The world is moving to a digital economy where financial and physical assets will increasingly have digital representations of their unique value. The World Economic Forum predicts that by 2025, blockchains will store 10% of all global GDP. Countries and individual states are already making the necessary regulatory and legislative changes to make this prediction a reality. An example is the state of Delaware in the United States which passed a Senate Bill allowing the maintenance of corporate share registries on a blockchain, therefore eliminating the need for duplicate record keeping. In a broader example, the city of Dubai in the United Arab Emirates has embarked on an ambitious strategy to move all government services onto the blockchain technology.
As regards commercial real estate, The pandemic has changed everything. Whether we’re looking at asset ownership, rental, sale, and ways to dynamically pivot the vast amounts of unused space we’re seeing in just about every city on the planet, everybody is scrambling for innovative short- and long-term solutions. This is coupled with the market changes and the growing use of technology. When it comes to real estate investment in particular, technology plays a major role in the form of tokenisation.
Storing securities in digital ledger creates exciting opportunities of making their transfer easier, opening companies access to global investors, making fraud nearly impossible and many others. However, this requires multiple parties having different degrees of access to this ledger: investors that create requests to modify company ownership when investing; а company that can approve such requests and view its entire shareholder register; а monitoring regulatory body that can see requests but does not approve them; and other parties that will be required.
What is Tokenisation?
Within the world of blockchain, the word “token” is part of the general vocabulary, often as part of a discussion about whether any given token should be classified as a security. However, tokenisation isn’t a concept borne of blockchain innovations. Physical tokens have long been used to replace real money. Banknotes and coins are some of the examples, which denote a legal right of ownership of the underlying currency.
The use of tokens in the digital world came about as a means of replacing sensitive data with a non-sensitive digital equivalent. Tokens can be defined as digitalised financial assets that allow the creation of fractions of ownership and almost instantaneous transactions.
These are now legally defined as “any intangible property representing, in digital form, one or more rights that may be issued, registered, retained or transferred by means of a shared electronic recording device(blockchain) that identifies, directly or indirectly, the owner of such property”
In practice, the notion of digital assets then concerns, on the one hand, tokens issued on the occasion of a fundraising event (or ICO for “Initial Coin Offering”), and generally exchangeable for crypto-currencies, and on the other hand, crypto-currencies themselves, negatively defined as not fulfilling the traditional functions assigned to money.
All steps toward regulation addresses volatility and risk concerns related to both initial coin offerings (collectively ICOs) and security token offerings (STOs)
As many groups are seeking to fine tune and standardise definitions of the different types of tokens, much of this regulation recognises that STOs- which, unlike most ICOs are backed by physical assets-could be the solution to security and fraud concerns surrounding ICOs and other types of crypto tokens.
Types of Tokens Circulated and Used in the Blockchain World
Tokens are broadly divided into two basis:
1. On the Basis of Nature
Tangible Assets – The term represents a set of assets that holds some monetary value and is available usually in a physical form.
Fungible Assets – These digital assets are created such that every token is equivalent to the next. Meaning, one bitcoin is equal to one bitcoin and is interchangeable with one bitcoin only.
Non-Fungible Assets – They are designed as unique and can’t be interchangeable.
2. On the Basis of Speculation
Currency Tokens – These tokens represent currencies in digital form.
Utility Tokens – The term refers to a digital token that is issued to support funding for the development of cryptocurrency and can be later employed for purchasing a particular product or service offered by the issuer of the cryptocurrency.
Security Tokens –Security tokens, one of the cryptocurrency trends, is basically the digital representation of traditional securities.
Now as we are familiar with the types of tokenization of assets via distributed ledger blockchain technology, it’s the right time to look into what are the benefits of this process
Asset tokenisation of real-world assets is the next evolution in tokenisation. Tokenising an asset involves issuing a digital token on a blockchain, whereby that token represents an underlying tangible or intangible asset. In this way, the economic value of the asset is conferred to the token. Ownership of the asset is represented by ownership of the token on the blockchain.
Real Estate tokenisation is the process of creating a digital asset that represents a single property or a portfolio of properties on a blockchain-based system.
Bitcoin and other cryptocurrencies enable the trading and exchange of digital tokens as assets by themselves. A cryptocurrency is used as a store of value or as a medium of payment. In this sense, the digital token of a cryptocurrency is itself, an asset.
Because there is virtually no limit to which assets can be tokenised, tokenisation of assets on the blockchain offers compelling and far-reaching implications across many industry sectors. It’s already possible to trade digital assets representing underlying financial instruments such as commodities, futures or stocks. Supply Chains are using digital tokens to manage the movement of goods.
The full potential of asset tokenisation is still unfolding. Perhaps unfairly, blockchain has come under some criticisms for acting as little more than a glorified database. However, tokenization elevates the technology far beyond record-keeping, providing a myriad of use cases that will ultimately prove invaluable to enterprises and individuals alike.
Fractionalisation Through Tokenisation
Digital asset fractionalisation, or tokenisation, has been successfully achieved in limited scale in fine art and machinery, and the real estate market offers a huge and irresistible opportunity to further develop and apply this technology in large scale. Blockchain applications are becoming fit for the purpose of underpinning a tokenised market.
