October 7, 2022

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Rise Of Digital Real Estate: Risk/Reward Unappealing

13 min read

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I’ve shared this with my regular readers a time or two before. But back when I was a kid, I used to love the game of Monopoly.

Go figure.

And I was good at it too.

Go figure again.

All of that real estate. All of that opportunity. All of that money to be made by, yes, some chance but also by knowing what to buy and what wasn’t worth it, not to mention strategic deals and finances maintained along the way.

I was definitely in my element whenever we played.

Now, admittedly, back then, I might have been a little overly competitive. And I definitely had a different mindset in my real estate selections than I do today.

Today, I want to make people money. But back then?

Oh, back then, I was all about bankrupting the competition. The bigger their downfall, the sweeter my victory.

I got quite the thrill from making all that money too. Those white one dollar bills, pink fives, yellow 10s, green 20s, blue 50s, beige 100s, and orange 500s. They were beautiful things to me, and I couldn’t get enough of them.

Who doesn’t like money, after all, especially a kid who doesn’t understand the hard work that’s almost always involved in making it… or the sacrifice of keeping it.

Modern-Day Monopoly Money

As I grew up, I learned more about that first part of the equation. It’s difficult to be raised by a single mother and not realize that.

Plus, I got a job of my own: a paper route, which taught me a ton. So did going to college as a business and economics major.

But apparently I didn’t learn my lesson well enough when it came to the sacrifice part of the equation. Because when I went on to become a successful businessman myself, I know I didn’t treat my money wisely.

Being a real estate developer and then a landlord on top of that, I definitely worked hard for it. But then I let it go far too easily.

It took my real estate empire crashing and burning around me to clue me in that I should have been saving much more of my millions instead of living like a rockstar.

Perhaps each person has to learn their own lesson in this regard. Perhaps I’m wasting my time writing these paragraphs.

But I’m going to share my thoughts on today’s version of “Monopoly” anyway. Because back when I was playing games, both the real estate and the currency were fake.

But today, the currency is very real. It’s just being spent on thin air.

Yes, I’m talking about non-fungible tokens, or NFTs. And yes, I’ve written about them before with varying shades of disapproval.

I might have even been a bit bullish on them at some point, thanks to my son’s influence. He’s enthusiastic about the asset class, even going so far as to teach others about it – myself included.

So before you rush to comment, I understand the appeal of NFTs. Especially when it seems like such easy money to make and “everyone’s doing it.”

But…

Don’t Confuse Virtual Reality With Actual Reality: One is Counterfeit

Thanks to the concept of NFTs, you can now buy digital “dollars”… digital expressions… and digital real estate.

Or maybe, instead of “digital,” I’d be more accurate in saying “virtual.” As in “simulated.” As in not physically grounded and therefore completely impractical.

I think it’s the fact that there’s “virtual” real estate people are paying good money for that’s officially set me over the edge into “this makes no sense” territory.

Here’s a Motley Fool writer’s take on the subject:

“Digital real estate doesn’t have any regulatory rules since it exists in a virtual world that’s the financially regulated equivalent of the Wild West.

“Digital real estate exists in virtual spaces, often referred to as ‘the metaverse’ or ‘sandbox platforms,’ where users can interact with and construct almost anything they want…

“Just like real-life real estate, virtual real estate lots are designated parcels within the space designated for the platform. There’s a limit on how many parcels are available, depending on the platform. And that creates scarcity in the same way that there is only so much land in the physical world.”

But with all due respect to the author – who did a great job explaining the subject – NFT real estate isn’t “just like real estate” at all. When push comes to shove, it has no actual value.

The real estate in it just isn’t functional. Or necessary. It’s not going to keep you safe from the elements. Or from criminal elements. Or from anything whatsoever.

It’s recreational alone, rather like a Super Mario game. And, also like a Super Mario game, once the power goes out, so does that “universe.”

That’s why I have an alternative suggestion to capitalize on this virtual, digital craze. And one that’s reality based.

Who Wants a Piece of Metaverse?

