What is the Tokenization of Real Estate?
Real estate tokenization is a process of making blockchain-based tokens by asset tokenization platforms that reflect a part of real estate ownership, making it easier for smaller investors to make any real estate investments. It’s an emerging trend in this industry that allows anybody to invest in property such as Empire State Building or luxury resorts. In 10 to 15 years, trillions of dollars in real estate will be tokenized and brought onto a blockchain. However, real estate developers are often extremely confused when it comes to the nuances of tokenizing the property and applying it in practice. This article will help you learn more about the mechanisms and advantages of this process.
Real Estate Investment Trusts
Real Estate Investment Trust is a corporate form enabling fractionalized investment in property. These are funds available for retail investors interested in real estate. They have a number of advantages thanks to the better taxation compared to regular companies, but they possess a certain number of drawbacks as well. REITs have to pay dividends that are sometimes as high as 90%, which deprives them of having this money for the acquisition of new properties. They also have a certain limit regarding the risk they can take upon themselves. For instance, they are limited in using leverage. Stobox usually recommends engaging in real estate tokenization not through REITs because real estate tokens can still get liquidity by using the decentralized finance tools but have fewer limitations, which enables them to deliver higher returns.
Two main benefits of tokenizing real-estate: why tokenize?
First of all, tokenization drastically reduces the minimum investment threshold. It represents the ownership of a building in the form of blockchain tokens, and, therefore, one building can be owned by thousands of people. This means that your investors don’t need to have millions of dollars to purchase a property: they can start with as little as $500. Such a feature allows developers to increase sales by tapping into a new audience interested in investing.
The second benefit is that now these pieces of real estate can be traded, which makes such investment opportunities even more attractive and makes finding investors easier.
Basic models of real estate tokenization
There is a common misunderstanding about the way property tokenization works. Though many people think that owning real estate tokens gives its holders a right to a square meter or a square centimeter of a given property, it actually doesn't work this way. The problem is that if many individuals own property directly, the benefits of tokens such as flexibility and the ability to be easily traded are lost. It happens because in such a case, each transaction would require changes in the property register which are expensive and take a long time. Therefore, direct ownership of real estate assets is inefficient.
Instead, what you are tokenizing is not real estate directly but securities issued by a company that owns that real estate or has a claim to it. In plain language, there is a company type called Special Purpose Vehicle that owns the real estate, and investors hold shares of this company that are represented in the form of tokens. Such implementation is much more flexible because in certain countries it is possible to store shares directly on the blockchain, and there's no need to report each transaction to regulators, which makes having thousands of investors and an active secondary market more feasible.
However, this does not mean that you can only tokenize the property that is located in a country where securities on the blockchain are recognized, such as Switzerland or Liechtenstein. It's possible to establish a holding company in a progressive jurisdiction, and this company will either explicitly own real estate in your country or hold a company over there that does that. The specific form depends on the local legislation of the real estate ownership and the double taxation rules, and should be decided on a case-by-case basis. Choice of the best model is part of the Consulting services that we at Stobox provide to companies seeking tokenization.
This methodology can be applied for the tokenization of any liquid asset, not just real estate. Consider taking advantage of it to tokenize precious metals or rare collectibles, such as fine art or expensive cars.
Investor Protection: what do investors receive?
One of the most common concerns related to real estate tokenization is investor protection. This issue of such a model providing investors with enough rights and being attractive for them is high on the agenda. The good news is that the tokens that investors hold are legally recognized securities, so the claim of investors on the company is protected by the corporate legislation, the Commercial Code, the Civil Code, or other laws depending on the given country. Furthermore, investors would have to sign a token purchase agreement that provides them with additional legal protection while buying a token. Notice that Stobox tokenization infrastructure includes a step of signing a token purchase agreement.
Another important point is the company that owns real estate. If the documents are satisfactory, and there is no litigation or other problems related to the company or the underlying real estate, it means the company's rights to a property are also secure. Therefore, when the company receives cash flows from the real estate, it is legally obliged to distribute these cash flows as income to its shareholders or bondholders. If the business is underperforming, real estate can simply be sold, the company liquidated and the proceeds distributed among their token holders.
The matter of providing investors with specific rights offers some flexibility. The two most common options are ownership and cash flows. That is, investors can claim their entire real estate and even have the voting right to choose the management of the special purpose vehicle; or have rights only to the revenue generated by the real estate or a certain portion of it.
Each of these options or some hybrid form is possible, and you can create legal agreements that guarantee the specific rights you want to give to investors. The issue here is to get the token pricing right. If you sell equity of the underlying real estate, for example, the token's valuation will be higher than if you offer a portion of the revenue. Our consulting services include assessment of your financial projections to ensure that investors receive accurate information.
Advanced models of property tokenization
We just guided you through the basic models of property tokenization. Let's take a look at the advanced models of this solution.
Raise-then-purchase: investor protection and financial attractiveness
One of the problems Stobox clients report is that sometimes real estate they want to tokenize is owned by them as by a physical person, and transferring it to the balance sheet of a company in some jurisdictions is quite an expensive endeavour which may cost from 15 to 30 thousand euros. Often this addition to the overall cost of tokenization makes it not feasible.
Passing on the cost to potential investors may solve this problem. In this case, the first thing to do would be to raise money; purchasing the property using proceeds from the token offering would be the next step.
There are two issues to discuss here: investor protection and financial attractiveness. As for investor protection, you have to ensure that the property will be there to be bought when the offering is finished. To do so, you must sign a reservation document prohibiting the sale of ownership of the land to someone other than the tokenized SPV for a set period of time. This ensures that you can eventually purchase the property.
Passing on the cost of transfer to investors reduces the financial attractiveness of the offering. For example, if the property is valued at €300 000, but you are raising €330 000 because you need additional money to transfer the property, investors who have invested €330 000 would own a company that has only €300 000 in assets.
If the property delivers a satisfactory return, the investment is still justified, but the return would be reduced. For instance, if the actual property appreciates by 20% to €360 000 euros, the investment appreciates only from €330 000 to €360 000, which is only a 9% return. However, for more significant properties and larger appreciation, the impact of this tail of 15 to 30 thousand euros will be lower. If the basic value of the property is 3 million euros and it appreciates by 20%, investors receive 18,8%.
Segregated Portfolio Company: Benefits For Investment Purposes
This next advanced model is helpful for those who wish to tokenize multiple properties. Instead of incorporating a separate company for each property, you might have one company own all of them to reduce the cost.
The problem with this model is that it implies a bigger risk. If one property is underperforming and the company cannot fulfill its obligations, it would have to use revenue from other properties, which other investors may own.
To solve this problem, you need a vehicle where each property would be part of a separate balance sheet, and assets and liabilities would be calculated separately for each property. This kind of company is called a segregated portfolio company. It was initially designed for investment funds that might have many different portfolios and want to protect investors if one or several of the portfolios are underperforming. You can use this idea for tokenizing multiple properties where one portfolio would represent one property: issue separate security for each piece of real estate that will represent the rights to cash flows from it.