Fractional asset ownership is seen as emerging alternative investment option for institutions.
Fractional ownership of properties is not new, What is new though, is the idea that institutional investors might benefit from a new generation of fractional ownership structures, which typically employ blockchain technology.
Since fractionalisation works for art, it can work for real estate. A blockchain based tokenised real estate market should deliver more efficient, fractionalised, primary and secondary markets.
Fractional ownership, provides an opportunity to bring unrelated parties together to enjoy trading in a digital world.
The biggest game changer will likely be found in unlocking the liquidity of smaller investors through democratising access, thanks to fractional real estate (FRE) opportunities.
Since this class of investment was previously only accessible to high net worth investors, Real estate investment trusts REITS opportunity for investment vehicles managed by major banks or institutional investors, the tokenization of investment grade assets into FRE significantly lowers the barrier of entry priced at single token value with no investments limits or lock in periods creating a simpler and more secured opportunity for investors to buy into.
Blockchain and Tokenisation
Blockchain has poised to bring a transformative difference in the finance world. The technology, with its characteristics like decentralisation, immutability, transparency, and distributed structure, has added new forms of benefits and applications into the ecosystem, One of which is asset tokenisation on the blockchain surface.
While tokenisation is a highly useful tool in data security, when combined with blockchain it becomes exponentially more powerful. When a token is issued on a blockchain, the blockchain records the issuance and maintains a ledger of every single movement of that token.
A critical feature of blockchain with regards to tokens is that it overcomes the “double-spend” problem. Before blockchain, any digital asset such as an image, or document, could be copied an infinite number of times by anyone with access to it. Consider an email trail with an attachment — everyone on the email trail has their own copy of that attachment.
The creation of Bitcoin overcame this issue by using a distributed ledger to keep a permanent, immutable record of Bitcoin transactions. Each Bitcoin is a token, and every time a Bitcoin transaction takes place, the ledger is updated to reflect the spend. Thus, no Bitcoin can be spent twice.
Overcoming the double-spend problem now means that with blockchain, digital tokens can be used in a similar way to banknotes.
Tokenisation also opens up these markets to new pools of investors. Imagine a fresh graduate who has little money that they could purchase tokens representing fractional ownership of a piece of real estate, which appreciate in line with the increasing market value, These tokens could in turn raise sufficient funds for a down payment on a home a few years later.
As well as opening up new avenues for investment, tokenisation creates new liquidity in markets for real-world assets which are traditionally highly illiquid.
Asset tokenisation provides transparency and security. Ownership is indisputably recorded on the blockchain independently of where an asset is stored. Any ownership rights can also be embedded directly into the token, with the possibility of having contractual obligations enshrined into smart contracts which execute automatically.
Advantages of Tokenising Real Estate
It is believed that the real estate industry will significantly benefit from the shift towards tokenisation. Tokenisation of real estate assets on a blockchain-based system addresses several challenges in capital formation and liquidity, Thus bringing about the following advantages:
(1) Access additional capital: Real estate owners and developers can offer smaller investment denominations by fractionalising a property through a blockchain-based system, expanding distribution to a broader and more diverse investor group.
(2) Lower illiquidity discounts & liquidity premiums: For highly illiquid assets such as real estate, institutional investors have often had an advantage over individuals due to the steep illiquidity discount associated with majority of commercial real estate investments. Conversely, more liquid investment vehicles, such as publicly-traded REITs, frequently trade at up to a 20% premium.
((3) Tokenisation of real estate will enable a broad variety of assets to trade on a secondary market, thereby reducing the spread between illiquid real estate investments and publicly traded investment vehicles and bringing an asset’s executable price closer to its true value.
(4) Enhanced price discovery: A digital secondary market for individual real estate properties enables real-time pricing information based on order books. Today, this type of information operates in paper-based systems with asymmetrical information by all parties.
(5) Improved transparency: the use of a blockchain-based system enables the programming of rights, restrictions, and data associated with the underlying property into the tokenized digital asset.
(6)Automated Processing: Digital, real-time cap table management with automatic distributions and governance reduces administrative costs while increasing settlement speed.
(7) Faster and cheaper dealing: Transacting in digital tokens is faster and cheaper and may not require an intermediary such as a broker. For this reason, tokenisation of financial instruments is making waves in the trade finance sector.
(8)Peer to peer investment in major commercial assets.
(9) Streamlining transactions.
(10) By offering supplementary investment opportunities through tokenisation, investors can have more flexibility and better returns on their portfolio.
(11) By wrapping a traditional asset inside a tradable piece of code (a token), digitised securities offer a way to broaden access to investments and lower barriers to entry such as illiquidity, high transaction minimums, and steep administrative costs.
(12) Digitised securities also enable additional investment configurations; for example, an issuer can create design return tailored to specific objectives while offering greater transparency concerning ownership and movement.
The Process Of Tokenising Real Estate
Tokenisation includes three key phases:
I. Deal structuring
II. Technology selections
III. Token creation and distribution
I. Deal Structuring
The deal structure depends on a variety of elements, including jurisdiction, asset type, shareholder types, and the applicable regulation. Often, issuers will opt to tokenize an existing deal to enable liquidity for current investors before raising funds for new offers.
