The tokenization of real estate assets: A step-by-step guide for beginners

The world of real assets is destined to be tokenized.  On the one hand, tokenizing real assets makes them inherently safer and less volatile than classic cryptocurrencies. And, the real estate market – among the safest generational-wealth building investments out there – stands to open a much lower price of entry for would-be buyers and a new way to raise capital for builders.

Of course, there are also risks associated with the tokenization of real estate assets. And it’s a new technology, so humanity is still ironing out its kinks. A lot can go wrong, but it’s exciting none-the-less. Plus, there are a lot of incentives lined up for the ones that get it right.

In a nutshell, the tokenization of real estate provides a much lower price point for investors because the underlying asset’s value is fragmented into digital tokens. These are governed by smart contracts that provide a clear set of rights, obligations, and rules that can’t be easily altered. A level playing field, if you will. In general, these tokens provide ownership of the asset and rights to the profits and losses it generates. It can vary, though. Each smart contract is unique.

The Security Tokens business is just beginning, and it’s already a $1B industry. The reason is simple: in the long run, the real estate business tends to be safe but illiquid. People need to go through all kinds of hoops and procedures to get to the final stage and sign the papers. The tokenization of real estate brings liquidity and new money to the marketplace, while making the process more efficient. 

The tokenization of real estate also makes the industry more transparent. The smart contracts are hosted by a blockchain, which is essentially a public ledger. All of the transactions are there, for both parties to see. They are also immutable, so what you see is what you get. This opens up this new variation of the real estate industry to real-time auditing, among other things.

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Quick tips about the tokenization of real estate

• Stocks rather than real estate are the main asset being tokenized at the moment. 
• By far, the US is the preferred jurisdiction for incorporating Security Tokens. 
• Security Tokens that use Ethereum as a blockchain often use the ERC-721 standard.
• The ERC-721 standard is optimized for fragmentation, traceability, and security.
• Security Tokens are not and should not be confused with REITs or Real Estate Investment Trusts. A REIT is an instrument for investing in a pool of real estate assets.

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What are Security Tokens and why do we use them?

Make no mistake, Security Tokens or STOs are considered securities by the SEC and thus are regulated. That means, the tokenization of real estate assets comes with certain guarantees and a good amount of paperwork. It’s also worth noting that, unlike the infamous NFTs, Security Tokens are usually fungible. All tokens represent a determined fraction of the underlying real estate property, so they’re interchangeable with one another. They are also highly traceable, so the fungibility might just be theoretical. 

How do we represent real-world assets in the digital realm? Using a smart contract that registers said asset, its rights, and the rules of the game into the blockchain. It then releases tokens that represent a proportional fraction of the underlying asset and voilá, the new asset is instantly tradable, available all over the world, and traveling at the speed of light. 

Law firm Dentons estimates that the real estate digital securities market currently sits at about $200M. According to Dentons, an STO can represent:

• “Ownership of part of a real property
• Ownership of the entire real property
• An equity interest in an entity that controls real property
• An interest in a debt secured by real property, or
• A right to share in the profits generated by real property”

For its part, the whitepaper for the T27S Security Token contrasts STOs with the infamous ICOs:

“STOs emerged as the answer to the failure of ICOs. The security token is the second type of investment token that has heritage value. Each security token is backed by an asset which can take the form of a share or a participation certificate. These regulated and tangible assets are the digital representation of traditional financial assets which makes STO investments much safer than ICOs.”

The catch here is the following: since STOs are subject to Securities Law, in some jurisdictions only accredited investors will be legally allowed to own them. Such is the world of regulated finance. 

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How to, a step-by-step guide to asset tokenization

Needless to say, tokenization platforms are currently available. Users interested in the tokenization of real estate assets could just use one of those platforms to handle the technical side and focus on sales and regulatory requirements. Speaking of which, since STOs are considered securities by the SEC, there are a few hoops to jump through and a few limitations. 

