REIT's on the blockchain

What is a Real Estate Investment Trust, and what opportunities do they offer when put on the blockchain.

In Brief

REIT's are a 3.5 trillion USD asset class that stands a lot to gain from moving onto the blockchain. The advantages include:
  • Increased liquidity
  • Reduced operating costs
  • Reduced transactions times (down from weeks to minutes)
  • Reducing friction and administrative costs
  • Voting

What is a REIT

A real estate investment trust (REIT) is a company that owns, operates, or finances income-generating real estate.
Modelled after mutual funds, REITs pool the capital of numerous investors. This makes it possible for individual investors to earn dividends from real estate investments—without having to buy, manage, or finance any properties themselves.
Key Points
  • A real estate investment trust (REIT) is a company that owns, operates, or finances income-producing properties.
  • REITs generate a steady income stream for investors but offer little in the way of capital appreciation.
  • Most REITs are publicly traded like stocks, which makes them highly liquid (unlike physical real estate investments).
  • REITs invest in most real estate property types, including apartment buildings, cell towers, data centers, hotels, medical facilities, offices, retail centers, and warehouses.

What Qualifies as a REIT in the US?

To qualify as a REIT, a company must comply with certain provisions in the Internal Revenue Code (IRC). These requirements include to primarily own income-generating real estate for the long term and distribute income to shareholders. Specifically, a company must meet the following requirements to qualify as a REIT:
  • Invest at least 75% of total assets in real estate, cash, or U.S. Treasuries
  • Derive at least 75% of gross income from rents, interest on mortgages that finance real property, or real estate sales
  • Pay a minimum of 90% of taxable income in the form of shareholder dividends each year
  • Be an entity that's taxable as a corporation
  • Be managed by a board of directors or trustees
  • Have at least 100 shareholders after its first year of existence
  • Have no more than 50% of its shares held by five or fewer individuals
Today, it's estimated that REITs collectively hold about $3.5 trillion in gross assets; publicly traded equity REITs account for $2.5 trillion

REIT's in the UK

Originally established in the US in 1960, REITs were eventually introduced in the UK in 2007, with the hope of fueling speculation and real estate sector growth. This was a decision so popular that most major property-linked companies became listed as REITs.

Who can apply in the UK

A company or principal company of a group can apply to be a REIT if it:
  • has an existing property rental business of at least 3 properties, where no one property represents more than 40% of the total value of properties involved
  • is UK resident for tax purposes
  • is not an open ended investment company
  • is “admitted to trading” A UK-REIT needs to be admitted to trading on a recognised stock exchange for at least part of the first day on which it enters the UK-REIT regime and thereafter. An additional share condition requires that shares in UK-REITs must either be listed on a recognised stock exchange throughout each accounting period or be traded in each accounting period. New entrants to the UK-REIT regime are not required to meet this condition in the first three accounting periods in which they are a UK-REIT.
An open-ended investment company (abbreviated to OEIC, pron. /ɔɪk/) or investment company with variable capital is a type of open-ended collective investment formed as a corporation under the Open-Ended Investment Company Regulations 2001 in the United Kingdom. The terms "OEIC" and "ICVC" are used interchangeably with different investment managers favouring one over the other. In the UK OEICs are the preferred legal form of new open-ended investment over the older unit trust. - Wikipedia
Who cannot apply..
You may not be able to apply to be a REIT depending on the type of business you are, or the type of activity you make money from.

Excluded businesses

Businesses that are not property rental businesses for REIT purposes and cannot apply include:
  • incidental letting of property held in connection with a trade in property
  • letting of temporarily surplus accommodation
  • structured finance arrangements
  • owner-occupied property, including:
    • intra-group owner-occupation
    • ‘stapled’ company owner-occupation
    • ‘stapled’ companies

