Holding large, physical real estate assets is naturally illiquid, and this is one reason many asset owners, asset managers, and even retail investors may avoid the asset class. Imagine having to wait for weeks before you can sell a property when you urgently need the sale to rebalance a portfolio, take advantage of an interesting opportunity, or just generate cash.
Today, real estate tokenization is one emerging solution to this illiquidity problem. With it, real estate assets can be digitally represented on a blockchain so that they can be as easily bought and sold as a token, making them liquid and more attractive.
The benefits of real estate tokenization are enormous but so are the challenges to its widespread adoption. In this article, we will consider what it is all about, its benefits and challenges, and what the future holds for this interesting technology.
We’ll cover:
- What is real estate tokenization?
- How does real estate tokenization work?
- Tokenized real estate vs REITs: How do they differ?
- Benefits of tokenized real estate: Why asset owners should consider them
- Risks and challenges of real estate tokenization
- What will the future of real estate tokenization look like?
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1. What is real estate tokenization?
For many, blockchain technology is equivalent to cryptocurrencies, and its impact lies in the millions of dollars people have made from various crypto assets.
However, the real-life impact of blockchain technology often exists outside the world of crypto trading and investing. This technology is currently revolutionising healthcare, finance, politics, media, supply chain, and logistics, and its impacts have only just begun.
The real estate industry has not been left behind. Tokenization is fast becoming an important discussion among various real estate stakeholders.
In general, tokenization is the digital representation of a physical asset or object on a blockchain. Applied to real estate, tokenization is the digital representation of real estate properties and cash flows on the blockchain network.
This tokenization can occur in various ways:
Single-ownership tokens
A single property or a group of properties can be represented as a single digital token. This is often done through non-fungible tokens (NFTs). These are tokens that represent a unique asset that cannot be replicated.
In this instance, the owner of the NFT owns the property or group of properties they represent. Similarly, real estate ownership can be transferred through the sale of the NFT to another party.
NFTs usually hold important data related to the asset they represent. For real estate, this will include the property’s address, condition (including images and videos), and ownership history.
Some dynamic NFTs can even update these data points automatically.
Fractionalization
A single property or a group of properties can be represented by multiple tokens. In this case, we are dealing with fungible tokens (each token is the same as another).
Fractionalization allows for fractional real estate ownership. That is, a single property can be owned by multiple people. Also, one of the owners can decide to take full ownership by buying out the other owners.
Just as multiple buyers and sellers help to uncover the price of a stock, fractionalization can help to discover the true (or fair market) price of real estate assets.
Tokenized cash flows
The cash flows generated by a property can be tokenized instead. A property owner in need of cash can represent future cash flows of the property as a token and sell it on the blockchain network.
The buyer will part with a lump sum for the right to the cash flow that the property will generate for a defined period.
Fractionalization can also work with tokenized cash flows. Instead of a single token sold to a single buyer, the owner can create multiple tokens and sell them to multiple owners who will share the cash flow based on their investment (just like stock dividends).
2. How does real estate tokenization work?
A better way to understand real estate tokenization is to briefly consider how it works.
Blockchain platforms
Every token needs to be digitally represented on a blockchain platform.
Ethereum remains the most popular blockchain platform in this regard. The platform has ERC-721 standards for NFTs and ERC-20 standards for fungible tokens.
Other blockchain networks that support tokenization include Binance Smart Chain, Polygon, Solana, and Tezos, STELLAR, Algorand, among others.
Asset tokenization platforms
Many asset tokenization platforms now exist that make the tokenization of real estate assets (and other assets) easy.
Each platform will have its preferred blockchain network or even support several blockchain networks.
So, what do asset tokenization platforms do?
a. Compliance
Tokenization platforms will ensure that there is a physical asset backing the token that is about to be created (verifying title deeds and land registries). They will also ensure that the regulations that apply in your jurisdiction (land registry rules, for example) permit the tokenization of the asset (real estate in our case).
Finally, they will confirm that the pricing of the token aligns with the fair value of the property.
b. Creating tokens
The platform will also handle the actual token creation process once they are satisfied that doing so has no regulatory barrier.
The token creation process will often involve the creation of smart contracts. These are automated digital contracts that are executed immediately after certain prescribed conditions have been met.
For our purpose, they will define the conditions for ownership, transfer of ownership, and compliance. Once these conditions are met, the contract will be executed.
c. Enabling token trading
They will also ensure that the token can be traded in the primary market through Security Token Offerings (STO) as well as secondary markets (on decentralised exchanges).
d. Investor onboarding
As part of its regulatory compliance efforts, asset tokenization platforms will verify new investors to ensure they adhere to various KYC (know your customer) and AML (anti-money laundering) regulations.
They will also ensure that new investors can own the physical asset behind the token based on local laws guiding such real-world assets.
Polymath, Securitize, Tokeny Solutions, Tokensoft, and tZERO are some of the most popular tokenization platforms available.
