REAL ESTATE TOKENIZATION BASICS
Updated: Nov 3, 2023
This is the second part of the “Real Estate Tokenization” article I previously wrote. In this article, I will discuss the challenges and opportunities presented in this space and the future of real estate tokenization.
Challenges and Opportunities
While tokenization can overcome several barriers and democratize access to real estate investing, challenges still exist and must be addressed given the technology's infancy.
Uncertainty in the Legal and Regulatory Environment
In contrast to established asset classes, the innovative nature of security tokens means that the legislation and rules governing them still need to be resolved and have not been challenged by courts or regulatory agencies. Although several regulatory bodies throughout the globe have published guidelines on security tokens, it is anticipated that advancements and modifications to rules and regulations will be implemented as the technology is more used and the market develops. Additionally, there can be no assurance that regulators and governments now supportive of or do not oppose tokenization will continue to be so in the future. As a result, the legal and regulatory requirements and constraints governing the sale, distribution, holding, trading, and administration of security tokens may alter in the future. This may create ambiguity for security token issuers and investors, impeding adoption and secondary market liquidity. However, it should be emphasized that several authorities distinguish between security tokens and cryptocurrencies. A critical distinction between a cryptocurrency and a security token is how value is created. Because the value of a real estate security token is derived from the underlying real asset, the value of a real estate security token is less volatile and more readily quantifiable than the value of a cryptocurrency. Additionally, security tokens are often regulated under current securities laws, even in places where cryptocurrencies are unregulated or prohibited. Therefore, Investors in security tokens may enjoy greater protections and privileges than investors in cryptocurrencies.
Confidentiality
By and large, real estate financing and transactions are secret. Managers and participants in such ventures typically do not want to divulge commercial terms or other sensitive business information, save to a small number of qualified potential investors to who nondisclosure agreements will bind. Occasionally, such anonymity may be required by law, for example, if the underlying project involves a publicly traded or regulated firm.
Historically, maintaining such confidentiality has not been a problem for real estate transactions and funds. They are typically offered to a small number of institutional, corporate, and high net worth investors who are generally subject to a lengthy lock-up period, frequently until the project's completion. However, when it comes to security tokens published on an exchange for secondary trading, it will be required to disclose commercially sensitive information to a broader pool of prospective investors to enable investments and transactions.
A critical area of growth will be striking a balance between the data openness afforded by blockchain technology and the information privacy necessary for financial transactions. On public blockchains, data privacy may be secured through protocols such as Zero-Knowledge Proof, which allows one party to authenticate their knowledge of particular data to a counterparty without disclosing what the data is. In addition, blockchain protocols will provide data transparency with further development and prudent structure, protecting stakeholders from illegal or improper information hiding without disclosing private company data.
The Future of Real Estate Tokenization
Thus far, real estate tokenization efforts have been heavily influenced by established business models, which is a wise precaution to take when embracing new technology. However, as tokenization technology and business models evolve, the technology may enhance current company processes and generate new business prospects.
Tokenization enables the integration of value-generating channels and the alignment of diverse stakeholder interests. Tokenization may be used in the future for employee incentive programs, lease-to-own agreements, and co-working spaces.
Case Study: Asia's First Tokenization of Real Estate for Employee Incentive Program Liquefy completed the first part of a project with a Hong Kong property developer to tokenize a group's real estate asset for use in its employee incentive program in Q4 2019. The project was created to encourage employee participation in innovation, foster entrepreneurialism, and acknowledge employee contributions. Tokens reflecting an ownership stake in the property are issued as part of the plan to provide high-performing employees with the option to partake in the wealth generated by the property's capital appreciation. Liquefy secured the digital register of members of the holding company that owns the property on blockchain as the technology supplier—allowing the developer to issue tokens indicating an indirect ownership stake in the underlying property, with the opportunity to participate in the property's capital appreciation. Employees may swap performance-based internal credits for real estate tokens, with the system recording each transaction in real estate tokens. Token holders will get a portion of the sale revenues when the underlying property is sold according to the number of tokens owned. The developer's next step would be to tokenize more properties to broaden the incentive program by allowing workers to internally swap tokens for alternative attributes.
Two Examples of Asset-Backed Tokens
Example one: Lease-to-own property.
Another potential use of tokenization may be asset-backed tokens combined with a utility component to permit lease-to-own residential property acquisitions. The exorbitant down payment is a significant impediment to house ownership for many young families in some nations. Real estate businesses may tokenize residential buildings they control, allowing tenants to eventually acquire ownership on a fractional basis. The down payment would less burden young families. They would have an incentive to rent tokenized property, knowing that they could acquire property tokens quickly and ultimately own their house. Meanwhile, the real estate company would profit from the money generated by the property as part of their portfolio.
Example two: Co-working space.
Another example of how tokenization might be used in real estate in the future is in co-working spaces, where it could create more prominent communities than the sum of their parts. Tokenized commercial real estate assets may be combined with time-sharing or co-working spaces to enable financial investment in the community. A community involvement mechanism might be implemented, merging fractionalized property ownership with the value contributed by the co-working community. By fostering community development, renters would be rewarded with the potential to profit from increases in the income or value of the property. A varied array of startup tenants collaborating and producing genuine business value as a community might increase income and property value.
Summary
For investors previously unable to pay the large upfront capital requirements associated with property investing, tokenized real estate allows them to participate in this asset class for the first time. For institutional investors seeking portfolio diversification, tokenization enables customized portfolio rebalancing with near-instant settlement. It allows investors to sell or buy tokens to adjust their exposure to a particular asset and manage a broader range of assets in their portfolio, including traditional assets like real estate and exotic sports teams.
Traditional intermediaries such as valuers, auditors, and brokers would benefit from greater data accuracy and availability, with sensitive data safeguarded against unauthorized parties through encryption. In addition, automation of procedures reduces repetitive labor. It decreases human mistakes, freeing up time and economic resources to concentrate on tokenized real estate asset transaction structuring value-added components.
While tokenization of financial products is still in its infancy, regulators and regulatory frameworks worldwide are fast changing to accept and promote the further growth of this new wave of financial innovation. Institutional engagement and business frameworks will be necessary for tokenization's widespread acceptance and quick progress in real estate investing. While technology is a vital facilitator, it cannot determine the result independently. To fully achieve the promised advantages of tokenization, stakeholders with the necessary expertise, experience, and influence must collaborate to create a larger ecosystem than the sum of its parts.
By Edith Lagunas
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