Multidisciplinary Guidance & Insights Newsletter #3
I have been asked by a number of valuers in various corners of the world to weigh in on the current rush to tokenize real estate. The question for this article is not whether tokenization is a good thing. It is, rather, how will valuers be able to analyze markets for real estate-based tokens and what might be the implications of their advent for fractional interest valuation generally?
Just as it is for all useful valuation questions, answering this one requires that we first recognize the nature of non-fungible tokens (often referred to as NFTs), then examine the asset- and market-related fundamentals that underlie value, and finally consider whether we might be able to extract useful information from newly created markets.
Tokenization is a method of creating divided or undivided interests in literally anything. For real estate, the interests can be undivided positions in a fee estate, or divided interests in such diverse rights as leasehold, airspace, occupancy, debt (or part of an income stream), and many others. Tokens are almost identical to contractual and deeded interests in this respect. But they can also represent less direct positions, such as member interests in LLCs that hold the underlying property. Such interests can also be very small, opening the way to involve the public in a way that lets smaller investors participate in a real estate market that appears to be getting away from them.
A non-fungible token or NFT is simply a record stored on the decentralized blockchain, where it can be securely held and traded. Although decentralized, tokens are still securities and are still subject to securities laws which (as is normal with any new technology) have not entirely caught up with the innovation. Yet. Securities law is not my field of expertise, nor is blockchain technology (although I am an engineer and former general securities principal). Valuation is my current field, and this article is prepared to assist valuers in understanding a newly invented means of fractional ownership while also pointing out the characteristics of such shared ownership that are not new at all.
What’s Not New?
Tokens themselves memorialize ownership in a new way. But the economic circumstances they represent are not new at all. The economics of such interests are still a function of the economics of the underlying asset(s) and the property and contractual rights attributable to the token holder. Our understanding of such fundamentals has improved greatly in recent years, and tokenization fits right into our models.
Any (undivided) real estate fraction is best understood if we view its relationship to the underlying asset as a whole. Fractions are created at a point in time where the sum of all of the fractions must either equal or exceed the cost of the underlying asset plus a little more to cover organizational and maybe promotional costs. In other words, every fractional interest must begin at a value equal to or exceeding its share of the whole. Every fractional interest. Whether as tenancy-in-common, an LLC member interest, or anything else, tokenized or not. There is no other way to “go in.” “Going out” is similar when the underlying asset is sold and the proceeds are distributed, although the amount is reduced a little by selling costs.
The valuation question to be answered now is this: “What happens to value between going in and going out?” We already know that fractional interests in real estate are famously not tradeable—trading is deliberately prevented by most operating agreements anyway—and are thus quite illiquid. One new attribute of tokenization is that it will solve the liquidity problem, right? Sort of, but not really. Let’s dig a little deeper.
A Value Spectrum
Fractional interests have value components that are tangible and components that are intangible. The tangible parts are the ownership rights that flow through to an interest-holder from the underlying asset—rights regarding operations, sale of the asset, lease division, and so on. (These rights are tangible because they are attributed to the tangible asset and are not personal to the interest-holder.) But because taking any actions to exercise these rights generally requires agreement of the other owners, an interest’s value is reduced from what it would be for a single owner of the whole asset. The reductions are control- and marketability-related, leading to discounts from the interest’s pro rata share of the whole. This has not been changed with the advent of NFTs. The tangible value component will always be subject to discounts during the period between going in and going out even if the interest is sold, because buyer and seller will be affected by the same restrictions.
Total value = intangible value + tangible (discounted) value
Intangible components make up the remaining value. Intangible benefits are necessarily present for every interest-holder at inception, and such benefits must at least offset the loss in tangible value. The loss isn’t erased, its effect on value is simply made up for by the intangible benefits. Such benefits might continue throughout the ownership period or they might change or even disappear. (Whether intangible benefits are present at the end is irrelevant since the proceeds will be distributed once a sale is consummated.)