In this phase, asset owners must decide:
1. Asset – Determine the specific property or properties to digitise.
2. Legal structure
Tokenisation of real estate requires a legal protection around the individual property(ies) to securitize and create an investment vehicle. The most common structures we have seen to-date are:
(A) Single asset Special Purpose Vehicle (SPV) : title and deed of the physical property are assigned to an SPV structure. Tokens represent shares of the SPV. This type of structure is typically limited to accredited investors or qualified institutional buyers.
Real estate fund : a private equity fund that invests in a portfolio of properties. Tokens represent ownership shares or units in the fund. Tokenized fund interest is typically available only to accredited investors or qualified institutional buyers.
(B) Project finance : tokenisation can be used as a new mechanism for raising funds for a project. Depending on deal size, tokens may be made available to retail investors as well as accredited investors.
(C) Real Estate Investment Trust (REIT) : a REIT operator can create digitised shares in a REIT to take advantage of the technology benefits. Token holders have the same rights to operating income from the REIT that traditional investors have today. REITs are costly to operate, however, they are advantageous in that they are available for retail investors.
3. Shareholder rights : based on the legal structure, determine if investors have the right to dividends or governance of the entity and/or property. You may also choose to offer multiple tokens that represent different investment classes. For example, you can create a token that represents preferred equity in a property with a liquidation preference, and another token that represents common equity.
4.. Investor types : the legal structure may dictate to which types of investors the deal will be made available. The jurisdiction in which the target investor group will reside must also be considered.
5. Execution regulation : the applicable execution regulation may be based on the location of the property or the SPV, the size of the capital raise, and the type and location of investors. It is important to note that execution regulation may also determine tax treatment of the tokens as well as solicitation restrictions.
II. Technology Selection
Once the legal structure for the property is set up and the deal structure is underway, you must make a few technology decisions. This part of the process is relatively straightforward and fast compared to other phases. At a high-level, You will need to make these four critical decisions below:
(1)Blockchain / Token Definition : choose the blockchain on which to create the token, and decide which data and transfer restrictions to include in the token.
(2)Custody : determine a physical custody solution that can suitably store real estate tokens. Investors may also need a custody solution.
(3)KYC / AML Vendor : determine a KYC / AML vendor that can integrate with the primary issuance platform and the digitised security infrastructure.
(4)Primary / Secondary Marketplace :where do you want these digitized securities to be offered to investors for the primary issuance? And on which exchanges do you want them to trade? These decisions will ultimately determine the success of the capital raise and the ability for investors to access liquidity. An alternative option is to create your own marketplace.
III. Token Creation & Distribution
Once the technology decision is underway, the deal has been structured, the next step is to launch the token and distribute it to investors. Please note the following on this process:
Acceptable Funds: Now that you are offering real estate as a digital token for investment, you have the option to accept different types of payment methods easily. You can stick to traditional fiat currencies, or you can enable investors to purchase the digitised real estate using cryptocurrencies or stablecoins.
Token Creation : the process of launching the token is handled in a web application set up by your technology vendor.
KYC / AML : Depending on your selection for the primary issuance platform, your prospective or committed investors will go through an investor onboarding and KYC / AML process. During this time, they may also need to link up their digital wallet.
Token Distribution: Depending on whether you collected funds in advance or sell the tokens in a live sale, you will either send tokens directly to investor accounts or list the digitised real estate on a primary issuance platform. Once investors make the purchase, they will receive the digitized securities, and in real time you can manage the raise and view the cap table.
The legal process of the real estate markets are now compatible with the blockchain due to the capabilities of smart contracts that are supported by compliance standards.
The smart contracts are the core elements of the tokenisation process since they are allowed to programmatically grant conditional rights to the tokens issued on the blockchain. It is possible to code the desired specifications of the transactions including legal procedures, trade conditions and asset descriptions.
Smart Contract is a computer protocol intended to digitally execute certain tasks if predefined conditions are met thus allowing to digitally facilitate, verify or enforce the negotiation or performance of a contract. With the Smart Contracts, it allows the performance of credible transactions without third parties.
How The investment Is Put On The Blockchain
At this point, the offering memorandum is taken and turned into a smart contract. Essentially, the conditions are taken from the offering memorandum and written on a blockchain program that clearly delineates what investors are getting.
It outlines that they are getting a part of the asset, which part of the asset they are getting, how much and exactly what they are entitled to, for example, dividends, interest, an upside when the project is sold, all of that is encoded in the smart contract.
The pandemic which brought about the disruption being witnessed across the world shows the need for tokenisation. Tokenisation would allow businesses to get a breather and the liquidity they need. The more liquid assets are, the more accurate is their price and the more likely they are to find investors or lenders in the time of need.
The government can incorporate this latest technology to enhance the growth of the real estate sector by introducing regulations that supports tokenisation. This tokenisation process will in turn provide surety of title to reduce fraud, tax leakage and critically attract foreign direct investment (FDI).
Deborah Enyone Oni(Esq)
Hilton Top Solicitors