Dealing with the high international demand for us real estate
– Maturation of investors regarding blockchain technology
– Real estate tokens are securities in terms of regulatory framework
– How he fell into the rabbit hole of real estate blockchain
– A generational way to change the way people invest in real estate
– Examples of real blockchain deals to date in real estate
– The Two Token Waterfall
– Still in the realm of the theoretical
– Fractional ownership vs. fractional investing
– Putting deeds on the blockchain
– Real estate is an archaic industry
– Level of efficiencies from blockchain technology
– Closing thoughts
Questions and Comments?
Guest Contact Information
Website: Digital Assets Advisors
Chitra: Henry, welcome to the program.
Henry: Thank you so much for having me. It's great to be here.
Chitra: It's great to have you. So I would open, I don't know why this show is making me want to use quotes, so I'm going to use a couple of quotes here. The first one is by Russell Sage, the American financier and politician. And he says "real estate is an imperishable asset ever increasing in value. It's the most solid security that human ingenuity has devised, it's the basis of all security and about the only indestructible security". Why is real estate considered a security?
Henry: Well, if I can respond in a quote, Mark Twain said, "Why real estate? Because they're not making any more of it, right?” That's why it's so secure. It is the ultimate imperishable good. There's not going to be any more real estate made. The real estate that you own will be the only real estate that ever exists there for all-time, right? Unless you build up. But the potential to build up on a piece of land just gives that land more value.
So he uses security in that sense and it kinda sounds like he's talking about investable securities, but I really think that he's talking about the security of, what's the word that I'm looking for? Bitcoin has the exact same characteristic in that it's scarce, it's scarce.
Chitra: So there's built in scarcity.
Henry: Yes, there is, it's the original built in scarcity. They're not making any more of it.
Chitra: So what does it mean then to tokenize the security?
Henry: So basically it means that you're taking the ownership interest, you are putting that ownership interest in some sort of a company and you're selling ownership of the company. And instead of investors taking that ownership interest in the form of a paper share, like you typically do, you're taking it the form of a token running on the blockchain.
Chitra: So I want to go to my second quote here, which is from President Franklin Roosevelt, and he says "real estate cannot be lost or stolen, nor can it be carried away, purchased with common sense, paid for in full and managed with reasonable care. It is about the safest investment in the world." If that is the case, why do we need blockchain technology and cryptocurrency to secure this form of real estate? What are the pain points? What's the friction in the system now? And how does blockchain technology make it safer?
Henry: So let's get back to that idea of security that the first quote brought up. It's sort of like Troy and the Trojan horse. Real estate is such a secure investment and the people who have been investing in real estate are so secure in that scarcity that they allowed in this Trojan horse of complacency thinking that look, I don't really have to worry about what goes on in the world outside. As long as I own this real estate, I'm secure.
And the problem is that the rest of the world continue to advance. And we live in this highly digital, instantaneous world now. Whereas real estate is stuck with these paper processes that are mired in the inefficiencies and a high friction of the 1950s. I mean, you could go back five, six, seven decades and talk to somebody who works in real estate back then and they would recognize nearly all of the processes that we're transacting real estate with today. It hasn't changed.
And so if you are, it's basically you divide it now between the wealthy and not wealthy. And if you're wealthy, you can go out and just purchase real estate wholesale or you can become an investor in a syndicate. And to invest in a syndicate you usually need to have in the order of hundreds of thousands of dollars at a minimum. And if you're not wealthy, your options are either crowdfunding or REITs (real estate investment trusts). And crowdfunding is not liquid and REITS, which are actually the only one of those four that I just said, buying real estate outright, investing in a syndicate and crowdfunding and REITS, REITS are the only one that's actually liquid. But the problem is that REITS are a cumbersome and expensive way to access the market for the people who actually own the real estate.
And so the only types of deals that you see hitting the market are very large deals on the order of hundreds of millions of dollars or more.
Chitra: So how does tokenization solve this problem and what does it mean to tokenize this real estate in that context?
Henry: Sure. So going back to what we were talking about before, it's you're taking the ownership of a company that owns the real estate. And this is totally normal in the real estate process. Typically if you're buying real estate, you're buying it through some sort of company. You control, if you're buying the real estate yourself, you spin up a completely new company. You create a new company, it's called a single purpose entity. And that company purchases the real estate and that company's name is what's actually on the deed. And then you own 100% of the company.
When we're tokenizing it, what we're doing is we're taking that ownership of the company and we are a encoding it into blockchain tokens and then selling those to people. In that process, what you're basically doing is you're combining the best parts of a REIT and the best parts of crowdfunding and mashing them together and creating a more efficient, less expensive process for you to access investors that's still liquid.
Chitra: And is this true for retail investors or is this primarily for institutional investors?
Henry: So it's true for both. The the adoption of this, I think, will primarily be driven by institutional investors because the companies that are doing this, that are sort of paving the way here are taking a lot of risk, right? They're trying a new technology. They're blazing a path, as they say, the pioneers take the arrows. And the safest investor for them to target first is the institutional investor.
There's a saying in the crowdfunding world, that's basically the guy who puts in $100 into your crowdfunded deal is going to be the most expensive client that you've ever acquired. Because those people, there's such a high level of education and customer service basically that they require, because they're not familiar with the tenets of investing. Whereas when you go and you find an institutional investor, they know how real estate investing works and they'll probably leave you alone for the most part to go do your thing.
So a lot of these people that are sort of blazing the trail with tokenization, I think they're probably going to be pursuing those institutional or high net worth investors first. However, the pipeline that they're creating, the technological rails effectively that they're creating to be able to do that, can easily start onboarding more retail investors once those companies have reached the size where they can deal with those investors.
Chitra: You've said to me before that tokenization is going to both globalize and democratize the real estate investing process. How is that going to happen? Especially the globalization piece?
Henry: Sure. So the globalization piece is particularly exciting for me. Earlier at the beginning of last year, actually spring of 2018, I was part of a team that tokenized a commercial real estate property in New York. And we took a $5,000,000 piece of that property and we sold it to international investors. We did that basically to prove the concept that you could use the blockchain to more easily access these investors and to allow them to more easily access real estate here in the United States.
Chitra: And how did you do that? Just simply, what was the process?
Henry: So that process, this was a little bit complex. It's interesting because, so first of all we had to build, we had to create that special single purpose entity. But the problem is that when you have international investors, they're subject to all kinds of different tax laws when they're investing in domestic US real estate. And so you have to build somewhat of a complex offshore structure in order to shield them from the effects of those tax regulations.
And so we had to build that whole structure. And then we had to go out and find these investors. Since we were one of the first people to do this there was a high educational hurdle that we had to surmount in order to get them to come on board. It's sort of funny because what we eventually ended up doing is, first of all the thesis that there is this massive unattended demand offshore that is trying to access US real estate, but that is unable to for whatever reason was proven out because every investor that we talked to was like, I want to invest in that real estate. I want to be part of this deal.
But nearly everyone that we talked to got hung up on the blockchain part of it because in early 2018 everyone was still thinking about ICOs. Everyone was still thinking about exchanges getting hacked. And Bitcoin being used for money laundering and human trafficking and whatever. And they didn't understand that the underlying technology was completely different. I mean, people get scanned on the internet all the time. That doesn't mean that email is not a good form of communication. But that connection was not there yet.
And so a lot of our investors just ended up coming in a without really caring about the blockchain side of it. Even though it did make it easier, not a lot of them realize that they were just like look, you're selling US real estate. I want real estate, US real estate, let's do it.
Over the past several months we've started to see that conversation change and we've started to see a maturation in those investors understanding of the differentiation between blockchain and ICOs and whatever stuff they're afraid of that's going on with Bitcoin or whatever, all of which I think is unfounded anyways.
Chitra: So when you do the tokenization, does that consider it a form of security?
Chitra: And that's different from the traditional ICO, the utility tokens and things like that. So what's the legality of the stuff? Is it going to fall under the same kind of regulatory hurdles that have confronted utility tokens and ICOs?
Henry: It will fall under them in a different way. The difference is that ICOs and utility tokens primarily we're trying to argue that they were not securities and the SEC disagreed with quite a few of them and said no, these actually are security.
Chitra: And therefore should be regulated by the SEC or else they're illegal.
Henry: Exactly. They should be regulated by the SEC. They should either be registered with the SEC or they should comply with the registration exemption, which is also a controlled by the SEC.
The difference is that security tokens, whether they're real estate or art or equities or debt or whatever they are, from the get go we said are securities and therefore they will comply with all of the necessary SEC regulations that regulate securities. And so there was no are we security, are we not a security, but it's just these are securities and we're going to do everything that security is needed to do.
Chitra: So in terms of legality, people can feel free to invest?
Henry: 100%. They're totally legal. It's exactly the same thing as when you go on, trying to think of familiar crowdfunding websites. I know all the real estate ones. There's Fun Rise and Realty Mogul and Peer Street. And then on the other side of the equation, there's Start Engine. Indiegogo I think also does regulated crowdfunding. Those are all completely legal and those all fall under registration exemptions for crowdfunding, for accessing retail investors without having to go through the incredible hurdles of doing a full IPO.