Excluded activities

Activities that exclude you from applying include:
  • caravan sites
  • way leaves
  • siting of a pipeline for oil and gas
  • mobile phone masts, satellite dishes or similar
  • siting of a wind turbine
  • dividends from another REIT
  • interest in a limited liability partnership (LLP)
UK REITs benefit from an exemption from UK tax on both rental income and gains relating to their property investment business. On an ongoing basis, the REIT business has to meet certain tests as well as being required to distribute 90% of its rental income in respect of each accounting period in order to obtain exemption from tax on its rental income. The requirements to qualify for REIT status include tests such as those listed below.
REIT setup requirements
  1. 1.
    At least 75% of the UK REITs gross assets must be used in the rental business and at least 75% of the UK REITs profits must be earned in its qualifying rental business.
  2. 2.
    Members of a UK REIT may have other activities. Such activities must not involve more than 25% of the UK REITs gross assets, nor generate profits of more than 25%. Such tests are carried out using the consolidated group results as set out in financial statements produced using International Financial Reporting Standards (IFRS) with adjustments for non-recurring or distortive items, e.g. movement on hedging, one-off transactions.
  3. 3.
    Only rental profits and gains realised on the disposal of properties used in the UK property rental business will be exempt from tax.
  4. 4.
    There must be at least three properties with no one property accounting for more than 40% of the value of the REIT assets (note, a single property which is multi-tenanted such as a shopping centre will count as more than one asset).
  5. 5.
    Property development by the UK REIT for investment on its own account is permitted, and is generally included within the property rental business unless development costs exceed 30% of the acquisition cost (or the property’s value at the time of entry to the REIT regime if higher) and the property is sold within three years of completion.
  6. 6.
    Property trading is permitted but is taxable, and falls outside of the property rental business for the purpose of the balance of business restrictions.
  7. 7.
    There are no restrictions on foreign assets, may invest outside the UK in real estate wherever located.
There are no restrictions on foreign assets, may invest outside the UK in real estate wherever located
The main reason why REITs are so attractive is because there is tax relief on rental income and gains from property investment. Other positive features include REITs being open to non-resident investors. As REITs are listed on exchanges, they are considered transparent and liquid investments which are positive characteristics for all types of investors.
To date, according to the British Property Federation there are circa 30 UK REITs listed in the UK with market capitalisation of circa £33 billion.

Types of REIT

Equity REIT
Mortgage REITs.
Hybrid REITs
Equity REITs
Equity real estate investment trusts are the most common type of REIT. They acquire, manage, build, renovate, and sell income-producing real estate. Their revenues are mainly generated through rental incomes on their real estate holdings.
An equity REIT may invest broadly, or it may focus on a particular segment. Here's a rundown of how each segment performed in 2019, according to the National Association of Real Estate Investment Trusts
Date source: Nareit
In general, equity REITs provide stable income. And because these REITs generate revenue by collecting rents, their income is relatively easy to forecast and tends to increase over time.

Their earnings are generated primarily by the net interest margin—the spread between the interest they earn on mortgage loans and the cost of funding these loans. This model makes them potentially sensitive to interest rate increases.
Mortgage REITs—also called mREITs—invest in mortgages, mortgage-backed securities (MBS), and related assets. While equity REITs typically generate revenue through rents, mortgage REITs earn income from the interest on their investments.
Their earnings are generated primarily by the net interest margin—the spread between the interest they earn on mortgage loans and the cost of funding these loans. This model makes them potentially sensitive to interest rate increases.
For example, assume company ABC qualifies as a REIT. It buys an office building with the funds generated from investors and rents out office space. Company ABC owns and manages this real estate property and collects rent every month from its tenants. Company ABC is thus considered an equity REIT.
On the other hand, assume company XYZ qualifies as a REIT and lends money to a real estate developer. Unlike company ABC, company XYZ generates income from the interest earned on the loans. Company XYZ is thus a mortgage REIT.
Like equity REITs, the majority of mortgage REIT profits are paid to investors as dividends. Mortgage REITs tend to do better than equity REITs when interest rates are rising.
These REITs use the investment strategies of both equity and mortgage REITs

Pro's and Con's for investors

Low growth
Potential for high management and transaction fees
Dividends are taxed as regular income
Stable cash flow through dividends
Subject to market risk
Attractive risk-adjusted returns

REIT vs. Real Estate Fund: What's the Difference?

REITS pay out dividends; real estate funds can appreciate in value
  • A real estate investment trust (REIT) is a corporation that invests in income-producing real estate and is bought and sold like a stock.
  • A real estate fund is a type of mutual fund that invests in securities offered by public real estate companies, including REITs.
  • REITs pay out regular dividends, while real estate funds provide value through appreciation.
Regular Dividends could be achieved through tokenisation

Leading REITs trading on London Stock Exchange (UK)

as of 31 October 2021, by market capitalization
All UK Listed REITs and key financials
52 listed REIT's and financials available here
The smallest market-cap REIT in the UK is £7 million followed by £51 million

How are profits distributed to investors

REIT's are tradable on UK stock exchanges, and so investors are rewarded with the capital gains on their investments as well as a dividend payout. LAND currently has a dividend of 3.92%.
We can see the external market forces such as the pandemic greatly affected returns on this REIT.

