Fractional property enabled by Blockchain

Problem

A house is a relatively illiquid asset. It is also one of the biggest purchases one makes. Saving enough for a deposit is difficult for younger generations in the era of ever increasing property prices, and getting it wrong can be quite damaging to a person’s financial health and overall wellbeing. Similarly, those who have built wealth through equity appreciation in their property cannot access it without either selling the property or borrowing against their equity which increases their debt burden.

Solution

We propose a fractional property marketplace where those looking to save enough money for a deposit in order to purchase a property (or those with existing properties looking to release equity) are matched with others who want to invest in property with smaller investment sizes, which also supports portfolio diversification.

We bring individual investors together to own a fraction or a share of the property alongside the principal purchaser.

This gives the investors the ability to invest in property with small amounts and gives those who are looking to buy or release equity from their own properties the money they need to do so.

Problems with existing market places

Fractional property platforms already exist in Australia as well as in other parts of the world. However their solutions don’t align with the market realities to deliver optimal outcomes for all involved.

1) Participants can’t propose their own properties for consideration

Most existing players limit the properties available on their platform to only those selected by the platform itself which effectively make them useless for those looking to raise deposits or release equity for their own properties.

2) Property is held by a trust or by some other entity instead of the principal purchaser

While a select few have started allowing anyone to start a syndicate on the platform, the legal structures used require the property to be owned by a trust or some other entity similar in nature to a trust in which all investors can then buy shares or units in. While this sounds good on paper, it creates several problems:

Problem 1: Prevents taking advantage of grants and other tax benefits

A number of benefits available as part of property ownership such as first home owner grants (FHOG), capital gains tax (CGT) concessions and stamp duty waivers are not available to these trust structures.

Problem 2: Lack of leverage

Fractional property is a securities offering and requires an issuer. This issuer becomes responsible for the offer and is also described as the Responsible Entity (RE). The RE is liable for the offer. Most financial institutions or licensees that qualify to play the role of the RE do not want to take on additional liability in the form of debt.

However, the reason property as an investment is so attractive is because of the ability to borrow against it. Banks will often lend up to 90–95% of the asset value.

Given the low interest rates, any uplift can create substantial leveraged returns for property owners. The current models impose liability of the debt onto the RE who in turn either restrict leverage completely or limit it to low LVRs with limited recourse borrowing with high interest rates..

Problem 3: Capital gain and rental yield is not attractive to the fractional investor

If an investor buys a $500,000 property with a $50,000 deposit and the property goes up in value to $600,000 in one year, then almost the entire gain of $100,000 is profit on the $50,000 investment. This is almost a 200% return.

This is called leveraged return and the ability to derive a leveraged return is what makes property interesting as an investment.

Without leverage, investors would require the entire $500,000 up front. This makes a return of $100,000 only a 20% return on investment — 10X less than our leveraged return example above.

This increased capital requirement and lower return means that unleveraged property investment is not so attractive, yet it’s how most existing fractional property platforms currently operate.

Problem 4: Limitation of leverage

Whilst a few of the existing platforms have started to offer leverage on their properties, the RE’s have only been willing to offer 30–50% max in a bid to keep the property in a positive cash flow position. Additionally, interest rates on these loans are on commercial loan terms, which are typically higher than residential home loans. It is highly unlikely current RE’s will allow higher leverage than this because it would impose untenable liabilities on them — effectively meaning existing platforms are limited to this amount of leverage.

Problem 5: Friction in secondary markets

Existing fractional property platforms try to establish a secondary market to provide investors an exit. There are a couple of issues with the current approach:

Not enough participants to make the offer liquid

Given that units in each individual property are not replaceable with others, the liquidity is limited to participants interested in a specific property. Without a large enough pool of participants interested in each property the secondary markets do not operate effectively.

Land stamp duty

Total change in ownership of the units once it exceeds a certain percentage can lead to land stamp duty costs which can be 5 to 6% on the total value of the property. This can significantly impact transaction costs hampering liquidity due to reduced returns.

Problem 6: No ability to release equity from existing homes

Given that existing platforms only buy property in a trust, it precludes the average property owner from releasing equity on their own properties because it’ll trigger a stamp duty event attracting a 5 to 6% (depending on jurisdiction) stamp duty on total value of property.

Our Secret Sauce

We propose a structure that addresses all the challenges mentioned above.

Instead of buying property in a trust we make an option agreement with the ‘Primary’ (the principal purchaser who owns or wants to own the property) that allows our marketplace’s Special Purpose Vehicle (SPV) to buy the property at its current price, at a future date. The value of this option thus becomes linked to the capital gain experienced by the property.

If a $500,000 property is now worth $600,000 then there is a $100,000 capital gain. Given the option allows us to buy the property for $500,000 its value is $100,000 that reflects the upside in value it carries. If the primary releases equity worth $25,000 at the start then the share of the SPV in the property is worth 5% of the property value.

When the property price becomes $600,000 the SPV is entitled to 5% of the proceeds which means its $25,000 investment is now worth $30,000.

On the other hand the Primary also has $25,000 in equity left in his name and he is going to get bulk of the upside.

So out of the $100,000 capital gain, the Primary is getting $70,000 and the investors are getting $30,000.

While it is true that the Primary is taking on the liability of the debt, investors are in a way still exposed as they have to take on the risk of primary defaulting against his debt. So we want to give the investors a share of the leveraged return. And instead of coming up with complex formulas to determine the share of the leveraged return we want it to be a market driven, decentralized approach.

THE BIDDING PROCESS

In the above example, the Primary can say that he will offer investors the same leveraged return which he is getting.

So the $100,000 will be split equally and investors and the Primary will both get $50,000 as return each.

In other scenarios the Primary might be more desperate for money, or his leverage may be higher or the market might not be as favorable. In that even the Primary can offer a higher fraction of the leveraged return. In that scenario the investors will get a stronger return than Primary.

In other cases the Property may be in a blue chip area and the Primary may not be as desperate for money. In that case he may offer a much lower rate of return.

Depending on the attractiveness of the offer, the fund unit holders will vote and take up each offer on a case by case basis. The votes will be conducted on the Blockchain to achieve transparency and immutability.

The ability to give investors a share of the leveraged return without taking on debt themselves is the key differentiator that would make this fractional property model more attractive to investors.

Note that the primary is still servicing the debt. In order to reward him we waive any rents due from him in lieu of the share he owes to the investors. This also keeps admin costs low and the overall rental yields are quite low to start with.

This model solves the biggest problem with fractional property which is investor interest.

While there will always be an unlimited demand from people looking to raise money for their deposits or those looking to raise equity but having this solution ensures investors are rewarded as well without saddling them with additional debt.

This solution also ensures the primary, or principal purchaser, is on title and gets all the relevant benefits and also given that this is not direct property ownership we also ensure that there are no stamp duties on the secondary market.

We also propose that instead of investors getting exposure to a specific property, we have investors vote on which property the fund options up but the investors themselves get a share of the fund which will be an aggregate of all the various options it owns.

This way each unit in the fund is fungible against another and a secondary market will have more participants in it and islanding of investors wont occur. Such a unit can then be bundled in an asset backed token and released for wider distribution worldwide.

There will be a separate Asset Backed Token or Master Fraction Token representing units or shares in the diversified property fund. The value of this token would be linked to the capital gain experienced by the underlying portfolio of properties.

The voting, registry, secondary market and all other activities of the fund including distributions processing can be handled on the blockchain.

The Master Fraction token is a security and will be handled as such.