When Market Zuckerberg announced that Facebook was changing its name to Meta Platforms Inc. (FB) last October there were reverberations throughout the rest of the stock market.

What is the metaverse exactly?

Well, Meta Platforms explains the concept rather simply, saying,

“​​The “metaverse” is a set of virtual spaces where you can create and explore with other people who aren’t in the same physical space as you. You’ll be able to hang out with friends, work, play, learn, shop, create and more. It’s not necessarily about spending more time online — it’s about making the time you do spend online more meaningful.”

Zuckerberg’s presentation pushed the term “metaverse” into the mainstream and the impacts have been far reaching.

Since Zuckerberg’s announcement, we’ve seen a slew of metaverse related rallies, ranging from the big-tech stocks whose massive balance sheets and strong cash flows provide them the flexibility to invest heavily into any areas of emerging disruptive tech (for instance, Meta Platforms plans to invest $10b+ into metaverse aspirations in the coming years), smaller speculative pure plays related to blockchain technology, augmented/virtual reality, and the digitization of the physical world, alternative assets, such as cryptocurrencies and non-fungible tokens, and even virtual land.

A lot of the momentum here appears to be driven by recent populous movements regarding decentralized finance and internet applications – in short, the growing distrust of major institutions amongst large swaths of the world’s population has led to a desire for individual ownership of assets, ideas, and ultimately, a sense of true freedom, which is outside of the traditional boundaries set up by Westphalian sovereignty.

This has led to the idea of internet 3.0, which is built upon decentralized blockchain technology. Instead of the current internet 2.0 reality where a relatively small bag of mega-tech stocks control the data and content, a shift towards internet 3.0 would shift control of data (essentially digital property) from the controlling corporations to the individual owners.

Grayscale Research released its “The Metaverse” report in November of 2021, where it highlighted the long-term potential of web 3.0 virtual cloud economies.

In the Grayscale report, the authors provided this graphic, which attempts to break down the evolution of the internet into relatively simple terms.

Grayscale Research Metaverse Report - Key features of web 1.0, 2.0 & 3.0

Grayscale Research Metaverse Report

Grayscale

The Harvard Technology Review recently touched upon this theme in a report titled, “Owning the Metaverse: Blockchain Democracy in a Virtual World”. The report’s author, Matt Tengtrakool, said:

“As a digital asset, blockchain establishes ownership and governance, a uniquely democratic power structure. In a society where all facets of media, entertainment, commerce, and governance converge digitally, it is up to decentralized autonomous organizations (DAOs) to lay down the law and maintain order.

DAOs, by nature, cryptographically allocate power to all. This government of the future allows for a trickle-up power structure where users take direct stake in internet-native organizations. Moreover, the administrative capabilities are bound to immutable smart contracts that establish transparency and equity.

Harnessing this technology, an embryonic promise awaits for populists and anarchists alike. Already, with as little as a few spare dollars, blockchain allows everyday citizens to partake in a global peer-to-peer exchange.

In a similar fashion, Metaverses provide a unified structure of global governance. This revolution is the first step toward disassembling artificial borders, releasing the constraints of our federated physical world.”

In a nutshell, the idea of the metaverse involves the merging of individuals’ physical, augmented, and virtual realities. As the technology surrounding virtual realities improves, the lines between all three states of reality will blur as social and work-related applications increase.

At this point in time, the entire thesis regarding the metaverse evolving from a thing of science fiction into something with real-world applications, appears to remain very speculative.

The term “metaverse” was coined by Neal Stephenson in his 1992 novel Snow Crash. This dystopian cyberpunk tale, along with William Gibson’s Neuromancer (which inspired The Matrix film franchise) and Ernest Cline’s Ready Player One (which was later made into a feature film by famed director Steven Spielberg) are widely considered to be the foundational pieces of canon when it comes to the fictionalized metaverse.

These stories involve a 3D virtual world where humans can come and go via portals (such as virtual reality headsets, not unlike the Oculus headset which is currently being produced by Meta Platforms).

