What is tokenized real estate? A beginner's guide to digital real estate ownership
The integration of blockchain technology into real estate has triggered a complete overhaul of the domain. It has facilitated digital real estate ownership, opening up the space to individuals previously left out due to insufficient funds and covering up issues like the lack of trust and transparency.
Real estate has been quite an illiquid asset, entailing significant capital commitments and long transaction processes. Tokenization, however, has altered the scenario. Moreover, the underlying blockchain technology has brought unprecedented transparency. That said, buyers can now execute transactions immutably using tokenized real estate.
This article demystifies real estate tokenization and addresses questions such as whether real estate tokenization is real, how real estate tokens work in practice, what tokenized ownership is and how much real estate is tokenized. But first, let’s dive into the fractionalization and resulting tokenization of real estate, and how it has altered the domain.
What is tokenization of real estate?
The tokenization of real estate refers to the process of fragmenting an asset into digital tokens that represent the underlying property with all its rights and obligations. Smart contracts are used to define contractual specifics. The algorithm encoded in the digital contract activates the events stated in the code if a predefined contract condition is satisfied.
For instance, a smart contract can execute a transfer in the land register without any human role. It validates the actions and generates another block automatically, adding it to the blockchain.
For fractionalizing NFTs, ERC-721 tokens are used. ERC-721 indicates a set standard on the Ethereum (ETH) blockchain and is associated with a smart contract that keeps track of the transactions in which these tokens have a role. The ERC-721 standard is designed to augment the traceability and security of the transaction.
How does real estate tokenization work?
Real estate tokenization works similarly to the crowdfunding process, where an asset is partitioned into small fractions with the help of a smart contract, an automated piece of code residing on a blockchain. Anyone who buys or owns a token owns a part of the real estate. They are entitled to the underlying asset and the associated profits and losses.
To understand it better, let's assume someone has a property worth $100,000, and they need some quick cash. But the investors that approach them don't have the required amount, and the owners are unwilling to let go of their real estate for a cheaper amount.
This is where tokenization comes in handy. Their assets will be fragmented and each unit will represent $1,000 of digital tokens. That way, the asset can be easily invested in over a period of time. This is done over a decentralized network, so there’s complete transparency.
The real estate can be tokenized whether it is commercial, residential or trophy. Expensive commercial properties such as shopping complexes and malls could be cut into fractional slices, making investments affordable. Apartments in multi-story residential towers can also be tokenized, facilitating quick sales and purchases. One could liquidate their trophy asset through tokenization while raising funds for projects.
Trophy assets refer to exceptionally scarce properties in great demand by investors. Iconic buildings with substantial real estate underpinnings fall into the category of trophy assets. It isn't necessarily a building. It could even be a vineyard producing grapes of exceptional quality for producing wines or a riverbank with precious stones. Therefore, it is possible to tokenize anything from a digitized share to a portion of the deed, an equity interest in a legal entity or ownership of the collateralized debt.
Multiple benefits of real estate tokenization
Tokenization can benefit the real estate sector immensely, introducing several phenomenal changes. Let's go through them:
More transparent and efficient transactions
Thanks to the decentralized structure of blockchains, transactions are immutable and transparent, making them ideal for real estate with a string of stakeholders and complex procedures. Automated smart contracts eliminate any human role in conducting transactions, thus eliminating any unfair deals.
In a blockchain-based system, there is no paperwork or waiting time for the completion of transactions. This results in prompt action and quick transactions. Unlike the conventional banking system, there are no specific office hours for transactions to get through when blockchain is used in real estate. Instead, the system works round-the-clock with transparency.
In the traditional system, selling a piece of real estate is always a pain. Before the emergence of digital real estate ownership, the liquidity problem plagued real estate and caused a heartburn to investors. Many investors were simply not ready to dabble in the affairs of real estate because of problems related to the lack of liquidity.
To enhance the value of any asset, its lack of liquidity has to be overcome and tokenization has provided the solution. When a real estate piece is fractionalized during tokenization, its liquidity improves. Rather than selling the whole property at a single go, the owners of tokenized pieces can sell their tokens quickly, leading to a swift change of ownership.
Opportunity for small-scale investors
Real estate is usually thought of as an investment option for elites. Tokenization, however, has made investing in real estate feasible for small-scale investors as well. The exorbitant price of real estate assets often deters investors from getting involved if their pockets aren’t running deep.
The tokenization of real estate investing, however, has changed the ballgame, making real estate accessible to small-scale and retail investors. Via tokenization, large assets are turned into small fractions, making them affordable and accessible for those interested.
A free-flowing market
Centralized financial systems are over-regulated and often biased, making them detrimental to the free-flow of the market. Blockchain-based tokenization introduces the real estate sector to a decentralized financial system independent of biases.
A bit of controlling power lies with each stakeholder and they make a collective decision. The elimination of unreasonable hindrances leads to a streamlined market that provides equal chances of growth to all stakeholders.
Decrease in counterparty risk
Longer transaction chains are hard to trace. This was a challenge in the era of pre-tokenized real estate, which involved third parties making things murky and far from being transparent. Smart contracts, an integral part of blockchain-based transactions, makes things better from a regulatory point of view.
Minimal human interaction keeps the chain of transaction short and eliminates the risks associated with weak links. As a result, the risk of counterparty involvement gets significantly reduced, if not completely eliminated.
Limitations of real estate tokenized assets
Like any upcoming technology, real estate tokenized assets have their own set of problems. Let’s take a glance at some of the limitations:
Smart contract security loopholes
The blockchain network is fairly secure. But when it comes to smart contracts, there are loopholes that need to be plugged. Hackers keep trying to sneak into the code of smart contracts and steal the money. Unless the smart contract has been diligently audited, the money involved isn’t secure. A hack or a glitch in the system could rob real estate investors of their assets. What makes matters worse is that once these assets are lost, their recovery is impossible.
Complex licensing requirements
The tokenization of real estate assets requires licensed platforms where the operations and management of STOs (security token offerings) can be regulated. The process of achieving the license is complex. Even before you reach the licensing stage, you need to undergo multiple phases of trial and error as well as recurrent tests to be successful.
Most people working in regulatory authorities and real estate employees have no idea how blockchain technology works and helps eliminate the issues the sector is facing. This unawareness leads to a poor regulatory environment, creating hurdles for all stakeholders. Regulatory uncertainty dampens the investors’ trust, resulting in poor growth.
Cryptocurrency tax regulations are undefined in most tax regimes, creating problems for stakeholders. Although the advantages of tokenization are recognized globally, it hasn’t been followed with a sound taxation system. The lack of a unified tax system creates doubts in the minds of everyone involved.
The road ahead
Real estate has always been a hot deal, even though it hasn't been as accessible as it now is. The tokenization of real estate assets has also made it accessible to small-scale investors. People who once felt disheartened by expensive real estate can now invest, thanks to the affordable prices, post-tokenization.
As the regulatory hurdles get better with time and crypto becomes part of the mainstream, you can expect the pace of tokenization to increase. Commercial and residential real estate tokenization might have different legal requirements and a diverse application of the underpinned technologies. Life may become easier for stakeholders at all ends of the spectrum.