NFT Use Case: Tokenizing Real Estate
The following text has been adapted from a chapter of the book Token Economy
Last week I was invited to speak at a conference on tokenizing the real estate industry. The focus was mostly on the tokenization of property rights and the potential of creating unique digital representatives (NFTs) replacing entire real estate back office management with smart contracts. However, once land registries are settled by some kind of distributed ledger and property titles can be tokenised, a complex set of other rights attached to these property rights can also be tokenised, such as voting rights, access rights, managements rights and many more. But before we dive into the topic here a quick overview of real estate tokens in general:
The tokenization of real estate refers to the process of creating a tokenized digital twin for an individual real estate object. The token represents the physical counterpart — such as an individual apartment, a family home, an apartment complex or an entire office building. The tokens are collectively managed by some kind of distributed ledger network.
In order to tokenize real assets such as a private home, one generates a token with a smart contract, and associates a value of that particular real asset with a token. The ownership right and other conditional rights to the corresponding tokenized representation can be divided into parts and sold to several (co-)owners. While physical counterpart of the real estate object is not easily divisible (depending on the type and size of the object) the tokenized representation itself is. Any type of real estate can — in theory — be tokenized at a fraction of what it would cost in the client-server world and divided into representative tokens, which could be traded on an open market. Tokens could either be issued for existing real estate or for a real estate project under development.
Advantages of Tokenization
Real estate is one of the largest asset classes worldwide in terms of market capitalization, however, real estate ownership is not open to all members of society. Many low-income households can never afford to buy real estate. To receive a loan, buyers must have a positive credit score, a steady and well-paid job, or a collateral of other assets. Furthermore, the real estate market is highly fragmented and centralized. Data is managed by a series of third parties like banks, attorneys, notaries, and land registries who all use their own proprietary and costly software that, for the most part, is not interoperable. Tokenization can create following long term market dynamics:
- Easier rights management: Smart contracts have the potential to facilitate rights management in the real estate industry, including the whole settlement process. Once real estate ownership is tokenized, it can be easily registered and managed on a public infrastructure and traded P2P, if it complies with regulation. The hashed data of each property could be recorded on a distributed ledger to provide a universally shared data set on all real estate–related activities, such as previous owner, repairs conducted, and amenities.
- More liquid market: Real estate is an illiquid asset, which means that buying and selling the asset is a lengthy and bureaucratic process; ownership does not swap hands quickly. Research shows that using Web3-based land registries could minimize bureaucracy and reduce market friction and the considerable costs involved in the transfer of ownership. The tokens could be easily fractionalized, which means that real estate owners could sell off fractional shares of their apartments. While selling shares of a property is not a new concept, tokenizing real estate would be the next step in the automation process, making it more efficient to issue and sell these assets at a fraction of the costs that were needed before.
- Global Trading: Depending on the regulatory environment and how the smart contract is set up, these real estate tokens may be eligible for global trading. In the future, an investor in France could easily buy fractional tokens in an office building in Canada with a few clicks. An investor in Mexico could fund a private apartment building in India. Opening up global markets adds even more liquidity and provides new opportunities for entrepreneurs and investors alike. This trend might make it feasible to buy shares (or fractions) of a property in a foreign country that were previously much more difficult to obtain.
- New forms of real estate funding: Private homeowners could issue fractional tokens of an apartment they want to buy, which would allow them to raise funds without needing to go through a bank or take out a private loan. The token holders would be co-investors and could collect fractional rent in proportion to the amount of shares they hold.
- More inclusive investment class? People who were previously excluded from such investments for economic reasons could now invest in only a fraction of a whole unit, which would make the market more inclusive to those who have less economic means.
- Automated rent collection: Rent collection is administered by the smart contract and ownership is more easily transferred. If, for example, another person buys 5 percent of the tokenized value of your apartment, proportional rent could be paid out on a monthly basis automatically by the smart contract. In the case of a sale of the apartment at a future date, fractional token holders of that apartment could get their money back, which might also be automatically managed and enforced by the smart contract.
Complex rights management use cases
With fractional real estate tokens, it is important to distinguish the type of rights that are granted to the different stakeholders in the system when designing and issuing a token:
- Property rights: Real estate tokens represent an investment class. Anyone can buy and sell their tokens at any point in time over specialised platforms that will be emerging.