Polymatch supports Ethereum and Polymech blockchain networks, Securitize supports Ethereum, Algorand, and Avalanche, Tokeny Solutions supports Ethereum and Polygon, Tokensoft supports Ethereum, Stella Codar, and Hyperledger, and tZERO supports Ethereum, Tezos, and Algorand.
e. Transaction records
Every transaction involving the token will be recorded as a block on the relevant blockchain network.
Since each transaction is publicly available on a distributed ledger, real estate transactions can be verified by anybody.
3. Tokenized real estate vs REITs: How do they differ?
Before considering the benefits of real estate tokenization, let’s consider how they differ from REITs (real estate investment trusts).
REITs are stocks of companies that invest in real estate (equity REITs) or provide mortgage financing to real estate buyers (mortgage REITs). Since they are stocks, they can traded on stock exchanges.
Many investors have gravitated towards REITs because they are required by law to pay 90% of their net income as dividends to shareholders. Some also prefer its liquidity to the illiquidity of owning actual properties.
REITs are comparable to fractionalized tokens. That is, just as a REIT investor has rights to a portion of the assets of the trust, the buyer of a fractionalized real estate token also has a right to a portion of the property.
Yet, there are important differences:
a. Nature of ownership
An investor in REITs has a direct ownership interest in the real estate company and only an indirect ownership in the properties the real estate company holds. In the case of mortgage REITs, there is not even any form of ownership in a property.
On the other hand, tokenized real estate provides direct ownership interest in the underlying property.
b. Income stream
The income stream follows the nature of ownership. REIT owners will earn a portion of the dividends distributed by the trust (indirect) while tokenized real estate owners earn a portion of the rental income of the property (direct).
c. Trading and liquidity
REITs are tradable on specific stock exchanges while tokenized real estate are tradable on blockchain ecosystems and decentralised exchanges.
Similarly, while participation in stock exchanges is often limited by jurisdictions (US citizens will find it difficult to trade on a stock exchange in China), decentralised exchanges provide a potentially global reach (depending on the regulatory environment).
d. Regulatory framework
Since REITs have been here for longer, they have settled and clear regulatory guidelines. With blockchain in general and tokenization in particular, things are not as clear-cut.
4. Benefits of tokenized real estate: Why asset owners should consider them
Some of the benefits of tokenized real estate may have become obvious already but let’s spend some time making them plain.
"The digitalisation of real estate diminishes market barriers, augments liquidity, enhances transparency, and streamlines processes within the real estate sector,” according to Vadym Bukhkalov, co-founder of Sabai Ecoverse, quoted by Forbes. “Blockchain technology offers heightened liquidity, fractional ownership, and fortified security owing to the immutable nature of blockchain.”
Let’s say more about these benefits:
a. Increased liquidity
What would you give to complete real estate deals in minutes rather than weeks?
That is exactly what real estate tokenization provides. You can sell your ownership in properties in liquid decentralised exchanges that have a potentially global reach.
The use of smart contracts and the removal of intermediaries is one reason for this liquidity advantage. Once prescribed conditions have been met, the contract will be executed and ownership will be transferred.
Also, fractionalization is a source of liquidity advantage. Maybe selling a $1 million property to a single person is a hurdle. Why not sell the same property to ten investors for $100,000 each? Instead of waiting for months to find the big-bag investor, you can sell to multiple investors in minutes or hours.
b. Opportunity for smaller investors
Just as fractionalization offers a liquidity advantage to the property owner, it also provides an advantage to small-money investors who can’t afford to buy a single property and don’t want the indirect ownership offered by REITs.
This is similar to how fractional trading democratised stock investing.
c. Transparency
Smart contracts are transparent. They provide clearly defined conditions that must be met before a contract can be executed. Both parties can be sure that the transaction is fair.
Similarly, the fact that blockchain ledgers are publicly available and transactions can be verified by anyone (at any time, due to their immutability) adds to the transparency of tokenized real estate.
Finally, digital tokens allow for real-time tracking of real estate prices and capitalisation tables.
d. Efficient transaction processes
Blockchain networks don’t go on holidays. Transactions can be completed and new blocks created at any time.
The absence of paperwork also makes them more efficient.
All of these ensure that transactions are completed quickly and can be verified instantly.
e. Lower costs
The removal of third parties through smart contracts and paperwork through the distributed ledger system leads to lower transaction costs.
f. Fraud reduction
Asset tokenization platforms reduce the possibility of fraud by conducting compliance checks on the property and potential investors.
In addition, the transparency of smart contracts and distributed ledgers makes it difficult for one party to defraud the other.
5. Risks and challenges of real estate tokenization
Tokenized real estate sounds like the next big thing. Yet, despite its potential to revolutionise the real estate market, some challenges remain:
Adoption and scale
For many people, blockchain technology is still reducible to trading cryptocurrencies. This is a negative thing for some whose experience or conception of the crypto market is negative.
How many real estate buyers and sellers understand blockchain technology or smart contracts? Even if the understanding is there, what about trust?
As early as 2022, EY (Ernst and Young) was still talking about tokenized real estate as a potentially revolutionising idea rather than something that has taken hold.
