Why tokenize real estate?
The potential benefits of tokenizing a real estate asset are numerous. To start, it gives real estate owners and developers greater access to capital while also providing increased liquidity for investors. Tokenization can also potentially remove the barrier to entry for retail investors, allowing anyone to invest in real estate with much smaller sums of money while also giving investors increased choice, as virtually any type of real estate asset can be tokenized. Furthermore, transaction costs associated with existing REITs and crowdfunding models will be significantly reduced while transparency will be greatly increased.
How do you tokenize real estate?
Technologically speaking, it’s not that hard to tokenize a property. However, there’s a lot of legal work that goes into tokenizing, especially when we’re talking about building an end-to-end solution that utilizes blockchain. Here’s a brief rundown of how it works:
1- Work out the legal structure/what the token will represent- The first step is working out what your token will represent. There is a nearly endless list of what the token can represent, but typically it will be representing ownership in a legal entity which owns the asset such as a SPV (special purpose vehicle) or some type of collateralized debt instrument that is backed by the property. Getting the legal structure right is of paramount importance as it will have far-reaching consequences ranging from tax implications to those related to securities-law.
2- Develop the necessary business logic smart contracts- Before you can tokenize a real estate asset you’ll need to be able to verify ownership of the asset as well as the identity of the owner and potential investors. This is essential and means being able to perform KYC/AML checks as well as verifying ownership and performing a title search among other things. On top of that, you'll need to develop other smart contracts relating to the business of managing the asset including but not limited to potential dividends/interest earned by token-holders.
3- Create a token issuance smart contract/protocol- Once you’ve verified ownership and identity you can get onto the creation of the security tokens. This can be done via a smart contract and will usually result in property-unique security tokens being issued once the contract is filled/met. This means that each real estate asset you tokenize will have its own unique security token.
4- Build a compliant Security Token Exchange- Now things start getting tricky. You’ll need a marketplace where users can buy and sell the security tokens you issue, and this marketplace will need to comply with existing state and federal regulations. This is more complicated than it sounds as you have to comply with securities law as well as other financial regulations. That means you will have to register as a MSB (money service business) with FinCEN. We will note that it may also be possible to simply issue the tokens without operating an exchange yourself (as the tokens could potentially be traded on other security token exchanges).
5- Solve the chicken or the egg problem and achieve marketplace liquidity- A key to the success of any marketplace is achieving a proper balance of supply and demand, also known as marketplace liquidity. While this step may not seem necessary to tokenize an asset it absolutely is and has been taken for granted by most blockchain startups. Most smart contracts are designed to only issue tokens once a certain amount of demand has been reached so it's safe to say that you can get through steps 1-4 and theoretically tokenize a property, but without significant demand, you will not be able to do it in the real world. It is extremely challenging to achieve marketplace liquidity, even more so when you're dealing with a highly regulated marketplace which presents both buyers and sellers with significant barriers to entry (here we refer not to the financial barriers of entry, but the need to go through identity verification/KYC/AML). This is further complicated by the fact that there have been numerous bad actors in the blockchain space which have severely damaged consumer faith in the emerging industry.
There are, however, significant legal and regulatory challenges
In theory, tokenization sounds great, but in practice, you cannot just disregard existing securities laws, tokenize any property, and start selling shares representing fractional ownership in that asset. Any type of token representing fractional ownership is a security and therefore subject to existing securities laws. This is precisely why existing fractional ownership and real estate crowdfunding products such as REITs (Real Estate Investment Trusts) and eREITs are limited. They would love to cater to retail investors but are typically limited to accredited investors due to existing securities laws. Any future reform that allows for blockchain based REITs, which typically tokenize commercial properties, to accept investments from retail investors would also apply to traditional REITs which is precisely why we don't see consider these types of projects to be particularly disruptive or exciting.
So considering all the challenges, do we really even need blockchain?
To be perfectly honest it really depends on what exactly you're trying to do. If you're simply tokenizing commercial properties and only accepting investments from accredited investors, no, you don't need blockchain. REITs already offer a comparable solution that is tried and true. REITs are amongst the best performing investments you can make, and we would recommend against investing in any "blockchain REIT" project as investing in a tokenized REIT likely does not offer any advantage over a traditional REIT and if anything, only comes with additional, significant risks.
There are however use cases where using blockchain makes sense and will be highly disruptive. One great example would be tokenizing existing home equity. The average American has most of their wealth tied up in home equity, and the potential advantages of issuing tokenized debt are many. Asset-backed loans on the blockchain, whether tokenized or not, are extremely exciting mainly due to the fact that it is theoretically easier to structure and issue them in such a way that they not be considered securities. The implications of this are tremendous as it removes the entry barriers, costs and regulatory concerns associated with securities. More generally speaking the best use cases for blockchain in real estate involve a mixture of a better value proposition than existing products/services combined with the novelty of a new experience (such as tokenization).
Many other use cases will require a great deal of regulatory reform to become viable along with a tremendous amount of marketplace liquidity and demand. A healthy marketplace for tokenized real estate would certainly be highly disruptive and create powerful network effects, but as of today, nobody is remotely close to achieving this.