The two value components carry different levels of risk. Just as in pretty much all valuation, fixed assets are at the lower end of the risk spectrum and intangible assets are at the top. For fractional real estate interests, tangible benefits are real estate-related, and their attributable discounts, price volatility and value should all be tied to the real estate asset itself. The intangible benefits, though, have no such anchor. It is entirely reasonable to expect that they can fluctuate with public sentiment, personal circumstances, or the past success (or lack thereof) of the investment. For example, given the recent run-up in real estate prices and consequent loss of affordability, it is possible that tokenized interests would allow participation by investors who would otherwise be shut out of real estate ownership. The intangible benefit could be driven by fear of being left out, for example, and I am sure readers can come up with other examples. But market trends and public sentiment change over time, along with owners’ experience levels, partner relationships, real estate operations, and personal needs and goals. The discounted tangible value component should be fairly durable through all of this. The intangible value component, not so much. This bifurcation of value has an interesting precedent.
Real estate is an illiquid asset, right? Well, it depends on your point of reference. The value of a real estate asset assumes a typical market exposure period, so the appraised value “bakes in” a delay from a few weeks to maybe a year, depending on the property type and market conditions. It takes significant exposure time to realize underlying value.
New decentralized markets are intended to provide liquidity for tokens in the same way that securities markets provide liquidity for publicly-traded real estate investment trust (REIT) shares. But such liquidity has nothing to do with the real estate. The token price still must be determined by a) the underlying asset markets, for which liquidity effects are already priced in; b) the reduction in property rights attributable to the shared ownership structure (discount for lack of control); and c) any intangible benefits that are perceived by the market at that moment.
The discount for lack of marketability might be greatly reduced if efficient market mechanisms are developed. But as of right now, lack of control isn’t going to change in an NFT holding (and it may even be made worse if partner exit and entry has no constraints). This would be quite similar to the position of the REIT shareholder whose share price is reduced by loss of control but for whom the market might increase or decrease that price for various intangible reasons (fear of recession, portfolio rebalancing needs and others).
Valuing Tokenized Interests
As with any other asset, tokenized interests will be worth whatever someone will pay for them, so there’s that. The market price gives us a value for this interest and that buyer, or for that group of interests and those buyers, at a particular point in time. But what value are we seeking, and how do we intend to apply it? If it is fair market value, then any personal benefits will have to be removed, as is done routinely when analyzing sales of individual properties.
Will token markets give us any insight into the value of a fractional interest generally? That would depend on whether a useful value indicator—most likely a discount from underlying asset value—could be extracted. But this can only happen if market participants have some predictable idea of underlying value in the first place, and if the discount notion was a factor in their purchase decision. It might also be expected yield, although that could be a conceptual stretch if the interests are very small. Intangible benefits might also be present, but fair market value disallows intangibles, particularly if they are personal. The problem is a difficult one and will depend strongly on data granularity provided by the market makers.
Tokenization is a technology-enabled concept that allows easy and efficient division of all kinds of asset ownership rights. This slicing and dicing doesn’t alter the nature of an asset nor its economics, but it does create all manner of interesting legal questions that will have to be worked out over time. The role of valuers—especially for fractional interests in real estate—is to penetrate legal and other wrappers that hold similar assets and identify and analyze how fundamental conditions affect value. We are finding that what we already know about fractional interest valuation is not changed much, if at all, by blockchain-recorded ownership, and it is also apparent that this new technology has a long way to go in defining rules and establishing active markets. I do hope that these markets will give us useful data that will allow greater understanding of fractional interest value, but my enthusiasm is tempered by the complexity of value influences and the ability of marketplaces to provide usable information. All I can say at the moment is “stay tuned” to this channel for further information. It is bound to get interesting.
 You can find a discussion of intangible benefits typically realized by fractional interest holders in my article “Intangible Value in Partnerships.”
 I made a presentation on long-term value titled “What is it Really Worth?” that you may access with a (free) membership at www.primusivs.com. The presentation describes valuation methods used by German Pfandbriefe Banks to underwrite covered bonds. Such methods are enabled under the European Mortgage Lending Value standard, requiring the bifurcated valuations that HypZert-qualified appraisers provide. The long-term value component allows much lower financing rates than does any increase above that value currently being realized in the market.
 The relationship between REIT share prices and underlying asset values is analyzed based on long-term total yields, as described on pages 148–161 in “Webb, Valuing Fractional Interests in Real Estate 2.0,” available at www.primusivs.com.
 These interests would be subject to the same considerations set forth for fractional interest markets in “Holy Grail or Can of Worms?”
Copyright © Dennis A. Webb, 2022, All rights reserved.