Tokenization: the future of real estate

Globally estimated at US $288 trillion, real estate comprises one of the largest market sectors, but the asset class has historically remained elusive. 

Real estate investing has traditionally only been affordable for ultra-wealthy individuals, institutional investors, or companies. And until very recently, it was inconceivable to own fragments of a property or trade them without incurring high transaction costs. 

Tokenization is the technology changing the game for real estate investing and making fractional ownership for small-scale investors truly possible. Today, the sector is reckoned to be about 40% of the digital securities market. 

This explainer looks at real estate tokenization and how it works, the benefits and challenges of tokenized ownership, and how tokenization platforms can be used to turbocharge utility from blockchain and smart contracts. 

‍

What is the tokenization of real estate?

Real estate tokenization is the process of converting the value of real estate assets into digital tokens on the blockchain to enable their digital transfer and ownership. 

The token represents the property with all of its rights and obligations. This means anyone who owns a real estate token has a claim to the underlying real estate property as well as any associated profits or losses. 

More specifically, tokens can be used to represent: 

• Ownership of part of a property
• Ownership of an entire property
• Equity interest in an entity controlling a property
• Interest in debt secured by a property
• Right to share in the profits of a property 
  ‍

Blockchain-based real estate tokenization enables the instantaneous synchronization of a real estate asset’s ownership and transaction data across a network of participants, bringing many benefits in terms of efficiency and optimization. The immutability of these records on the public distributed ledger also provides high transparency and leaves less room for human error or misconduct. 

Ultimately, blockchain-based tokenization can make the process of real estate investing much less timely and costly for all participants involved.

How does real estate tokenization work? 

Real estate tokenization has lots of moving parts. As the tokenization of a real-world asset, there are important considerations involved at every step in the process; it’s not as simple as just creating a token! 

Let’s take a look at a few key components. 
‍

Smart contracts 

Owners of blockchain-based tokens can benefit from leveraging programmable smart contracts, which automatically execute certain events specified in the code once a predefined condition is fulfilled. 

Smart contracts remove the need for human intervention burdening much of the current real estate transaction process. A classic example is the automatic enforcement of compliance restrictions. 

On Polymesh, compliance rules are built into the token at protocol level, removing the need to create smart contracts for individual tokens to specify compliance restrictions. However, smart contract functionality can still be useful for other stages in the transaction process to make it easier. For example, smart contracts could be used to automatically execute transfers with land registries upon a successful token transaction.
‍

Special-purpose vehicles (SPVs)

Most jurisdictions have yet to enact laws recognizing tokens may represent partial ownership of a real estate asset, but jurisdictions are increasingly recognizing that tokens may represent partial ownership of a company. 

For legality, tokenization of a real estate property has typically involved tokenizing the shares of a company that owns the property instead of the property shares themselves. This company is commonly a Special Purpose Vehicle (SPV) that owns all or part of the asset; tokenizing its shares into security tokens amounts to tokenizing ownership of the asset. 

SPVs are usually structured as limited liability companies (LLCs). However, in contrast to traditional investing where investors receive a paper representing membership interest in an underlying LLC, investors of tokenized real estate will receive a token. This token lives on the blockchain where it can easily be traded or sold (usually following an initial holding period). 
‍

Security token offerings (STOs)

Most digital real estate tokens are initially issued and sold during a security token offering (STO), also known as a tokenized security offering or tokenized asset offering. 

There’s no right way to run STOs. Asset owners can choose to issue and sell their tokens on their own or they can use a method such as crowdfunding. Aspen Coin, a token representing ownership of the St. Regis Aspen Resort and one of the first commercial real estate STOs, successfully raised $18 million USD this way. 

STOs rely on fungible security tokens, whereby each token for a real estate property is the same as any other for that asset. These security tokens are explicitly securities,  and their offering and operations are subject to securities regulations. 

