The Good, The Bad, and The Unknown: Some Sobering Realities of Real Estate Tokenization

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There has been so much discussion regarding the benefits of tokenization of real estate and how the advent of Blockchain and smart contracts would add liquidity and lead to the democratization of this asset class. That is true, as it allows real estate to be traded like a stock and lowers the cash minimum barrier to entry that has always existed with real estate. The speed at which certain transactions can happen will undoubtedly be much faster—instantaneous in some cases—which will appeal to those in a hurry to deploy capital quickly. Participation rates will be much higher than they are today, which will significantly impact the landscape.

No More Fire Sales Needed: New Benefits Added By Tokenization

The liquidity created by the tokenization of real estate can eliminate some of the heart-wrenching financial losses that people experience now as a consequence of ill-timed real estate transactions. It can simplify the process of dividing assets, such as when family wealth is being passed down from one generation to another, when divorce forces a division of real estate assets or even when real estate funds must be sold in order to fulfill their promises to their limited partners. These are all examples of real estate “fire sales” that happen at exactly the wrong time. Real estate tokenization solves these issues by creating greater liquidity.

It's Not All Perfectly Liquid…Yet

There are some other realities of tokenization that don’t quite live up to the dream just yet. For example, when you buy an STO (security token offering), or real estate token, you are currently actually buying a “restricted security.” Because these are being sold in unregistered, private sales, purchasers are required to hold those securities for a year, which actually does not allow this blockchain blockbuster to fulfill its promise of complete and instant liquidity. While it is a better solution than paper certificate legends (because it can be “locked” in the purchaser’s digital wallet during that initial holding period), it is not completely liquid.

 

 

Moving Away from the Wild, Wild West

Real estate tokenization is still in its infancy and just like the Internet before the turn of the century, there is a sense of the “wild, wild West” about it. For the future of this type of asset class to really succeed, the people creating companies to serve these marketplace needs must ensure they are ready and willing to navigate the regulatory waters surrounding real estate tokenization.

These new opportunities carry with them bigger responsibilities than might be apparent at first glance. Pre-2019, many people jumped in before the regulators had really gotten their arms around the implications of these new financial opportunities. This resulted in so many violations of the rules, as enthusiasts of the magic of Web 3.0 jumped in before they really understood what they were talking about. Blockchain, smart contracts, decentralized finance (DeFi), non fungible tokens (NFTs), security token offerings (STO‘s), regulated security coins and cryptocurrency are bandied about as though they are all interchangeable concepts, when really they are inter-related…but very different.

Beyond Investing’s Latest Shiny Penny

People are starting to figure out that blockchain is more than just a shiny penny or the answer to someone’s get rich quick scheme and are getting more sophisticated about how to leverage blockchain as the underlying framework upon which these marketplaces are built.

The appeal of being able to trade real estate in milliseconds versus the current red tape and antiquated processes is quite heady. In 5 to 10 years, I would expect that real estate will be able to be treated like stocks. That’s both a blessing and a curse. Regulators are having to grapple with the implications of this new marketplace, with all its opportunities and potential pitfalls.

Real estate’s strengths are also its weaknesses. Because it has never been very liquid, it takes thought and time and a certain amount of financial maturity to participate. Its slow transaction times and large capital requirements ensured thoughtful investing and discouraged speculators from “dabbling” in real estate, at least less so than, for example, day traders looking to make a quick killing bet for or against GameStop or AMC’s financial demise. The slow, methodical, cumbersome process of real estate acquisition actually worked to protect owners from hucksters and blackmarket activities. With Blockchain and tokenization, people will be able to hold real estate from 9 to 10 AM, trading in and out of it as quickly as a stock.

It's Not Anonymous

Many people who don’t like government interference love the blockchain for its anonymity, but security tokens cannot be sold anonymously. In order to comply with anti-money laundering laws, the issuer has to know the identity of the purchaser and confirm their “accredited” status prior to any purchase of a real estate token.

The Long Arm of the Law

The SEC has set up regulations for the real estate fractionalization to happen via security token offerings (STO‘s), which are much more complicated to navigate than many first believed. Getting a broker dealer license is difficult and expensive. There are those who argue that, in fact, these new offerings are still securities, which need to be sold in a way that follows decades-long, well-established securities law. When you look closely at the SEC regulations surrounding this emerging asset class, there are four areas which could potentially come into play:

  • Regulation A+ (Reg A+): This is the incredibly burdensome SEC regulation (that allows for equity securities, debt securities, and convertible or exchangeable securities) that is most applicable, but it is very hard to get licensed. At the moment, I know of no company that has been approved for this regulation at this time. Because it is so costly, time intensive and will slow a company down from a compliance standpoint, it is generally considered as a last resort. In general, a VC who sees a startup presenting a path to Reg A+ is going to be skeptical about that company’s agility within the marketplace.In the future, when Reg A+ licenses are granted more frequently, VCs may shift their views and see adherence to such guidance as a moat, a resource-heavy barrier to entry that can keep the competition at bay. Companies who achieve this level of compliance would have (at least in the short term) a competitive advantage, but the market is simply not there yet .
  • Regulation CF (Reg CF): Crowdfunding has been used in the past to pool funds together to purchase a property, but this regulation is not really applicable to true real estate tokenization.
  • Regulation D (Reg D): This is where most companies who raise money for specific investments are complying, as it is easier to achieve this designation. However, this allows only accredited investors with $1 million in assets and over $250,000 in income to participate (which doesn’t really foster the democratization of real estate investing to be realized, does it?).
  • Reg S: This regulation, which provides safe harbor procedures and reporting requirements for offshore sales of equity securities for U.S.-based issuers, is another regulation that VCs are accustomed to seeing in real estate tokenization startups today. Compliance here makes it easy to raise capital outside the U.S and work with overseas investors, which can broaden the pool of potential revenue streams and is in keeping with the global nature of the blockchain.

The Taxman Always Cometh

There are also murky tax implications globally, and the future is still being built here. Because real estate tokenization is decentralized, it is necessarily global, international, not bounded by any borders. However, everyone lives somewhere where the government is looking to stick its hand in the pockets of every citizen. They are going to figure out how to take a piece of that pie and navigating so many different regulatory obstacles can become tricky. Companies beginning to expand into this space are finding it more difficult than originally thought to actually execute both domestic and international offerings that are properly structured.

 

 

A Need For Greater Security

The financial world is grappling with how to leverage the strength of blockchain, reducing wasted time and money, while still protecting against hacking both in primary and secondary exchanges. Removing friction from the transfer of ownership is fantastic but comes with some drawbacks, as well. Everybody wants to reduce the expense of the (suddenly unnecessary) middlemen; the promise of the immediacy of smart contracts appeals. Smart contracts that execute automatically when certain pre-conditions are met, whitelisted wallets and other gatekeeper concepts can help ensure these new, tokenized transactions happen smoothly--without giving up security.

In our password-based society, fraud seems inevitable, and security is a huge issue. As companies move forward there is a great deal that needs to be done to regulate and protect the investors who use these platforms for custody of those securities, as hacking can have devastating effects. Again, real estate’s historical weaknesses have also worked in its favor, making transactions slow and difficult (which makes it more difficult to “steal”). With real estate tokenization and smart contracts, transactions are instantaneous and final, and a change of ownership that has been called for if certain conditions are met will happen immediately (and irrevocably).

I remain very excited about the possibilities created by real estate tokenization but I see so many startups stumbling in the space. I’m happy to say that I have the sense that we are moving into a new phase of working within the bounds of the legal requirements, of less speculation and frenzy and more companies being willing to do the work necessary to “do it right. I can’t wait to see what comes next!

 

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