In his “Founder’s Letter” regarding the Facebook-to-Meta rebrand, Zuckerberg said:

“When I started Facebook, we mostly typed text on websites. When we got phones with cameras, the internet became more visual and mobile. As connections got faster, video became a richer way to share experiences. We’ve gone from desktop to web to mobile; from text to photos to video. But this isn’t the end of the line.

The next platform will be even more immersive — an embodied internet where you’re in the experience, not just looking at it. We call this the metaverse, and it will touch every product we build.”

The aforementioned Grayscale report highlights the potential size of the metaverse/internet 3.0 economy, touching upon trends like increased leisure time, especially amongst younger generations, being dedicated towards digital entertainment (largely gaming and social media), increased in-game spending, and rising digital advertising spending.

As you can see below, Grayscale points out that the current market caps of publicly-traded internet 2.0 companies is in the $15 trillion range and that these companies risk major disruption if they don’t adopt metaverse/internet 3.0 adaption.

Market Cap: Web 2.0 & 3.0 Metaverse, Facebook, Gaming

Grayscale Research Metaverse Report

Grayscale Research

We’ve already seen many examples of big businesses adopting these technologies…

For instance, Sotheby’s has launched digital art galleries where individuals can showcase and sell their NFTs, and Nike (NKE) has recently purchased RTFKT, a company that specializes in digital goods.

Nike hopes to maintain the relevance of the swoosh in the digital world, famous celebrities, such as Justin Bieber and Ariana Grande have performed concerts for fans as their avatars in digital settings and Paris Hilton DJed a New Year’s Eve party on her own virtual island this year.

Also, Disney (NYSE:DIS) recently patented technology for virtual theme parks, Microsoft (MSFT) has announced plans to add AR/VR capabilities to its Teams platform in 2022 and Microsoft has already entered into a partnership with the U.S. Army to help train soldiers using its HoloLens 2 virtual reality headset, and there are numerous video game companies which are already offering VR experiences for gamers.

As more and more events take place in virtual settings, it’s expected that the digital advertising opportunities for companies who want to capture the attention of all of these avatars will become a major opportunity worth hundreds of billions of dollars.

The Rise Of Digital Real Estate

What’s potentially even more interesting to us at iREIT is the growth that’s being seen in the world of digital real estate.

The idea of a virtual real estate market is especially interesting to us at iREIT, even if the idea of these virtual properties having, maintaining, and holding long-term value seems a bit far-fetched.

Admittedly, the idea of people paying millions of dollars for digital dwellings seems pretty absurd. And yet, that isn’t stopping people from doing so.

We recently came across an interesting report regarding the digital land rush and a massive purchase by Republic Realm, which is an investment firm focused on metaverse & NFT investment and development.

Republic Realm’s co-founder and CEO, Janine Yorio, has a history in the real estate investment/development space. In the past, she served as a portfolio manager and other leadership roles in various property management companies in the hospitality space.

Her resume is undoubtedly impressive. And now she’s focusing that knowledge/experience on building out a portfolio of digital real estate, which she believes is akin to getting in on the ground floor of modern society’s development.

Regarding the $4.3 million purchase of a 24×24 parcel in the Sandbox metaverse that Republic made in December, Yorio said,

“We bought a city, or the equivalent.”

In the same Yahoo Finance article, Lorne Sugarman, Metaverse Group’s CEO, spoke about the purchase, saying,

“We think the Fashion District purchase is like buying on Fifth Avenue back in the 1800s … or the creation of Rodeo Drive.”

Obviously, Yorio hopes it doesn’t take 200 years to find out, but can you imagine paying $4.3 million for the entirety of 5th Ave?

That sort of upside remains extremely speculative, but the land rush in the digital property space is real right now, and prices continue to rise, showing significant demand and a widespread belief that properties in the metaverse will maintain (and grow) long-term value.

Andrew Kiguel, CEO of Toronto-based Tokens.com, recently took part in the digital land grab, spending $2.5 million on a parcel of digital land in the Decentraland metaverse. He said,

“Prices have gone up 400% to 500% in the last few months.”

In short, it appears that Zuckerberg’s announcement has stoked a digital property market that is even hotter than the current trends that we’re seeing in the physical residential space.