Chitra: So how did you get involved in all of this, because I know you were kind of going about your own way and all of a sudden you saw the light on all of this real estate and tokenization and then you kind of went down the rabbit hole and then you said oh, I'm giving everything else up and this is my life. Talk a little bit about how that happened.
Henry: Yeah. And I did that after the market started going down. At the beginning of 2018 I was like, you know what, now's the time for me to jump in full-time. And I haven't looked back. I've loved it. But, so 2017 I think three security token issuances, Blockchain Capital, maybe there were four, but Blockchain Capital, Protose, Science Blockchain and I can't remember if Spice VC was 2017 or early 2018.
But so those sort of said all right, this is possible. But nobody really caught on because ICOs were going crazy and people were just making insane amounts of money in this more unregulated market. It wasn't until early 2018 that I saw real estate security token offerings starting to come down the pipeline. And the first one I saw was Slice. And so hopped on the Slice team [crosstalk].
Chitra: And you were in real estate at the time?
Henry: I was in real estate. I was working at a private equity fund in Beverly Hills doing value add commercial real estate deals all over the country. Which means that we would work with a real estate owner who wanted to buy a 200 unit apartment building and fix up all of the apartments and then sell it three years later for more money. I mean, it's the same thing as if you have a house and you fix up the the kitchen, right? You put in a new kitchen for $20,000 and the house was worth $50,000 more, right? Exact same thing just on a larger scale.
Chitra: But then you got involved in the whole tokenization piece.
Chitra: So what was the light bulb moment?
Henry: So the light bulb moment was a little bit something that's somewhat a little bit personal to me. And then also just the incredible opportunities in the blockchain space. But my family's been in real estate in Los Angeles for four generations.
Henry: And so real estate is something that I was always going to go into. I was doing this job, I was loving it, I was really good at it, but as I got further and further down in the blockchain rabbit hole, I was like wow, this technology and the protocols that underlie it are basically providing us with a new opportunity for humans to change the way that they interact in a business sense. And that presents a generational opportunity for us to change the way that people do real estate. And there was no way that I was going to be able to be a part of that conversation unless I just jumped in feet first.
I loved what I was doing beforehand, but it's something that I would have just done for the next 40 years and nothing would have changed. Or if it changed, it would have changed without me. And if the conversation was going to change, if it could change, I wanted to be a part of that. I wanted to be a driving force behind that.
Chitra: Now you try, you successfully did this New York deal to show that this is possible, but it seems like a lot of this stuff is still very much esoteric in the realm of the theoretical. How many real deals that have gone down using blockchain technology and real estate and where do you kind of see, what's the trajectory for this?
Henry: Yeah. So with blockchain and real estate, I think that ours was the first, the Slice deal. But then there were a couple of follow ons. There was the St. Regis deal, the St. Regis resort in Colorado, they tokenized $18,000,000 and sold that to a syndicate of investors. And then this group out of New York called Propeller teamed up with Air Swap to create a platform called Fluidity. And they created this two token waterfall basically taking the real estate capital stack and slicing it up in this innovative way. Because typically real estate is debt and equity. And then there are different ways that you can sort of cut that up, right?
With debt, you can have mezzanine debt, you can have junior debt. With equity, you can have preferred equity, you have common equity, you have LP equity, you have GP equity. What each of them are isn't pertinent to this discussion. But what Propeller realized is that with tokenization, since you're changing the way that people do business and you're opening their mind up to different ways of doing things, you could take those different pieces of the capital stack and combine them in ways that hadn't been done before.
And they demonstrated this with their white paper called the Two Token Waterfall. And then they put it into practice on a condo project in New York for I think it was $30 million dollars, which I thought was super interesting. And then another group, Cold Harbor did a $20,000,000 tokenization of a student housing property in South Carolina. And so all of those were I think in the second half of 2018. And in total, I mean, that's like what, $100 million less of, of deals.
So like you said, we still are sort of in the realm of the theoretical. Here are people who have done this, but they've been typically just single asset tokenization and they've been fairly small on the grand scheme of things. And so a lot of the benefits that tokenization can offer have not been fully realized yet because we don't have a large enough market to realize those things.
Chitra: So I don't want to go too in the weeds, but I think maybe we should talk a little bit about the difference between fractional investing, which I guess this falls under and fractional ownership, right? There's two different things. So is it relevant and is it important for people to understand the difference and the context?
Henry: Yes. So that's an interesting conversation because like you said, what we're talking about right now is fractional investing. And when you hop on Crypto Twitter or a Medium Post, a lot of them talk about how they're excited about the advent of fractional ownership. But that is very different in the context of real estate.