Alternatively, non-fungible tokens (NFTs) can be used to digitally represent ownership of real estate assets. For example, Unusual Whales tokenizes houses and mints them as NFTs with the properties each run by a traditional LLC. 

Due to their inherent uniqueness, each NFT (i.e. asset) will only have one owner, although fractional ownership of NFTs is possible. NFTs may or may not be securities in compliance with regulatory frameworks, so investors interested in real estate NFTs should tread with caution before purchasing. 
‍

Decentralized autonomous organizations (DAOs) 

Blockchain-based tokens can take advantage of using fundamentally-democratic decentralized autonomous organizations (DAOs) instead of traditionally centralized and hierarchical LLCs. 

DAOs leverage smart contract software to allow any token holder to vote and share in decision-making (such as property management) via an automated governance system enforced on the blockchain. The decentralized, immutable network also offers complete transparency to the DAO’s self-management. 

In a DAO, each member has authority to decide on a myriad of governance decisions regarding a property proportional to the number of tokens (or percent of the asset) that they own. This translates over time to the formation of like-minded communities with shared interest in keeping the property at its highest value. 

An example of a real estate DAO is BonfireDAO, which sold their MVP single-family rental priced at $310,000 in a mere 15 days.

‍

‍

What types of real estate assets can be tokenized? 

Any real estate asset – whether retail, residential, or raw land – can be tokenized with blockchain. Some examples include multi-family housing, self-storage units, office buildings, farmland, and commercial development projects. 

For commercial properties (e.g. office buildings, retail stores, shopping complexes), real estate tokenization facilitates easier commerce as it can fractionalize investments into affordable sizes and make it easier to find worldwide investors. 

Fractionalization also benefits investors of residential real estate holdings (e.g. apartments in multi-story residential towers). Partitioning these assets into smaller units tokenized on the blockchain enables smaller asset owners to quickly profit from the market with a larger number of potential purchasers. 

Finally, real estate tokenization can facilitate new investment opportunities. For example, real estate developers can easily tokenize new development projects to raise money before the project is completed, with smaller investors finally getting access to this asset class. 

‍

What are the benefits of real estate tokenization? 

Real estate tokenization is a more convenient and economical way of investing that benefits both issuers and investors. 

Historically, real estate investing has been plagued by difficulty with transactions. Investments have required a ton of paperwork and manual processes that leave open room for human error and misconduct. The many phases involved make transactions time-consuming and highly costly. 

Real estate tokenization is a much more streamlined and effective way to trade and can bring transparency to the traditionally opaque industry. 

Tokenization enables fractionalization, or the fragmentation of assets into multiple encrypted tokens to represent fractional shares of ownership. These tokens can be easily transferred between investors on digital securities exchanges or trading systems almost instantly and for a low fee, opening up a whole new world of investment opportunities for both individuals and institutions. 

Through fractionalization, tokenization brings liquidity to a normally illiquid asset class, reduces the high capital investment requirement by real estate assets, and broadens access to quality real estate for a wider range of investors. Asset owners and developers can in turn raise funds more quickly without requiring financial intermediaries to underwrite the project, ultimately unlocking more unique real estate developments. 

Take a look at the chart below for a few of the many benefits of real estate tokenization:

‍

What are the risks and challenges of real estate tokenization? 

Blockchain technology has existed for years now, but tokenization has yet to truly infiltrate the mainstream real estate market. A few reasons for this include:

• Lack of established processes around tokenizing real-world assets
• Lack of personnel or back-end support to execute processes
• Market confusion and knowledge gaps about blockchain technology 
• Concerns with technological vulnerability and asset recovery 
  ‍

The main roadblock, however, is the issue of regulatory compliance. Unclear market regulation, the need for centralized reporting, and post-trade processes like reconciliation with land title registries all present issues for market participants. 
‍

Unclear market regulation 

Legislative frameworks around tokenization are in their infancy. And with new types of products possible via blockchain technology (e.g. fractional NFTs), it’s not as easy as mapping certain token types to existing financial instruments; the nature of assets can vary and token types can have multiple use-cases (e.g. NFTs can be used to tokenize monkey.jpegs or a house!). 

