Real Estate Tokenization – An Overview for Issuers
Insight Herman Enayati · June 04, 2021
While real estate security token offerings have been around for a few years, the increased adoption of cryptocurrencies and the emergence of decentralized finance (“DeFi”) protocols have created a powerful use case for the tokenization of additional assets, such as real estate. This article summarizes the basics of a tokenized real estate fund offering, as well as some additional benefits and considerations for issuers considering a security token offering.
Tokenization of real estate broadly refers to the process of representing interests in real estate assets on a blockchain or distributed ledger in the form of a token, the ownership of which can be transferred via the blockchain’s protocol. Tokenization is part of a larger trend in fintech over the last decade towards democratization of assets and disintermediation of traditional gatekeepers. The evolution of the cryptocurrency markets over the past few years has further accelerated this movement, allowing broader access to investments and greater control for investors. At its core, the tokenization of real estate makes it easier to buy and sell real estate interests, adding liquidity to the market while increasing transparency and security, and reducing costs and risk compared to traditional private real estate securities.
How Does it Work?
While there are different forms of real estate tokenization, the focus of this article is on the tokenization of interests in real estate funds or single asset syndications. In a typical real estate syndication, investors purchase equity in a limited liability company or limited partnership that owns an underlying property. In this context, tokenization refers to the representation of such LLC or LP interests in the form of tokens that can be custodied directly by investors and traded or used as collateral in smart contracts.
Much like a traditional fund offering, the issuer must first make some basic decisions about the offering, such as what type of security is being offered and what exemption(s) to registration will be relied on, taking into account such factors as the total number of investors, the location of investors, whether investors should be accredited and also whether public solicitation is desired. Issuers will also need to prepare customary offering documents, including operating agreements, subscription agreements, a private placement memorandum and appropriate risk factors for the specific investment being offered, and make appropriate SEC and/or state filings.
So, given that so far a lot looks similar to a traditional offering, what’s different? Issuers will have to make a few more decisions and consider some tweaks to their normal deal terms. For starters, given that tokens will exist on a blockchain, issuers must first decide which blockchain will be used taking into consideration issues like transaction fees, security, and scalability. In addition, many tokenized offerings give investors the option of investing with cryptocurrencies such as Bitcoin or ETH. Doing so may be attractive to investors, but raises the issue of how to deal with conversion and escrow of funds in a deal that will ultimately need US dollars to purchase and operate the real estate.
Once the offering details are finalized, issuers will issue tokens representing the rights of securities holders. These tokens typically include built-in compliance features, such as appropriate restrictions on transfers and secondary trading. The offerings must still comply with applicable KYC requirements, and take appropriate measures to protect user data. Lastly, consideration should be given to mechanisms for payment of distributable cash, which can, for example, be made using stablecoins (i.e. coins pegged to the US dollar), as well as appropriate reporting requirements to make future valuation of tokens possible.
At present, the dominant form of tokenization relies on the Ethereum platform through the issuance of ERC-20 tokens, or non-fungible token interfaces, such as ERC-721 or more recently, ERC-1155 token. As noted, tokens can further be programmed to address compliance issues, such as limiting transfers during a lockout period or limiting transfers to whitelisted wallets that have passed applicable screening requirements. Issuers have the option of developing their own tokens or utilizing the services of an increasing number of crowdfunding platforms, NFT platforms, and even transfer agents that support the issuance of tokenized offerings on behalf of issuers.
Benefits of Tokenization
Tokenization and the incorporation of blockchains more broadly offers unique advantages. Issuers benefit from the ability to access new sources of capital while taking advantage of the compliance and administrative ease of smart contracts. Investors benefit from the trust-minimizing features of blockchain and smart contracts, allowing more secure investments and greater access to investment opportunities. Both issuers and investors will ultimately benefit most from the ability to hold equity interests in a form that can be deployed in smart contracts for frictionless borrowing and lending, which has the potential to increase liquidity and enhance the return profile of real estate assets.
Challenges in Realizing the Full Potential of Real Estate Tokenization
While tokenization of real estate offers many benefits, effectively realizing those benefits presents a number of challenges that will need to be addressed to realize the true potential of the space. Regulatory challenges present the most significant obstacle, given that even issuers that want to create liquidity in secondary exchanges remain subject to KYC and AML requirements, as well as a minefield of other considerations ranging from licensing and reporting obligations. The still-nascent adoption of cryptocurrency and DeFi mean that it could take time for the type of widespread adoption that facilitates seamless borrowing and exchanges. Issuers will also need to tread carefully to ensure that the tokenized structure fits within the larger capital stack, where mortgage lenders and other counterparties less familiar with tokenization could be reluctant to entertain new structures.
Herman Enayati is a partner in the Los Angeles office of Rimon, P.C., specializing in real estate debt and equity financing. His practice includes the representation of real estate sponsors in the issuance of tokenized real estate offerings, as well as advisement of fintech and crypto startups on regulatory matters relating to tokenized offerings and the integration of DeFi into traditional financial models. Read more here.
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