Ownership means that your name is on the deed right? It means that you are the owner, you're not an investor, you're not somebody who just put in money to see that money grow and get it back. You are the person who's making the money grow. And the difference particularly in real estate in the US is that if you are the owner and you make a bunch of money on a real estate project, then you can sell that project, take all the money that you made and use it to buy another project and you don't have to pay taxes on that, but you can only do that... You do have to pay taxes eventually, but you can basically continue doing this process and defer your taxes forever.
Chitra: Indefinitely, yeah.
Henry: You could do it until you die and then your children will inherit all of that property at a stepped up basis and all of it is wiped out. They never have to worry about that deferred tax bill. And this is all... do your own research. I'm not an attorney and I don't want anybody to jump in the real estate space and come back to me later.
Chitra: We're not in the advice business.
Henry: But that can only happen if you are an owner of real estate. It doesn't happen if you're an investor. And in real estate, there's two ways of ownership. There is direct ownership and there is tenant and common ownership. In order for that to happen in the tokenized world, what you need to start doing is representing deeds on the blockchain. And once we start doing that, that opens up a fascinating new world of real estate investment and ownership.
And there are people who are working on that, on putting title on the blockchain, but it's a long process. If I think real estate is archaic, I mean title is the most archaic part of it. I mean it's literally like, so title insurance, which I'm sure you're familiar with, there are these title companies, right? And these title companies maintain a record of the ownership for a bunch of different properties. And they work in concert with the county recorder's office, which holds the original record, but the title companies have had their records as well.
And what you're basically doing is you're paying the title company insurance against the fact that their record is wrong. And it's because this is a paper-based, high friction, manually verified process. It's totally ripe for disruption. But you have this mix of public, private, which is very difficult to, you've just got a lot of bureaucracy that you have to like weed your way through in order to start moving title onto the blockchain. But once it happens, you do open up that form of fractional ownership.
Chitra: So I guess to sum up, no area of investment is probably better suited for innovation like real estate and could really use the benefits of blockchain technology. But given how archaic everything is, it could take a while.
Henry: It could take a while.
Chitra: You could be a gray beard by the time it actually [crosstalk].
Henry: I love that, that term gray beard. But I certainly hope that I'm not, although I already have quite a few gray hairs, I'm very proud of them.
Chitra: All brought on by this.
Henry: Yeah. And I'm also like almost entirely incapable of growing a beard. I've tried several times. It's not something you want to see. But I would like to think that once people start to see the efficiencies, and was actually just talking about this yesterday at a real estate conference. I don't think that blockchain is necessarily going to give us 10x or 100x process efficiencies in real estate. But I am absolutely 100% certain that it will give us 5%, 10%, 15% efficiencies. And when you extrapolate that across the hundreds of trillions of dollars of real estate across the globe, that's a massive amount of money. That is huge. Like unfathomably huge.
And so once people start to realize that and they see oh wow, I can do this 10% better, I think the change is gonna come pretty quickly. The title thing is different, but the transactional part of it, tokenizing securities in real estate, I think that once you hit that hurdle of terminal velocity, I mean it's just like, it's going to go crazy from there.
Chitra: Great. Do you have any closing thoughts or key takeaways for people?
Henry: Yeah. I mean, number one is I jumped into this space eight or nine months ago and it feels like it's been multiple lifetimes. But I have to say I could not be happier that I did that. You hear a lot, like you'll go on YouTube and you'll see influencers and whatever and they're like oh, quit your job, blah, blah, blah, you'll be fine. And it's really difficult to make that leap and be like oh wow, maybe I really should do this thing.
But if you create a plan, save some money and you have something that you know you're really good at and you think it's gonna change the world and you can make a difference, I would definitely say, maybe you don't have a mortgage and you don't have kids. I noticed that I do, I do have those benefits. Then go for it. Go for it. There's no better time than now. And if you want to change the world then you should probably start yesterday because either you do it or somebody else is going to do it and you're just going to get left behind. And it's better to just be a part of that.
And so yeah, I'm happier than I've ever been and super excited to be a part of what's going on in this space.
Chitra: That's great to hear. That's a great closing thought. Where can people learn more about you and the work that you're doing?
Henry: Oh sure. On LinkedIn, I'm LinkedIn/in/henry_elder. And then my company's website, which is www.digitalassetadvisors.io or daa.ninja if that one's too long.
Chitra: Awesome. Thanks so much. Great having you.
Henry: Thanks Chitra. Yeah, awesome to be here. Thanks.