For instance, in the U.S., there’s usually a 99-person limit on the number of investors a tokenized security could have. However, it depends on the chosen exemption. A Reg D 506(b) can have unlimited investors, for example. Plus, since this is a fully regulated affair, the full details of the token’s characteristics should appear in the project’s corporate documents.

Jurisdiction plays a big role in the tokenization of real estate assets. And there’s a limitation, the real-world asset’s physical location usually determines the jurisdiction that token issuers have to incorporate in. Founders should pay special attention to the area’s Securities Laws and specific regulations. Another big factor to take into account is the token issuer’s nationality. We’re talking about a fully regulated security offering here, so there might be restrictions in some jurisdictions. 

Let’s assume an interested party has a desirable property in a favorable jurisdiction. And let’s assume said party doesn’t want to use a tokenization platform because they want to keep all of their data and control over the project. On the technical side, they would have to:

• Pick a blockchain - Ethereum is not the only game in town, and other smart-contract-enabled blockchains could offer a similar service for a much lower cost. Not only for the issuers but for their users, too. However, Ethereum offers status, a vibrant ecosystem, and other advantages. Each project has to evaluate which blockchain is the right one for them.
• Create tokenomics - Before programming, you have to specify the rules of the game on paper. These characteristics are called “tokenomics,” and they’ll be the project’s best marketing tool. They’re hard to change once they’re set, so it’s better not to rush them.
• Program the Smart Contracts - Different blockchains use different programming languages, and once the code is deployed it’s virtually immutable. That means, if the code is exploitable it’ll always be exploitable. It’s wise to hire professionals for the programming and have a third party validate or verify their code. Better safe than sorry. 
• Select the token type - When it comes to the tokenization of real estate assets, STOs are the standard. They’re not mandatory, though. Some projects might require a regular ERC-20 token and others an NFT. After picking the right one for their project, token issuers have to include these details both in the smart contract and in the regulatory paperwork. 
• Integrate the token with wallets - Investors in tokenized real estate need a wallet to store their tokens in. It’s the issuer's job to provide options for them to do so.
• Exchanges - If a secondary market for the tokens is desirable, issuers should consider getting it listed on at least one exchange. This is costly, but it’s not hard to do or find. 

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Advantages, the tokenization of real estate is beneficial because:

• It brings forth a more efficient marketplace with fewer intermediaries.
• It provides liquidity to a traditionally dry market. The new and shiny digital assets are available in exchanges and p2p marketplaces. 
• The market is suddenly open 24/ 7, every day of the year. And available in every country with Internet access.
• Digital assets can be transferred, bought, and sold peer to peer. No central third party is required. 
• The blockchain is an immutable ledger that facilitates real-time auditing.
• Expensive properties and trophy assets can be chopped into smaller pieces and thus become affordable to retail investors.
• This opens up a new way to raise capital for owners and builders.
• Retail investors get tokens in a convenient form that makes it easy to rebalance their portfolios and keep their custom-made perfect mix of real estate assets in there. 

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Disadvantages, the tokenization of real estate is detrimental because:

• A programming error in a Smart Contract can cost you millions. There are security risks and bad actors willing to exploit them.
• The licensing requirements require a lot of paperwork. Acquiring a license is not an easy task. 
• The complete traceability of digital assets is an advantage in a way, but it can also be a liability. In any case, count on traceability being there when it comes to STO tokens.
• Regarding STOs, there’s currently no regulatory clarity in the US. Investors have to be aware of that and willing to take the risk anyway.
• Tax is also a complex issue. Currently, the rules are not set in most jurisdictions including the US. 
• The automation of Smart Contracts might be a good thing, but it also translates in a loss of control.  

Security Tokens are just the digital version of what the traditional financial system has to offer. And like TradFi, these digital versions are not perfect. The tokenization of real estate assets can, however, democratize the sector and open access for retail investors at a lower price point. And it unleashes the real estate game into a trustless, highly efficient market that’s always open and available worldwide.