Tokenization of real estate refers to the process of converting a physical asset into digital tokens that can be bought, sold, and traded on a blockchain network. These tokenizations typically involve security tokens because they represent an underlying asset with ownership rights, just like regular securities (e.g. shares of public companies). As with all security tokens, tokens representing fractional interests in a real estate project will be launched via self-executing programs known as smart contracts.
To learn more about real-world examples of security tokens, visit our post "Nine Examples of Security Tokens In Web3".
The process of tokenizing fractional interests in real estate has generated significant interest among real estate developers, real estate investors (and fund managers) as well as entrepreneurs. This genuine interest in tokenization of real estate is due to the benefits it can provide.
Tokenization in real estate provides improved access to both capital and investments, increased liquidity, efficient and automated dividend distribution, and customization of new real estate products.
The Benefits of Real Estate Tokenization Are:
Investors can purchase fractional interests in a security. Tokenizing existing portfolios of assets enables them to be traded fractionally among buyers across the globe, 24/7/365 and on secondary markets.
Issuers gain access to a global market for investment when fundraising for new projects by offering fractional interests in underlying securities via tokens.
Issuers can convert illiquid holdings into liquid cash by selling fractional ownership through asset token sales on secondary markets. Issuers can raise capital for their next project without having to divest of an entire asset.
Lower settlement costs and easy administration with instant dividend distributions benefits issuers, investors, and other administrators (e.g., transfer agents).
Custom Products (Entrepreneurs)
Configuration of products to specifically achieve a desired set of outcomes (e.g., programmable affordable housing, community staking, local liquidity, etc.).
Custom Products (Investors)
Creation of new types of real estate investment products in the form of investment portfolios.
Underlying the blockchain technology that enables tokenization of real estate is an immutable ledger that makes it easier than ever to identify who owns which interests.
Creating granular financial interests in real estate projects was impractical, until very recently.
The legacy options available for fractionalization are not as liquid, configurable, accessible, or efficient as security tokens in transferring value. Paper stock certificates, over-the-counter (OTC) trading, and brokerage firms differ in their degree of efficiency and cost, but they often involve a significant amount of paperwork, intermediaries, and personnel who are resistant to change and prefer to adhere to traditional methods. This has all changed thanks to blockchain technology.
How does tokenization of real estate work from a practical perspective?
Below, we describe two different types of real estate projects, and how they can be tokenized - an existing development or portfolio of assets, and a real estate project from scratch.
Developing The Scope
Every tokenization project starts with an understanding of what will be accomplished. Identifying the decision points within a particular project or type of project is key to moving forward.
The first step is to decide what type of real estate tokenization project will be launched. For example, tokenizing a single piece of land is different from tokenizing an investment fund that is managing the purchase and transfer of interests in numerous pieces of land.
Scoping your project is so important because tokens are so configurable. It is simple to develop custom project configurations based on a number of different contexts, and to replicate a specific project multiple times.
Incorporation Of Your Project
Deciding which project to launch will also determine how you want to incorporate the entity that will manage your project. Unless you already own the property you want to tokenize, you may choose to incorporate an entity before purchasing property due to the tax implications. For example, if I purchased a property as an individual, and then transferred it to the entity I incorporated, I would be taxed as an individual on the sale of the property.
A corporation can bestow both tax benefits and strategic advantages. Entities of various types are primarily governed by two documents – a set of articles that are filed with the governing body (typically referred to as the articles of incorporation) and a set of rules developed by the founder or founders of a venture (typically referred to as an operating agreement).
The incorporation phase of a project is important for ensuring your project is set up to allow financial interests to be tokenized. Tokenize interests in a property, an entity will need to provide language that enables the desired tokenization mechanics. This may be done by enabling electronic voting, incorporating entries in a blockchain by reference, and ensuring the requisite safeguards for using a blockchain are in place before launching.
Create a Securities Strategy
One of the most daunting challenges of real estate tokenizations may be developing a securities strategy. Personally, I find the history of securities as financial interests to be complex, old, and fascinating (and I discuss this in the video below).
Your choice of the type of security offering or offerings to use to raise funds for your project will determine:
- How many people will be involved in your project;
- What transfer restrictions will be in place;
- How much money you can raise; and
- What type of marketing you can do, etc.
In our eBook, The Taxonomy of Tokens, we dive into the mechanics of launching different types of securities. Generally speaking, a securities strategy will be guided by the costs and benefits. The costs are typically related to things like complexity, legal fees, time, administrative and reporting costs, etc. The benefits usually involve raising different amounts of money from different audiences.
Typically, many single properties will be tokenized under Reg D because single properties are not very expensive and usually involve a small number of investors. Privately managed funds will typically issue security tokens via Reg D or a combination of Reg D and Reg S. The strategic benefit of using Reg D is that it is lightweight and enables a smaller pool of investors, with the option to raise higher amounts, and with fewer filings required.
The strategic benefit of using Reg S is that it is also relatively lightweight and enables a larger pool of international investors. Combined, these two allow issuers to raise from a large amount of money from a large pool of investors with the fewest filings. Publicly managed funds typically use Reg CF or Reg A to take advantage of the large amounts that can be raised from the largest numbers of people.
Raise Funds Through a Private Sale
Thisis where it starts to get exciting. Once you have an incorporated entity and understand your security strategy, you are in a position to start a private sale to fund the purchase of the property that will be tokenized.
A private sale simply means a fundraising event from investors.
Private Sales can take place using a number of different legal instruments. Popular examples of contracts used to purchase security tokens include: