In our latest post we discussed why the time for security tokens, or digitized securities, is right. There are many industries that are ripe for digitized securities disruption and real estate is one of the most prominent examples of this. In the blockchain technology space the word “real estate tokenization” has become rather omnipresent, and yet we have found that what it means to actually “tokenize” real estate is a confusing and misunderstood process. In this blog post, we will break down the crucial steps needed for a physical property such as real estate to construct a digital asset.
Real estate tokenisation is the process of creating a digital asset on a blockchain-based system that represents a single property or a portfolio of properties. Our recent blog post on Security Token Offers (STOs) provides a detailed overview of the STOs and their benefits for more context and perspective. To date, Elevated Returns is the most well-known real estate STO, generating $18 M for the St. Regis Aspen Resort. Other examples include the Muirfield client AlphaPoint.
The momentum in real estate is part of a broader trend – we are moving into a digital economy where financial and physical assets will increasingly have their unique value represented in digital form. The World Economic Forum estimates that 10 per cent of all global GDP will be held by blockchains by 2025. Countries and individual states also make the administrative and legislative reforms required to make this prediction a reality. For example, the US state of Delaware recently passed a Senate Bill that allows corporate share registries to be maintained on a blockchain, thus eliminating the need for duplicate record keeping. In a wider example , the United Arab Emirates city of Dubai has embarked on an ambitious plan to shift all government services to blockchain by the year 2020.
Tokenizing Immovable Profits
Digitization of real estate assets into a blockchain-based network tackles many capital development and liquidity issues. Profits include:
- Additional access to capital – property owners and developers can offer smaller investment denominations by fractionalizing a property through a blockchain-based system, expanding distribution to a larger and more diverse group of investors.
- Lower illiquidity discounts & liquidity premiums – Institutional investors have historically had an advantage over individuals for extremely illiquid assets such as real estate because of the substantial illiquidity discount associated with most commercial real estate transactions. By comparison, more liquid investment instruments, such as publicly listed REITs, often sell at a premium of up to 20 per cent.
Real estate tokenisation will enable a wide range of assets to be traded on a secondary market, thereby reducing the spread between illiquid real estate investments and publicly traded investment vehicles and bringing the executable price of an asset closer to its true value.
- Enhanced price discovery – A secondary digital market for individual real estate properties allows for real time price information based on order books. Today all parties operate this type of information in paper-based systems with asymmetric information.
- Improved transparency – the use of a blockchain-based system allows the programming into the tokenized digital asset of the rights, restrictions and data associated with the underlying property. For example, AlphaPoint’s APIs can connect data and valuation systems with “off-chain” to increase investor transparency into the underlying value of the property.
- Automated processing – Automated, real-time table cap management with automatic delivery and administration decreases administrative costs while rising speed of settlement.
By wrapping a conventional asset into a tradable piece of code (a token), digitized securities provide a way to expand access to assets and lower entry barriers such as illiquidity, high transaction minima and steep administrative costs.
Digitized securities can require different investment configurations; for example, an issuer may generate design returns customized to particular objectives while providing greater ownership and movement transparency.
How to Digitise Properties
There are three key phases of digitalisation:
- Deal structuring
- Technology selections
- Token creation and distribution
I. Structuring the Deal
The structure of the deal depends on a variety of elements, including jurisdiction, type of asset, type of shareholder and the regulations applicable. Sometimes, issuers would opt tokenize an existing deal to enable current investors to take liquidity before collecting funds for new deals.
At this stage, proprietors of assets must decide:
- Asset-Determine the property or properties to be digitized
- Legal structure – Digitizing real estate requires a legal wrapper to securitise and create an investment vehicle around the individual property(ies). The most frequent structures we’ve seen to date are:
- Single asset Special Purpose Vehicle (SPV) – an SPV structure is entitled to title and deed of the physical property. Tokens reflect SPV shares. This form of structure is usually limited to accredited investors or eligible institutional buyers.
- Real estate fund-a private equity fund investing in a property portfolio. The tokens reflect shares or units of ownership in the fund. Tokenised fund interest is usually only open to eligible institutional buyers or approved investors.
- Project funding – tokenisation may be seen as a new method for increasing a project’s funds. Depending on deal size, tokens may be made available to retail investors as well as accredited investors.
- Real Estate Investment Trust ( REIT) – a REIT operator can create digitized shares in a REIT to take advantage of the technology benefits. Tokenholders have the same REIT operating revenue rights as traditional investors do today. REITs are costly to operate, however, they are advantageous in that they are available for retail investors.
- Shareholder rights – determining whether investors have the right to dividends or the entity and/or property governance based on the legal structure. You may also choose to sell multiple tokens that reflect different groups of investment. For example, in a property with a liquidation preference you can build a token that represents preferred equity, and another token that represents common equities.
- Types of investors – the legal structure may dictate which types of investors will have the deal made available. It must also recognize the jurisdiction in which the target community of investors should live.
- Control on the execution – the relevant execution legislation may be dependent on the position of the property or the SPV, the size of the capital increase and the form and place of the investors. It is important to note that regulations on execution can also determine the tokens’ tax treatment, as well as restrictions on solicitation.
II. Tech Selection
Once the legal structure for the property is established and the structure of the deal is in progress, a few technology decisions must be made. Compared to other phases this part of the process is fairly straightforward and simple. In a follow-up blog post, we’ll go into these selections in depth, but at a high level, the four critical decisions that you’ll have to make are:
- Blockchain / Token Definition – select the blockchain on which the token is to be created, and decide which data and transfer restrictions to be included.
- Custody-determine a solution for physical custody that can store property tokens appropriately. Investors may need a solution for custody, too.
- KYC / AML Vendor – identify a KYC / AML vendor capable of integrating with the primary issuance platform and the digitized security infrastructure.
- Primary / Secondary Marketplace – where would you like these digitized securities to be offered to primary issuance investors? And what exchanges do you want to trade them on? Ultimately, these decisions will determine the success of capital raising, and the ability of investors to access liquidity. An alternative is to create your own marketplace, which many of our larger customers choose to use the Exchange technology from AlphaPoint.
III. Creation & Distribution of Tokens
The next step is to launch the token and distribute it to investors once the technology decision is under way and the deal has been structured. A few notes about this process:
- Appropriate Funds – Now that you are offering real estate as a digital investment token, you have the option to easily accept that forms of payment methods. You can adhere to traditional fiat currencies, or you can use cryptocurrencies or stablecoins to allow investors to purchase the digitized real estate.
- Token Creation – The token launch process is handled in a web application created by your technology vendor, like AlphaPoint. You will start the digital asset by clicking the button, and then create a tokens supply, a process called “minting.”
- KYC / AML – Your prospective or committed investors will go through an onboarding investor and the KYC / AML process, depending on your selection for the primary issuance platform. They may need to link up their digital wallet during this time, too.
- Token Distribution – You will either send tokens directly to investor accounts, or list the digitized real estate on a primary issuance platform, depending on whether you collected funds in advance or sell the tokens on a live sale. If the investors make the order, they obtain the digitized shares, and you can handle the increase and display the cap table in real time.
Our clients believe the real estate sector will benefit significantly from the shift to digitization. Tokenizing real estate by rising the illiquidity discount and streamlining transactions would increase the value of the property. In addition , investors can have more flexibility and better returns on their investments by providing additional investment opportunities through tokenisation. We are excited to be a part of this shift at AlphaPoint, and look forward to contributing to new market standards.