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Will Tokenization Revolutionize Real Estate?

Written by: Jor Law, Jenny Liang and Elijah Parton

Tokenization is the process of representing items of value with digital tokens, generally created through blockchain or other decentralized ledger technology. Tokenization can help innovate the real estate industry and perhaps revolutionize it. One of the defining characteristics of real estate is that it often requires large amounts of money. In contrast, purchasing an interest in tokenized real estate, through a security token offering (STO) for example, allows fractionalization of interests and less investment capital. Lower transaction thresholds may be especially attractive to individuals and retail investors who wish to buy or trade assets that would otherwise be overly expensive. It also helps investors build diversified portfolios with limited funds. Of course, fractionalization of real estate interests isn’t a new concept, but tokenization offers a new twist on the concept.

Here is the deal: you can purchase a token representing a fraction of real estate (or even a fraction of such a token) while retaining the ability to transfer or sell your ownership at any time. In fact, tokenization comes with other benefits for both issuers and investors which are highlighted below. It also helps future-proof your offering because there is a strong possibility that over time, tokenization through blockchain technology may even begin to replace traditional transaction methods.

Let’s take a closer look at some of the benefits of tokenization.

Confidential, Convenient Transactions

Unlike traditional paper-based transactions, tokenized transactions are recorded and encrypted on blockchain information blocks that cannot easily be modified or falsified. Most blockchains have pseudonymous protection, with many exploring different methods to obtain further privacy. The transaction history on the blockchain offers investors and issuers proof of ownership or other information that is recorded on the blockchain. Furthermore, the technology facilitates more efficient processing of securities transactions, allowing issuers and investors to perhaps eliminate some unnecessary intermediaries when conducting their digital transactions. All of these improvements help make liquidity easier assuming the market demand for liquidity is there.

Smart Contracts Prevent Contract Breaches

Written in computer code, a blockchain-based smart contract is designed not to require manual compliance with contractual obligations. Instead, blockchain technology automatically enforces terms as they are programmed. Even when investors and issuers do not entirely trust each other, they can rest assured that on the blockchain, it is difficult to falsify information or back out of smart contracts. There are significant limitations to what can be coded into a smart contract for automatic execution though; parties should fully understand when to use a smart contract and when some elements may require traditional contracts instead. It’ll also be helpful to understand the enforceability of the smart contract; in many cases, a traditional contract may still be advisable. Because smart contracts are automatically fulfilled, it is important to properly program a smart contract. It may be useful to consult with a contracts attorney for assistance.

Digitized Land Titles

Amidst the advent of a secure method for storing information, blockchain has also been considered and even tested for use in managing land rights. Disputes and complicated legal processes plague land acquisition and ownership rights. These issues are especially prevalent in third world countries where land can be exchanged informally, and there may be no traditional ledger at all. The decentralized and impregnable nature of blockchain lends itself well to curtailing some of the land titling concerns mentioned above.

Even countries with a long history of property rights may benefit from this technology. In the United States, for example, buyers routinely rely on title insurance to cover them for the possibility that a seller might not have the full land title rights to convey the property being sold. Like many emerging technologies, the issue is carrying these practices to scale. According to economist Sebastian Kriticos, land titling through blockchain will benefit mostly developing countries and small pilot areas first and then can be used at scale as technology improves.

One of the first breakthroughs for this new trend occurred in June 2019, when Medici Land Governance put Teton County, Wyoming's land title information on their blockchain platform. Medici Land Governance is a relatively new company formed in 2018 as a subsidiary of Overstock.com, and its lofty accomplishment in Teton County is the first in the nation. Just one year ago, First American Financial, the third biggest issuer of title insurance in the US, created a blockchain platform to help underwriters more easily transfer title insurance. With blockchain technology helping track ownership more reliably and transparently, the cost of title insurance could be reduced or even eliminated.

Regulated Tokens Offer Legal Protections

It’s important to keep in mind that legal compliance is always crucial. Tokens must be issued in accordance with securities or other laws and are generally regulated financial instruments. Examples of relevant regulations include Know Your Customer (KYC) and Anti Money Laundering (AML) laws and regulations. Generally, all real estate tokenizations for investment purposes will involve securities, and the JOBS Act of 2012 implements several regulations that affect both issuers and investors in tokenized offerings. While the regulatory oversight causes some inconveniences for issuers, they provide a great deal of protection for investors and the general public.

Recent Real Estate Tokenization Offerings

Quite a few sizable real estate transactions have occurred in recent years. For instance, Elevated Returns, an asset management firm, completed an $18 million USD tokenized offering of the St. Regis Resort in Aspen, Colorado on the Ethereum blockchain in 2018. Soon afterward came Manhattan's first tokenized real estate offering, a new 12-unit development worth over $30 USD million. In October 2019, leading blockchain technology company tZERO announced its partnership with Alliance Investments to tokenize what was reported to be the first real estate-backed STO in the UK. The property, River Plaza, is a 180-unit luxury residential development in Manchester, UK. According to the announcement, over the next few years, Alliance Investments plans to tokenize around $640 USD million worth of real estate across the country.

Must Investors in a Tokenized Offering Be Accredited?

It depends on what SEC registration exemption companies are utilizing. Companies utilizing Regulation A+ can raise money from accredited investors or non-accredited investors, and they may publicly solicit their offerings. More specifically, issuers of Tier I offerings under Regulation A+ can raise up to $20 million. Although these offerings have no ongoing reporting requirements, they are subject to both SEC and state-level review. By contrast, Tier II offerings raising up to $50 million require both SEC review and ongoing reporting.

Rule 506(c) of Regulation D is another popular exemption to SEC registration requirements and is probably the most utilized exemption for securities tokenizations. Issuers utilizing this rule may generally solicit their offerings to anybody but may sell only to accredited investors, who must meet specific income, net worth, or other requirements. To qualify as an accredited investor under the income test, an individual investor must earn $200,000 USD or more ($300,000 USD when combined with a spouse) in each of the two most recent years and have a “reasonable expectation" of reaching the same minimum income level in the current year. Otherwise, to qualify based on net worth, an individual’s net worth must be $1 million USD or more, excluding the value of the primary residence. Entities may also qualify as accredited investors under different tests.

Conclusion

Tokenization offers improvements to how real estate is currently transacted. In some cases, the improvements can be so dramatic that it will be seen as revolutionizing the industry. In some other cases, they will change the real estate industry but not really revolutionize it. The real estate industry has been around for a long time and the fundamentals will remain the same. Some people may view tokenization as revolutionary, just as many saw crowdfunding as revolutionary; however, there will certainly be those who will reflect that it’s not revolutionary when the business fundamentals are the same but the transactions just effected a different way.

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