SL - REIT in Sri Lanka (introduced in 2020)

Prior to the global disruptions and market uncertainty due to COVID-19, the real estate market in Sri Lanka had shown steady year on year growth over the past several years. The general rate of increase in property values though had diminished in the past two years in comparison to the 2017/18 period.
SL-REITs are an alternative investment scheme, which offers investors an opportunity to invest in the real estate asset class in Sri Lanka without having to make direct investments in property. A SL-REIT is a portfolio of investments in property created by investing funds subscribed by investors through the purchase of units of a SL-REIT.
A SL-REIT Managing Company is licensed to operate a SL-REIT under the Securities and Exchange Commission of Sri Lanka Act No. 36 of 1987 as amended by Act No. 26 of 1991, No. 18 of 2003 and No. 47 of 2009 (SEC Act). Such managing company is required to comply with the terms and conditions applicable to a Managing Company of a Unit Trust as stipulated in terms of Part IV of the Schedule to the SEC Act to obtain such licence and will be governed and regulated by the following;
  • The SEC Act and the Directives issued thereunder
  • Unit Trust Code for Sri Lanka Real Estate Investment Trusts, No. 01 of 2020
  • SL-REIT Trust Deed
  • The Explanatory Memorandum
  • Applicable Laws relating to Tax
  • All applicable Laws relating to property in Sri Lanka
Specifications of REIT in Sri Lanka
Listing Rules of the CSE have been updated to accommodate REITs
  1. 1.
    SL-REIT can take the form of (a) a property purchased with the intention of leasing; (b) a property leased with the intention of sub-leasing. All properties, however, have to be fully completed. The real estate property forming the underlying asset of a Sri Lankan REIT should have a minimum occupancy of 20% or as may be specified by the SEC.
  2. 2.
    The REIT should have a life of over 5 years. REIT holders may exit via sale of their holdings in the secondary market. However, redemption not allowed unless at the point of winding up or terminating the REIT (i.e. at sale of property or expiration of lease).
  3. 3.
    REITs to be listed and traded with a minimum of 20% of units issued by the REIT to be held by a minimum of 100 public unit holders on the date of listing.
  4. 4.
    Bi-annual property revaluation is required. Additionally, the REIT Manager is required to disclose the Net Asset Value (NAV) per unit of the SL-REIT to the Colombo Stock Exchange on which the SL-REIT is listed, every quarter. REIT to maintain minimum public holding requirements as per the Listing Rules.
  5. 5.
    Direct foreign ownership of properties is currently prohibited in Sri Lanka (other than under certain limited circumstances), with foreigners either required to enter into a long-term lease agreement or create a corporate structure with Sri Lankan partners, which is a costly and time-consuming process. However, foreign ownership of REITs will be permitted enabling a more diversified investor base for the asset class.
  6. 6.
    Valuer qualification criteria will be specified and need to be rotated every 2 years. SEC will have a panel of valuers who will advise if there is a dispute.
  7. 7.
    A Trustee should be appointed with the prior approval of the SEC and should be a bank licensed by the Central Bank of Sri Lanka.
  8. 8.
    A Sponsor is a person who transfers or leases property to a Sri Lankan-REIT. The Sponsor / Strategic Investor must hold a minimum of 30% of total units, which would be locked-in for a period of 6 months from the date of listing of the units.
  9. 9.
    The minimum value of SL-REIT should be LKR 500 mn.
Interesting Read on introduction of REITS in Sri Lanka - FT Article
Cost of Listing in Sri Lanka
The Initial Listing Fee
  • The initial listing fee payable by the Managing Company in respect of units of a REIT listed on the Exchange shall be Rs. 100,000/-. The initial listing fee will be waved off for application received within the first 18 months of the rules being published. (11th September 2020)
The Annual Listing Fee
  • When the units of a REIT are listed on the Exchange the annual listing fee payable by the Managing Company to the Exchange on or before the 15th day of February in each calendar year shall be Rs. 100,000/- (Listing fee for the initial year will be pro-rated based on the approval)
The Listing Fee For Further Issue And Listing Of Units
  • The listing fee payable by the Managing Company to the Exchange for further issue and listing of units of a REIT on the Exchange shall be Rs. 50,000/-.
It looks like the main documentation needed is the Explanatory Memorandum and the SL-REIT Trust Deed

Tokenisation of REITs

Now to the interesting part, how can companies adapt the REIT model to launch on the blockchain.
Voting: It's possible to create a DAO - fund raise and raise capital and make investment decisions as a whole, then use regulated entities to structure a REIT and distribute dividends through tokens.
If you offer a token that had a fixed supply, backed by shares in a UK REIT - you could provide investors with yield on their current tokens generated through the steady rental income provided by the rental properties. It would be pinned to property and would be stable so could lend itself to becoming a counter-cyclical hedging tool within the cryptocurrency space.

What Problems does tokenisation of Real Estate solve?