In a recent interview with CNBC, Yorio touched upon her company’s recent digital real estate deals, which involved developing and selling 100 private digital islands for $15,000 each last year. She said,

“Today, they’re selling for about $300,000 each, which is coincidentally the same as the average home price in America.”

With regard to the comparison between residential real estate and digital properties, rapper Snoop Dogg is building a digital mansion in the Sandbox metaverse and recently, someone paid $450,000 for an adjacent plot of land so that they could be his neighbor.

(Woof, woof)

The metaverse appears to be the next iteration of social media and with that in mind, the value here is all about practical use cases, the congregation of people, and the purchasing power of those avatars.

We’ve seen the NFT market take off, in many cases, because of its club-like aspects and the networking effects that owning certain assets can produce. Digital property is in the same boat.

But, even $1 trillion TAM targets for metaverse operations being pushed by research firms like Grayscale, those with a deep understanding of the space admit that these digital property investments carry incredible risk. In her CNBC interview, Yorio said,

″[It’s] highly, highly risky. You should only invest capital that you’re prepared to lose. It’s highly speculative. It’s also blockchain-based. And as we all know, crypto is highly volatile. But it can also be massively rewarding.”

Risk/Reward Unappealing

And, with all of that being said, we still don’t find the risk/reward with these digital real estate investments attractive.

Maybe we’re missing out on a major opportunity here, but overall, we remain pretty content to allocate our investment dollars towards publicly-traded REITs which offer well-diversified portfolios of physical real estate that exist, and generates cash flows, in the real world.

But, that doesn’t mean that we don’t recognize the disruptive nature of the metaverse, internet 3.0, cryptocurrency, NFTs, and the other new-age digital growth markets.

Thankfully, we can have our cake and eat it too when it comes to one of our favorite sub-sectors of REITdom – the data center and cell tower REITs- when it comes to the secular growth of these digital trends.

You see, all of the data associated with the metaverse is going to have to be transferred and stored somewhere.

And while it’s true that semiconductor companies across the world are working tirelessly to combat Moore’s law and come up with ever more efficient solutions to computing power and data storage, the fact is, barring some sort of unforeseen technological breakthrough, the metaverse is going to drive demand for cell towers, server farms and data storage systems far into the future.

This leads us to believe that one of our biggest long-term winners, Digital Realty (NYSE:DLR) stands to benefit from this trend.

Is buying shares of Digital Realty today akin to buying Rodeo Drive a century ago?

No, probably not.

But, DLR has generated very reliable returns for its shareholders over the years, it continues to provide a dividend yield that is well above the S&P 500’s (DLR yields 2.92% compared to the SPY’s 1.21% yield), it is well known for its predictable dividend growth (DLR has now increased its annual dividend for 17 consecutive years), and the funds from operations that are thrown off by the business are much more than fantasy.

We’ll take a reliable wealth generator over a speculative bet any day.

We recently updated our outlook on DLR, raising our fair value estimate on shares from $135 to $150, noting that while DLR currently trades with a P/AFFO premium which is well above its historical norm, the company’s increasing global scale, low cost of capital, and strong future growth expectations make it an intriguing stock to follow as its sells off from prior highs.

Today, DLR trades for $157/share (down approximately 11.6% from its recent 52-week high of $178.22), which represents a modest premium to our current price target.

Even though we already own a large stake of DLR within iREIT’s Durable Income portfolio, as its stock price falls, Digital Realty is moving higher and higher up our watchlist.

And, at the end of the day, if we were forced to choose between shares of DLR and a plot of land in the metaverse right now, we’d much rather pay a modest premium for shares of a blue-chip stock than to gamble our hard-earned money on digital assets that may or may not stand the test of time.

Digital Realty Trust Operating Cash Flow

Fast Graphs

By the way, I noticed this morning that Cyxtera Technologies, Inc. (CYXT) has now dropped into our “buy zone”. Although not a REIT yet, we added the company to our research platform ($11.50 is our buy below target).

Cyxtera Technologies stock dropped to buy zone

Yahoo Finance

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