Real estate tokenization is a modern way of investing in real estate. This revolutionary concept, made possible because of blockchain technology and smart contracts, has disrupted the traditional real estate industry by offering investors access to fractional ownership of a property.
Real estate tokenization converts the value of real estate into tokens stored on a blockchain, enabling digital ownership and transfer. These divisible tokens represent a fractional share of ownership stake in that real estate.
Despite universal globalization, the real estate market's main problem is that it is still not global. Mass buyers and investors generally look at the real estate market within their country or city. Accordingly, for real estate development companies and property owners, this means an artificial reduction in demand, limiting opportunities for growth in their business. Smart contracts and tokens come to solve these problems. Together, they erase boundaries for real estate transaction participants, reduce transaction costs, and open new opportunities for market participants.
A real estate token can represent, among other things:
Ownership of part of a real property
Ownership of the entire real property
An equity interest in an entity that controls real property
An interest in a debt secured by real property, or
A right to share in the profits generated by real property
One of the first successful commercial real estate tokenization projects raised approximately US$18 million in 2018 through the issuance of Aspen Coins, where digital tokens represented fractional
ownership of the luxury St. Regis Aspen Resort in Colorado, USA.
According to a recent study by the international management consulting firm McKinsey & Company, $4T to $5T of tokenized digital securities could be issued by 2030
Finance Magnates, a multi-asset online trading knowledge hub, suggests that “Tokenization and digital assets' transformational capacity in transforming ownership and investment, paves the path for a more equitable, efficient, and integrated financial environment”.
How Does Tokenization Work?
There are three main phases of tokenization:
Phase 1 – Deal Structuring and Shareholders
Property owners decide the type of asset they wish to digitalize – they could either form a Special Purpose Vehicle (SPV), or a subsidiary created by a parent company to isolate financial risk. Shareholders may have various rights to dividends, equity shares, and partial governance depending on the asset’s location, expected funding, taxation structure, and type of investor.
Phase 2 – Selecting a Tokenization Platform
Property owners then choose from a range of platforms that create tokens. Tokenization platforms use blockchain technology to generate automated agreements highlighting transaction terms between buyers and sellers. These “smart contracts” are essentially codified rules and behaviours that follow the token throughout its lifecycle. Smart contracts are the bedrock of blockchain, and the reason blockchain is nearly impossible to change, hack, or cheat.
Phase 3 – Issuance, Regulation, and Distribution
During the Security Token Offering (STO), digital tokens are created and issued on blockchain in the form of regulated assets – like stocks issued on the stock market during an Initial Public Offering. Token issuance and distribution must meet certain regulatory standards, therefore a clear understanding of the regulatory framework is necessary to decide where the SPV should be set up.
BENEFITS OF TOKENIZATION
Additional Capital
Developers can tap into more capital at any stage of development through tokenization. By efficiently fractionalizing properties and reducing market barriers, developers facilitate greater market participation, which increases capital inflow.
Flexibility
Anyone can invest a certain amount and become a partial owner of a property and benefit from the potential profits. Moreover, tokens can be purchased and sold on secondary markets. The property owner can also sell some part of their assets by issuing tokens. Additionally, tokens can be exchanged like stocks, with their value fluctuating based on how the price of the property changes. Tokenization provides a benefit over crowdfunding because it gives you immediate digital ownership, allowing you to sell at any time.
No geographic limits
Property tokenization, like any type of tokenization, eliminates barriers related to location. Nothing prevents you from buying a property on the other side of the world in the middle of the night. You can participate in and profit from the construction of resorts, housing estates, or rentals anytime and anywhere.
Ease and speed of investment
The most effective optimization of any activity is to limit unnecessary expenditures by acting within the legal framework. Blockchain technology enables this by removing barriers like notary fees and bank fees. This results in increasing the investor’s returns and shortening the process of raising capital by the entity managing the investment, which streamlines the entire process. Investments made with tokens significantly reduce costs, but also give greater freedoms because you can buy a share in real estate and profit from it at any time. The whole process is automated and does not entail any unnecessary formalities. The right to the property is acquired through the purchase of a token, which does not require any changes to the real estate or mortgage records.