- Access right: In the design of the access rights you have to ask yourself who you want to grant access to the object. While private homeowners might want to use fractional tokens to raise fund for the future home, they only want to pay the co-owners fractional rent, but not grant them access rights to their house. The case is quite different for a co-working space that is co-owned buy its members. Depending on the membership types, you would want to grant different access rights that might be tied to the amount of hours per month that you are allowed to use that co-working space. In the case of Web3 based home-sharing, access right tokens could be used to allow the next Web3 based Airbnb to issue access rights to a specific house rented for the duration of their stay (this use case only makes sense if the property rented in question can be opened with a digital key).
- Voting rights & management rights: Ownership rights also need to be detached from the management of that real object. The governance rules of the token will need to regulate who gets to decide on selling a private home. In most cases, it would only be feasible to grant profit sharing rights, but not decision/voting rights. In the case co-operative ownership of a co-working space, special voting rights might be granted to member and co-owners of a co-working space. In this case the token contract could also grant special management rights for day to day management of the space to delegates.
Most of the above mentioned use cases — however — would require a regulatory environment that allows such differentiated rights management and edge cases also have to be considered. What if the issuer of the tokens fails to pay rent to the fractional token holder? Details of such business cases would need to comply with regulatory standards and have a meaningful way to be executed. There is a variety of established legal options for conflict solutions in fractional ownership situations, like so-called “drag along” and “tag along” rights or “Dutch auctions,” which could all be modelled in a smart contract to arrive at a solution fit for the purpose of a given situation.
While tokenizing real estate has a lot of potential, this use case comes with many practical challenges, most of which concern legal and regulatory questions, which vary from country to country, or state to state. Unfolding the full potential of tokenisation of the real estate market we need a few prerequisites: (i) a Web3 compatible regulatory environment, (ii) trusted custodians of wallets that can manage multiple real estate tokens and ideally also grant self-custodianship to the token holders, and (iii) specialized online exchanges:
- Web3 compatible land registries: One prerequisite for tokenizing real estate would be that the legal process of the real estate market is made Web3 compatible, from the land registry process to the general regulatory environment accepting smart contract processes. In some countries, land ownership is barely tracked at all; in most countries, the process is still predominantly paper-based, requiring a myriad of intermediaries. All involved stakeholders of the real estate market, from developers and brokers to banks, real estate funds, and facility managers, also need to be distributed-ledger compatible before such a use case can become feasible.
- Collateral management: The current process of taking out a loan for home ownership comes with a lot of regulatory oversight and due diligence from the bank side to make sure that the person taking out the loan will also be able to pay the loan, including interest, back. If they can’t, the bank is co-registered in the land titles. If the homeowner fails to pay back the loan, the bank can claim the property, sell it, and liquidate the apartment on the market to get back the credit they gave out. In the case of fractional ownership, how will such a case be managed? By trusted third parties and liquidators?
- Collective facility management: Maintenance processes also need to be covered by the smart contract; otherwise, it would be a regulatory nightmare to try and force litigation against hundreds, if not thousands, of owners of an office building who don’t take care of maintenance.
- Potentially negative market dynamics especially in combintaion with DeFi elements: Tokenizing and fractionalizing real estate could also have potentially negative ramifications that would require regulatory oversight. There is much learning to incorporate from the housing market collapse in the United States that led to the financial crisis of 2008. When many people do not understand what they’re buying into, fractional ownership of real estate can become a dangerous investment game and result in the same “magical thinking” by uninformed investors who have little understanding of the big picture of the market dynamics when making investment decisions. The potential interactions of such tokenized real estate assets with other DeFi — especially in combination with decentralized credit and lending tools — could create adverse market effects, especially for non-institutional investors with little DeFi knowledge.
Many countries are already looking into registering land titles on some kind of distributed ledger system, and many more are following. A fast-growing ecosystem of service providers offering some kind of real estate tokenization are evolving, however, most of them are still limited to tokenizing real estate baskets due to the lack of adequate regulatory frameworks to do more. Some early examples of solutions in the field where “Atlant,” “IHT Real Estate Protocol,” “LATOKEN,” “Max Property Group,” “Meridio,” “BitRent,” “Etherty,” “Caviar,” “Propy,” “PropertyShare,” “Rentberry,” “Treehouse,” or “Trust,” but many more service providers have emerged over the last 2 years.