We’re one day away from a “revolution of the global real estate market,” promises LiquidBricks, a bleeding-edge technology based startup with very interesting financial engineering ambitions.
I first learned of LiquidBricks while reading Commercial Observer’s coverage of Wall Street’s most recent efforts to securitize commercial property leases.
Some quick background: securitization is the name for the act of taking an illiquid asset, or a group of them, and packaging them for sale and resale as a security, usually a bond.
Mortgage-backed securities are a classic example of securitization, and in the residential real estate space, have earned a terrible reputation as a means to mix bad credit in with good credit, with the potential to bring the global economy to its knees, as was done in 2007-2008.
In the commercial space, securitization of mortgage debt hasn’t earned the same lousy reputation, and commercial mortgage-backed securities are not associated with scorched earth in the way their residential cousins have been.
In that light, Wall Street has been working on applying securitization principles to commercial real estate. One of today’s goals for the Street’s “financial engineers” is to apply securitization not just to debt incurred in the financing of commercial property, but to commercial leases themselves.
The idea is to create pools of like-kind leases and treat them like bonds – putting the combined leases up for sale on the open market packaged as one instrument.
Leases Aren’t Mortgages, So How…?
The big problem with this is the fact that commercial leases are far more than just payment schedules. They are not financial instruments as much as they are sets of conditions and rules that underpin a living, working, productive business. One lease does not fit all retailers, one set of clauses that works for one warehouse project is completely inappropriate for another, et cetera. Some experts say that efforts to securitize assets in commercial property belong under the umbrella of CMBS and not lease securitization.
“The CMBS market is very hot. I’m not sure why now would be the right time to” securitize leases, said Stijn Van Nieuwerburgh, director of the Stern Center for Real Estate Finance Research at New York University.
Mr. Van Nieuwerburgh said that while securitizing commercial leases is theoretically possible, he fails to see the “business logic” behind it and questions the appetite for these exotic investments.
“Why on earth would they invest in these commercial lease securities if they could invest in CMBS instead?” he said. “I don’t see what kind of need this addresses that CMBS does not.”
Enter The Blockchain and “Smart Contracts”
At a technical level, the problems posed by the marked differences between commercial leases are problems of standardization. Commercial rent income flows are conducted according to a schedule and are often variable subject to the terms of the lease. What if there was a way to make the rent flows as well as the rules embedded in the lease part of the same automated financial system, creating predictability and transparency in sufficient amounts so that the lease could be packaged as an investment vehicle?
This seems to be the key idea behind LiquidBricks. In the same Commercial Observer article, LiquidBricks (founder: Luigi Boschin) Chief Technology Officer Dan Doney talks about using the “blockchain“, a kind of public and irrevocable digital ledger, to create self-executing or “smart” contracts. If a commercial property’s lease arrangements are conducted in a currency that uses the public blockchain as a ledger and can define its rules in a programmatic way so that when X condition is met, Y adjustment is applied to the income flow (also automated), it becomes possible to introduce liquidity where there was none before. Fast transference of ownership and similarly fast alterations of income flow become possible. Lease terms that are unlike can, in theory, be treated as similar terms, clearing the way for packaging and resale.
“Liquid bricks”, indeed.
When LiquidBricks launches, we should expect hype, skepticism, and confusion. We should expect a lot of caution surrounding the carefully-crafted leases that the industry runs on. The blockchain technology proposed to be used here is the same that powers the alternative currency Bitcoin, and Bitcoin is still not ready for prime time.
But also expect the bleeding edge of financial engineering to call upon us to challenge our imaginations and question long-held assumptions. The only thing we shouldn’t expect in the long run is for commercial real estate’s financial instruments to escape the evolutionary pressures of technology or financial engineering. The only constant is change.