Tokenized real estate assets will typically be implicated by securities law, with the issuance and operations of real estate security tokens subject to applicable regulatory requirements for securities such as “accredited investor” exemptions or registration requirements.

Complicating things, regulation specifically around security tokens isn’t in-depth. This poor regulatory environment creates hurdles for stakeholders and prevents growth; regulatory compliance is needed to scale, but when regulators and real estate participants lack understanding of blockchain, it’s difficult to reconcile the two. 

It’s generally sensible for platforms dealing with tokenized assets to obtain relevant licensing and focus on compliance with local regulations, but with an unclear regulatory environment it’s not always clear what the best process is. Licensing can involve multiple phases of trial and error, and legal applicability might vary between commercial vs. residential vs. other properties. 

Finally, there are tax implications that remain undefined or lacking unification in most tax regimes. 
‍

Need for centralized reporting of transactions 

Although decentralized networks offer many benefits, participants can feel disconcerted with the reduced privacy and control. For some, there may be confusion about how to fulfill regulatory requirements around reporting and auditing. Others want to ensure certain information remains protected from investors and the secondary market; the information required by primary investors is not always appropriate to release to a large audience. 

It’s important for technology to be able to automate controls and strike a balance between privacy and transparency, as Polymesh has done by building compliance and confidentiality into its core. 
‍

Reconciliation with land registries and other legal requirements 

As the tokenization of real property, tokenized real estate transactions necessitate the execution of various post-trade processes such as reconciliation with applicable land registries in the jurisdiction where the asset is located. 

For tokenized real estate that involves the use of an SPV, there may also be additional legal considerations. For example, the SPV may need to establish a legal document such as a subscription agreement that all investors sign and which specifies their rights and obligations. 

Ultimately, market participants should seek advice from legal, financial, and real estate experts and professionals before engaging and benefiting from tokenization. 

‍

What are real estate tokenization platforms? 

Real estate tokenization platforms such as DigiShares or Polymath can make the process of tokenized real estate investing even easier for everyone involved.
‍

Benefits of real estate tokenization platforms for issuers

Real estate tokenization platforms use software to help asset owners issue and manage real estate token sales as well as perform a range of other functions for maximum convenience. For example, real estate tokenization platforms can be used to:

• Issue and manage initial token sales
• Manage sales on secondary token exchanges 
• Perform investor communications
• Execute distributions
• Provide marketplace environments for investors to find real estate offerings 
• Connect owners with ways to raise money
  ‍

Real estate tokenization platforms can also help facilitate and enforce compliance by performing Know-Your-Client (KYC) and Anti-Money Laundering (AML) procedures as well as checking investor accreditations. They can also leverage identity verification to ‘whitelist’ or pre-approve particular buyers for purchases. 
‍

Benefits of real estate tokenization platforms for investors 

Real estate tokenization platforms can play an important role in guaranteeing the quality of investments, too. For example, platforms can help source and validate income-producing properties before tokenizing them to give investors certain guarantees. Examples include:

• Proper vetting by industry professionals 
• Assurance that the property title is clean
• Assurance that there are no outstanding taxes
• Proper passing of inspections 
• Calculating appraisals
• Establishing existing tenants and managers 
  ‍

For best results, participants should look for real estate tokenization platforms with proven track records of investors and successful investments. 

‍

Conclusion

Real estate tokenization has major potential to revolutionize the way we invest in real estate. It opens up new market opportunities for investors that allow for increased liquidity and diversification, while issuers can benefit from broader, more global investor bases. 

There may be a few regulatory pieces to figure out first, but there’s no doubt that as regulatory hurdles resolve, tokenization will pick up the pace and many more real estate assets will find themselves represented on blockchains such as Polymesh.