“Tokenization has an enormous potential for development but remains elusive due to its inherent complexity,” according to Erik Ganz, Director, Head of Real Estate Strategy & Transactions and Assurance in Financial Services at EY, Switzerland. “The advantages range from the fragmentation of the property into its components, to securing liquidity and to the automation of property-specific processes, such as the title transfer or transaction execution.”
Regulatory framework
Having a regulatory framework to guide tokenized real estate remains a challenge.
“With no definitive regulatory framework in place, real estate token issuers face major uncertainty over which laws, reporting requirements, and licences apply to their tokens in different jurisdictions,” according to Zircon Tech, a software development company. “If incorrect assumptions are made or token issuers fail to comply with requirements that are ambiguous, it can lead to severe consequences including penalties, blacklisting, and even potential legal prosecution.”
Also, the fact that the laws guiding the real estate market were not made with tokenized real estate in mind makes their application to it ambiguous and uncertain.
“The major challenge here is the blurred lines between securities and property rights; while tokens represent a stake in physical assets, they often behave like securities, complicating regulatory oversight,” according to Primior Asset Management, a real estate company.
These regulatory uncertainties continue to be a problem for adoption and scale.
Cybersecurity
Digitisation always raises cybersecurity questions. The same thing holds with tokenized real estate.
“While they are fairly safe applications, they are a new technology. There are concerns that malicious actors could find loopholes and ways to go around the rules of smart contracts, which can lead to hacks,” according to Victoria Chynoweth, a Tech Writer at Cointelegraph, a cryptocurrency media company.
Imagine losing your property not because of foreclosures but because you lost your token to an online scammer.
Coordination
The possibility of hacks and investors forgetting the password to their wallets raises the question of how to align digital and physical ownership.
Should new tokens be created in such cases and if so, who has the right to commission such a thing? A related question is whether the government should be involved in such cases. But doesn’t that defeat the whole point of decentralisation?
6. What will the future of real estate tokenization look like?
The tokenized real estate market was worth $2.7 billion in 2022 and is projected to reach $18.2 billion by 2032, according to Token City, a blockchain digital asset management company.
This growth potential tallies with Boston Consulting Group's (BCG) expectation that the entire illiquid assets tokenization industry will be worth $16 trillion by 2030 even as tokenized assets as a whole grow to 10% of global GDP.
In 2022, Erik Ganz mentioned that only a fraction of the global property value (worth CHF 302 trillion) was traded and he expected that “Tokenization should change this in the coming years.” In other words, it is the need for liquidity that will drive adoption.
For Cointelegraph, it all depends on whether the regulatory hurdles can be crossed and crypto can become mainstream. “As the regulatory hurdles get better with time and crypto becomes part of the mainstream, you can expect the pace of tokenization to increase,” they said.
“As the regulatory hurdles get better with time and crypto becomes part of the mainstream, you can expect the pace of tokenization to increase.”
In this regard, some may point to the election of Donald Trump, who is crypto-friendly, in the US as a positive sign.
Deloitte, a management consulting firm, is also positive about the prospects of tokenized real estate in particular and blockchain technology in real estate in general.
“Industry players now realise that blockchain-based smart contracts can play a much larger role in CRE (commercial real estate), potentially transforming core CRE operations such as property transactions (purchase, sale, financing, leasing, and management),” they said. “Over time, blockchain adoption can have a broader impact, as it can be linked to public utility services such as smart parking, waste, water, and energy billing, and also enable data-driven city management.”
Furthermore, while recognizing that “very few properties are tokenized and limited opportunities exist for the secondary trading of real estate tokens,” Steve Streetman, a CRE investor and writer at HoneyBricks, a real estate investing platform, believes that as the benefits become well known, adoption will increase and “real estate investing is likely to start resembling stock investing.”
In summary, blockchain-tokenized real estate's future depends on how well it can solve its challenges and increase adoption (based on its benefits).
For asset owners and managers who want to invest in the real estate market without its traditional illiquidity and inefficiency issues, tokenized real estate remains a viable option. It is important then to keep an eye on the market and see which opportunities will present themselves.
If you are not sure if tokenized real estate belongs in your portfolio, what better way to proceed than to discuss the idea with other investment experts, especially those with more experience in the real estate market?
At cio investment club, we provide you with a community of investment professionals and decision-makers where you can exchange and discuss investment opportunities, including relatively new ones like tokenized real estate.
In addition, we also organise exclusive roundtables and investment breakfasts where you can network and have physical interactions with other investment professionals. These provide even further opportunities to discuss the latest industry trends and seek collaborations.
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Takeaways
- The tokenization of real estate addresses the illiquidity issue by allowing assets to be traded digitally, making it easier for investors to buy and sell properties.
- Tokenization enables fractional ownership, which lowers investment barriers and democratizes access to high-value real estate.
- Blockchain’s transparency, combined with smart contracts, ensures clear, secure transactions that protect both parties.
- Regulatory uncertainty and cybersecurity concerns remain major hurdles, which could impact adoption and require careful navigation by investors and asset managers.
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