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:
Access (Investors)
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.
Access (Capital)
Issuers gain access to a global market for investment when fundraising for new projects by offering fractional interests in underlying securities via tokens.
Liquidity
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.
Dividend Distribution
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.
Transparency
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.
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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:
| SAFE | |
|---|---|
| Simple Agreement for Future Equity | |
| SAFT | |
|---|---|
| Simple Agreement for Future Tokens | |
| SAFT/E | |
|---|---|
| Simple Agreement for Future Tokens or Equity | |
| DPA | |
|---|---|
| Debt Payable by Asset | |
| TPA | |
|---|---|
| Token Purchase Agreement | |
Different documents are used to conduct a private sale (or otherwise finance a tokenized real estate project) based on a number of unique considerations. Usually, these will be guided by maturity of the product and likelihood of launch success.
At Upside, we have streamlined Private Sale processes to make it as easy and trustworthy as possible to take your project from idea to launch.
Launch Your Token
Taking into account what has happened so far…
For projects starting from scratch, e.g. fundraising to purchase property or re-condition property, the scope of your project determines what structure you set up for your tokenized real estate project. Your entity type and your security strategy determine where you incorporate and which transfer restrictions need to be in place. Different jurisdictions have different benefits in regards to things like tax, privacy, efficiency, cost, etc. Different issuances have different rules around which groups can transfer tokens to others and under what conditions.
For projects tokenizing the interests of an existing real estate development (or developments), you will already have an incorporated entity and security strategy.
In either case, the final step in tokenizing your real estate project is to launch the token. For every launch, a specific number of tokens are minted on-chain and sent to the specific wallet address of a designated project administrator. The number of tokens minted varies from project to project. The choice of blockchain to mint the tokens is also project specific, based on unique considerations (e.g., transactional velocity, security, etc.).
Even the type of address the tokens are initially minted to varies from project to project. Some projects will elect to do the initial token distribution to a multi-sig wallet (i.e., a wallet requiring a certain threshold of signatures before tokens can be moved). The project administrator is then responsible for the subsequent distributions of tokens to investors, creation of transfer groups and transfer restrictions, and coordination with Transfer Agents.
Ensure Compliance by Design
The first thing the project administrator does after launch is develop a more robust set of access control lists These lists describe who can do what for the project. Each project needs to define the following roles before a launch occurs.
Contract Admin
Akin to root level administrator. Can upgrade internal contract dependencies or grant Admin permissions. Recommended to be a secure multi-sig wallet.
Reserve Admin
Receives initial tranche of minted tokens from deployment. Also can adjust the supply of tokens by minting or burning or forcibly initiating transfers.
Transfer Admin
Can set transfer restriction permissions/rules between groups or invokes snapshots. Transfer Admin capabilities are a superset of Wallets Admin
Wallets Admin
Can manage Holder/Wallet transfer group assignments.
Transfer Agents are usually granted Transfer Admin and Wallet Admin roles in order to make sure the ownership of the underlying securities is accurately recorded and that the transfer of ownership is properly executed.
Once these roles have been identified, the project admin creates transfer restrictions based on the project's underlying securities strategy and distributes tokens to investors according to the amount each purchased prior to launch.
The benefits of access control lists do not end there. Once a token has been launched and distributed to the appropriate investors, these lists also help ensure distribution mistakes are able to be corrected (via mint, burn, and freeze functions). Finally, access control lists are also utilized for secondary trading functionality.
Enable Secondary Trading
Trading securities has traditionally been a manual and relatively inefficient process. Unlike traditional securities, which require onerous and manual enforcement, security tokens benefit from programmatic enforcement. In other words, the code behind the token ensures that all trading is compliant. This enhancement allows the concept of decentralized finance (DeFi) to be applied to the securities industry.
Due to this technical breakthrough, a security token can be made available on a decentralized exchange, where investors from around the world can buy and sell their ownership rights on secondary markets that enforce the associated compliance regulations.
Examples and Use Cases
The following examples illustrate how these processes could play out in practice.
1. Unlocking Liquidity in a Real Estate Portfolio
Alice, a portfolio manager, is looking for a way to boost liquidity for her investment firm's real estate portfolio.
Some of the properties do not have buyers for one reason or another. Possible reasons include an inability to find buyers willing to purchase a complete interest in a property, the prohibitive cost of transfer fees, and uncertainty about the price the market will pay for the property. By working with Upside, Alice can boost liquidity for her portfolio by tokenizing existing assets, e.g., creating an access control list, setting up transfer groups and restrictions, ensuring vestings are properly accounted for, and selling tokens individually in smaller units. If Alice wants to go one step further, she can set up secondary trading for her tokens on a platform and create custom incentives for how and when her tokens might be traded with different trading pairs.
2. Raising Funds to Buy an Investment Property
Bob is a real estate developer looking to break ground on a new project to build an apartment building in a fancy part of town.
Instead of financing the project with a large percentage of debt, Bob hopes to finance his project through a token launch. By tokenizing all the financial interests in the construction of his new apartment building, Bob will be able to programmatically issue dividends to investors once his units start collecting rent. Throughout the process of constructing and managing the apartment building, investors will be able to buy and sell their interests in the building to others meeting the same criteria of investors in a compliant fashion.
3. Community Equity
Carol wants to develop an innovative new product to make the possibility of homeownership more accessible. Carol creates a framework that allows tenants in apartment buildings to become partial owners of the building each time they pay rent (instead of actually paying rent).
By developing a real estate fund, incorporating in Delaware as a C-Corp, and issuing the securities under Reg D, financing the building via a Debt Payable by Asset, and transferring shares from investors to tenants each time rent payments are made, Carol has developed a configurable product that provides faster liquidity to investors in commercial real estate deals and unlocks a new wealth-building opportunity for tenants. When the tenants move out they are able to participate in the upside of their presence in the building by selling their interests on a marketplace.
Conclusion
Whether you are looking to tokenize an existing asset, an existing portfolio of assets, or want to use tokenization to finance the creation of a new real estate investment product, Upside is uniquely positioned to help you on your journey. If you would like to learn more, set up a time with our team to discuss real estate tokenization options.
