A Primer on the Tokenization of Real Estate

September 14, 2021

By Leonid Gurevich, Eric Tuckman and Brian McFarlane

Tokenization, as it pertains to real estate, is the process of creating a virtual token that would represent ownership of a type of real estate asset. This is similar to the recent digital asset craze, non-fungible tokens (“NFTs”), except a real estate token would be tied to the value of a physical asset. With the rise of virtual tokens, here are some common questions asked about their use.

How does tokenization work in real estate?

As tokenization is highly flexible in its usability, the token could represent ownership in real estate in many ways. The overall type of real estate that can be tokenized can vary just like traditional real estate investing; however, tokenization would allow for little third-party input over the investors. As physical assets would back the tokens, the value of the tokens would fluctuate based on the performance of the asset, similar to traditional real estate investing but with the ease of transfer conferred by the utilization of blockchain technology.

What problems can tokenization solve?

Liquidity of real estate

One of the most significant issues with investing and selling real estate is the liquidity of the asset. In the normal course of a transaction, there are many different parties involved, especially with the legal transfer of the asset. Tokenization could potentially mitigate this issue in specific situations. As easy as it is to buy and sell various cryptocurrencies in the marketplace, tokenization could simplify transactions in the real estate space. Rather than the normal transfer of the ownership process that takes place when selling a share of ownership in a real estate investment, tokenization could cut out the middleman and allow ownership to be transferred directly from investor to investor.

Searching for property

Another issue encountered when investing in real estate is the actual search for the property in which you will invest. There are many marketplaces where these assets are available for sale. If the assets were tokenized, they could be listed in one centralized marketplace. This eases the investor's job by allowing the search for a potential investment to take place in one location. Through this possibility, investors will have access to search for potential investments located in other geographical areas and allow sellers to gain access to a large pool of potential buyers.

Undeniable proof of ownership

Proof of ownership is another issue encountered by traditional real estate investors. Legal ownership is usually displayed through various legal documents that show the sale of the asset and the ownership rights of the new investor. Tokenization utilizes the distributed ledger system, just like cryptocurrencies. A distributed ledger is a database that is consensually shared and synchronized across multiple sites and accessible by multiple people. Any changes or additions made to the ledger are reflected and copied to all participants in a matter of seconds. Each transaction is sent and validated by the network that makes up the marketplace. This feature of blockchain technology mitigates any issue arising from various ownership claims because the network could validate each transaction and show the rightful owner of the asset.

Crushing the entry barrier

Assets can now be divided into smaller amounts of ownership, thanks to tokenization. Like Bitcoin, a real estate token can be divided to make the barrier of entry to smaller investors much easier to overcome. Since the transactions will take place in a virtual environment, it also makes it easier to start investing in real estate. Rather than needing legal documents to transfer ownership, someone with little to no experience can make a purchase online. This gives far more people the ability to invest in real estate without going through the daunting legal process of transferring ownership, with which many beginner investors may not be familiar.

Improving transparency and market security

Utilizing the distributed ledger system not only helps mitigate the issue with undeniable proof of ownership, it also helps improve overall transparency and security in the real estate market. Considering that every transaction will be processed and approved by other users in the marketplace, each transaction will be transparent to the public. In addition, the security of the market will be backed by blockchain technology, which has proven to be extremely secure when treated as currency. This application of the technology will be just as secure as it will be utilizing the same technology to process transactions of investments.

Decreasing transaction costs

The use of blockchain technology platforms for exchanging tokens will have the potential to greatly lower transaction costs associated with real estate. Real estate investment trust (“REIT”) funds propose a similar value proposition, but REIT funds often come with high minimum investments and upfront fees. Tokens allow investors to buy and sell real estate without incurring the traditional closing costs on real estate, which lead to significantly lower transaction costs.

What is involved in the tokenizing of real estate?

When developing a token, it is important to understand what the token represents. The token can represent a portion of the deed, an equity interest in a legal entity, ownership of the collateralized debt, or any other form of asset related to that real estate. The nature of the interest being tokenized may impact which regulations apply to the token. Real estate tokens may qualify as securities under state and federal law. The options are to register with the Securities and Exchange Commission (“SEC”) or satisfy an exemption. Regulations permitting exemption from SEC registration will force different restrictions and limitations on transactions associated with the token. The platform chosen for the token should be able to create custom reports that can then be passed on to the SEC, public transfer agents and so forth.

When establishing the legal entity for the token, the agreements involved must automatically allow the blockchain technology to implement and enforce equity transactions related to the token. These “smart contracts” are designed to make the different processes involved with the token, such as dividend distributions or sales to other investors, seamless and essential to a token's proper setup. Smart contracts must be tested to identify any technical or security flaws in the code that could cause the blockchain technology to create errors or allow for fraud. These flaws would lead to reissuance of tokens and be costly to the reputation of the token.

What are the tax and reporting considerations?

Virtual token issuers must be careful to comply with all laws and regulations wherever they offer their tokens. The steps that issuers may have to take include actively verifying that investors are accredited. As virtual tokens are subject to more than just regulation as securities, some tokens may also be regulated under anti-money laundering, money-service laws and regulations, and general anti-fraud and consumer-protection laws. Issuers and investors should consult the appropriate legal representation and tax professionals to develop a complete strategy.

What is the future outlook for real estate tokenization?

Although the development of real asset tokenization is still hindered by a lack of financial markets, a weak legislative framework around digital assets and a low level of awareness among investors, the tokenization of real estate assets is becoming an increasingly popular sector of investment activity. Real estate tokenization is a promising application of blockchain technology that will increase the investor base by increasing liquidity in the market, because it allows for more small-scale investor participation. This value proposition is particularly needed in real estate as the market for real estate is more valuable than any other asset class in the world, yet it remains highly illiquid. Tokens are the next phase in the development of blockchain technologies, allowing investors to move from highly speculative cryptocurrencies without collateral to asset-backed tokens. As the amount of functioning secondary markets for real estate tokens grows, the adoption of this investment platform will continue to grow as well, which will help the real estate market continue to thrive.

About Brian McFarlane

Brian McFarlane is an Audit Manager in the Real Estate Services Group, with over 10 years of experience in public accounting providing audit services to clients in the real estate and hospitality industry.