Lower entry barrier and higher diversification
To date, investing in real estate has mostly been done with large sums of money. Thanks to tokenization, however, you no longer must purchase an entire property. A particular property can be divided into millions of tokens. Due to the tokenization of assets, you can participate in a smaller shareholding structure such as distributed investing. Millions of dollars of investment capital are no longer required. It only requires a few dollars to buy a part of some real estate, resulting in a lower entry barrier for those with less capital. This has to do with the diversification of your investment strategies and assets, too. Instead of only investing in a single property, you may consider investing in several properties by purchasing tokens in them to diversify your investment wallet. In this case, diversification also applies to various sources of revenue.
Efficiency
Tokenization is cheaper and more efficient because blockchain technology automates processes and cuts out middlemen. For example, tokenization does not involve agents and brokers who act as middlemen to real estate transactions. Accordingly, real estate tokens are cheaper because they do not capture the costs associated with lengthy document reviews and layered communication. Alternatively, the smart contracts on blockchain’s unalterable framework drive down fees and costs associated with traditional real estate.
The highest level of security
In addition to making transactions secure, tokenization also makes them transparent. Although new technologies often raise concerns, tokenization uses the highest security standards based on two pillars: tokens and blockchain technology. The first pillar promotes security because investment is assigned digitally to an investor and remains so until it is refunded or sold to someone else. This level of security would not have been possible without the second pillar, which is the implementation of blockchain technology.
CHALLENGES TO TOKENIZATION
Regulations
Addressing regulatory uncertainties is of utmost importance to adopt tokenization on a larger scale. Accordingly, there is a growing consensus on the need for the development of a well-defined regulatory system for real estate tokens. Generally, the tokenization of real estate will be considered a security but an analysis on each specific token should be considered at the outset. If the token is a security, the issuance of such a token will be subject to the applicable prospectus requirements or reliance on an exemption, such as the “accredited investor” exemption. In addition to the prospectus requirements, the issuer must consider the applicable registration requirements.
Lack of Public Awareness
The lack of public awareness of real estate tokenization poses another obstacle to adoption. Despite cryptocurrencies drawing much attention from the public in recent years, real estate tokenization remains largely unknown. The lack of public awareness may be attributed to minimal market participation by sophisticated parties like large real estate companies and investors. However, publicizing large-scale real estate token transactions demonstrates the advantages of tokenized real estate that could likely address this problem.
Volatility
Finally, the general volatility surrounding blockchain-based systems leads to hesitancy with investing. First, as an emerging market using developing technology, cryptocurrency has been a highly volatile investment. Second, the cryptocurrency market thrives on investors making speculative bets that prices will go up or down to make profits, and these bets lead to sudden market influxes and crashes. Third, most cryptocurrencies experience fluctuations because they are purely digital assets with no backing of physical commodities. However, real estate tokens are less susceptible to volatility because they are backed by physical properties.
The benefits of real estate STOs compared to two existing structures – private real estate
funds and real estate investment trusts (REITs)
Key pain points of private real estate funds:
High investment ticket size and long lock-up period, making these funds suitable only for institutions and/or ultra-high net worth individuals
Distribution methods and secondary trading are administratively burdensome, resulting in little to no liquidity in secondary markets and operational inefficiencies.
Key pain points of REITs:
High structuring costs and complexity
Highly regulated and subject to significant limitations on investment scope
More restricted than STOs given the limited flexibility for the portfolio components, nature of underlying asset and dividend distribution method.
Benefits brought by STOs:
Low structuring costs and complexity
Greater flexibility in terms of investments scope, portfolio components and nature of underlying asset
Enhanced liquidity with a lower investment ticket size and no mandatory lock-up periods, making it more accessible by a broader range of prospective investors
Greater operational efficiency and liquidity through programmed distributions via smart contracts
In conclusion, real estate tokenization is expected to become a mechanism that will be both safe for investors and convenient for developers. Investors can access new investment opportunities because of the use of this technology. In turn, estate developers will not have to issue large amounts of bonds or other for financing new and running ongoing projects.
Several legal and practical issues could dictate the success of tokenization. Accordingly, property owners should consult knowledgeable legal, securities, tax, accounting, and real estate professionals during the early stages of tokenization to minimize the risks and costs associated with navigating the novelty investment.
By: Alexis Nicolaou – Leader Distributed Ledger Technologies at Grant Thornton Cyprus
(member of FuturEstate Alliance Tokenization platform)