Liquidity of real estate
Searching for property
proof of ownership
Entry barrier
One of the most significant issues with investing and selling real estate is the liquidity of the asset. In the normal course of a transaction, there are many different parties involved, especially with the legal transfer of the asset. Tokenization could potentially mitigate this issue in specific situations. As easy as it is to buy and sell various cryptocurrencies in the marketplace, tokenization could simplify transactions in the real estate space. Rather than the normal transfer of the ownership process that takes place when selling a share of ownership in a real estate investment, tokenization could cut out the middleman and allow ownership to be transferred directly from investor to investor.
Another issue encountered when investing in real estate is the actual search for the property in which you will invest. There are many marketplaces where these assets are available for sale. If the assets were tokenized, they could be listed in one centralized marketplace. This eases the investor's job by allowing the search for a potential investment to take place in one location. Through this possibility, investors will have access to search for potential investments located in other geographical areas and allow sellers to gain access to a large pool of potential buyers.
Proof of ownership is another issue encountered by traditional real estate investors. Legal ownership is usually displayed through various legal documents that show the sale of the asset and the ownership rights of the new investor. Tokenization utilizes the distributed ledger system, just like cryptocurrencies. A distributed ledger is a database that is consensually shared and synchronized across multiple sites and accessible by multiple people. Any changes or additions made to the ledger are reflected and copied to all participants in a matter of seconds. Each transaction is sent and validated by the network that makes up the marketplace. This feature of blockchain technology mitigates any issue arising from various ownership claims because the network could validate each transaction and show the rightful owner of the asset.
Assets can now be divided into smaller amounts of ownership, thanks to tokenization. This gives far more people the ability to invest in real estate without going through the daunting legal process of transferring ownership, with which many beginner investors may not be familiar.
Real estate tokens can represent a portion of the deed, an equity interest in a legal entity, ownership of the collateralized debt, or any other form of asset related to that real estate. The nature of the interest being tokenized may impact which regulations apply to the token.

The future of Real estate tokenisation

Although the development of real asset tokenization is still hindered by a lack of financial markets, a weak legislative framework around digital assets and a low level of awareness among investors, the tokenization of real estate assets is becoming an increasingly popular sector of investment activity. Real estate tokenization is a promising application of blockchain technology that will increase the investor base by increasing liquidity in the market, because it allows for more small-scale investor participation. This value proposition is particularly needed in real estate as the market for real estate is more valuable than any other asset class in the world, yet it remains highly illiquid. Tokens are the next phase in the development of blockchain technologies, allowing investors to move from highly speculative cryptocurrencies without collateral to asset-backed tokens. As the amount of functioning secondary markets for real estate tokens grows, the adoption of this investment platform will continue to grow as well, which will help the real estate market continue to thrive.

Automation of REIT management

For a REIT to be integrated on the scallop blockchain, there would need to be automation of the following services:
  • Exercising due diligence to ensure the property is valued correctly.
  • Collecting and investing lease rentals appropriately.
  • Ensure income is distributed in a timely manner.
  • Perform KYC and Customer Due Diligence.
  • Appoint a property manager to manage and maintain the real estate properties of the SL-REIT including ensuring validity of all material contracts.
  • Ensure adequate insurance coverage is obtained for all properties.
  • Appoint investment committee and ensure compliance of the REIT’s investments (as per SEC regulations).
Eliminating these tasks would allow Scallop to take a fee from investors, as well as the capital gains from token ownership from the initial fund raise.

Key Stakeholders of a REIT

  1. 1.
    An Individual or a Company who owns the property which is to be transferred into the REIT through the Managing Company
  2. 2.
    Trustee - A bank licensed by the Central Bank of Sri Lanka and appointed with the prior approval of the SEC, with a Fiduciary duty to hold the assets.
  3. 3.
    Managing Company - Perform duties in accordance with applicable Rules and Trust Deed and will oversee the Property Manager, Compliance Officer, Construction Contractor and any other Designated Persons.
  4. 4.
    Property Manager - The property manager would be required to Maintain the asset in a marketable condition.

What makes REITs a superior investment model

  • Simple business model any investor could understand.
  • Better earnings visibility reduces the possibility of over/under valuation.
  • Since most of the surplus cash is paid out, there is better transparency. New investments require debt or equity, which means additional scrutiny of commercial viability.
  • Limitation on share ownership reduces conflict of interest.
  • Higher efficiency; companies can expand rapidly due to easy access to capital. This brings in economies of scale.
How can blockchain add to this - we can see rapid expansion due to capital raise bringing a better economy of scale.

BlockChain and Real Estate

Real Estate Tokenisation - The process of real estate tokenization involves converting a real estate asset into a token on the blockchain and putting it for sale. You can also create tokens for properties under construction. These tokens represent an interest in real estate or can work to raise capital for investment development.

In Summary

REIT's are a 3.5 trillion USD asset class that stands a lot to gain from moving onto the blockchain. The advantages include:
  • Increased liquidity
  • Reduced operating costs
  • Reduced transactions times (down from weeks to minutes)
  • Reducing friction and administrative costs
  • Voting
REIT's are an exciting example of how blockchain technology can create real world utility, and we at Scallop see a bright future for the technology.