Blockchain technology, specifically smart contracts, offers interesting opportunities for several new ways of investing and verifying ownership. One area where smart contract technology has potential is in real estate.
Tokenized real estate can potentially offer access to real estate deals previously only available to the very wealthy. However, before you decide to jump into tokenized real estate, it makes sense to take a step back and determine whether it’s truly the right move for you.
Here’s what you need to know about how tokenized real estate works.
What Is Tokenized Real Estate?
The blockchain makes use of tokens to represent ownership and act as currency. Tokenized real estate provides a way to digitally represent a hard asset on the blockchain. In order to structure the deal in a way that allows for the real estate asset to be represented on the blockchain, a company is usually created.
For example, an LLC might be created as the company that owns the hard asset. It’s then created as a private placement or syndicated real estate deal. Tokens are used to represent a portion of ownership in the LLC that owns the hard asset. Let’s say there’s a four-plex building worth $500,000. To represent an ownership interest in the property, there are 100 tokens created.
Each token can be purchased for $5,000. Rather than being issued a paper certificate describing your interest in the LLC, you have this token. It’s stored on the blockchain. When rent is received, you get your 1/100th of the income. If the property appreciates in value, the LLC can redeem the tokens for more than you paid for them.
The idea is that you can own a portion of a real estate project and that ownership is represented by a digital token on the blockchain. Not only that, but you can also more easily sell the token on the secondary market.
Smart Contracts And Tokenized Real Estate Requirements
Because tokenized real estate uses smart contracts, different requirements can be baked in. In general, tokenized real estate is considered a security. However, it’s structured as a private security, so there are exemptions related to regulations that govern public securities.
Depending on where the real estate is located in the “real” world, there might be other requirements related to holding times and other aspects of the deal. All of the items, including your holding period, when you’re allowed to sell the security and other information, are embedded in the smart contract.
In many cases, platforms offering tokenized real estate follow different money laundering regulations and identity verification regulations. You might also need to be an accredited investor to buy tokenized real estate. Once you meet the requirements, though, the smart contract enforces the terms of the deal.
Real Estate Tokenization vs. Other Investment Structures
There are plenty of other ways for someone without millions of dollars to add real estate exposure to their portfolio. Real estate investment trusts (REITs) and real estate crowdfunding are two of the most common ways to move forward.
As a REIT investor, you can access an entire real estate portfolio. Whatever the trust owns, you have a portion of it. You don’t actually get to choose individual properties. With tokenized real estate, you have the opportunity to buy an interest in a specific project. This allows you a little more flexibility in building your real estate portfolio.
Crowdfunding is another option that can help you access real estate deals at a lower price. However, you often have to invest in a portfolio of assets. You might have access to individual properties as an accredited investor. One of the biggest issues, though, is that crowdfunding often requires you to hold onto the asset for a longer time. With tokenized real estate, you might be able to sell your token sooner.
Real Estate Tokenization vs. Non-Fungible Tokens
Non-fungible tokens (NFTs) have been popular in recent months. They offer access to unique assets. It’s possible to use an NFT to represent real estate as well. However, a real estate NFT can’t be fractionalized. It represents something similar to a deed. There can be only one owner. Real estate NFTs can make sense in the future as a way to prove property ownership and could potentially speed up real estate transactions.
However, real estate tokenization for investment purposes is a different type of token known as a security token offering (STO). These are fungible, meaning that you can exchange one for the other, and it will represent the same thing. Basically, each of the tokens in our example above can be exchanged for another token that represents the same amount of interest in the LLC that owns the real estate.
Make sure you understand these differences before buying a real estate token.
Pros and Cons of Tokenized Real Estate
Before you decide whether tokenized real estate makes sense for your portfolio, it’s important to know the pros and cons of this type of investment.
Pros Of Investing In Tokenized Real Estate
Buy into real estate projects for less. In many cases, you need hundreds of thousands of dollars — or even millions of dollars — to buy into a private real estate project. Tokenized real estate makes property investing more accessible for those who don’t have as much ready capital.
Easier to sell on the secondary market. When you invest in a project, you’re often stuck with a long holding period. You might wait years to see results. On the other hand, with tokenized real estate, it’s relatively easy to sell your interest on the secondary market. While you might still have a holding period, it’s often shorter. And all you have to do to sell is to use the blockchain to sell the token to someone else. There isn’t a lot of messy paperwork.
Reduced paperwork and smoother process. Using smart contracts to complete real estate transactions has wide-ranging uses. The entire process is much smoother, from buying a primary residence with an NFT to buying tokenized real estate for investment purposes. You don’t have as much to sign, and the records of the transactions are kept on the blockchain to prove ownership.
Cons Of Investing In Tokenized Real Estate
- You’re not directly buying a portion of the property. Because many countries require a land registry, you aren’t actually buying a portion of the property directly. Instead, a company structure is created to own and register the property. You’re buying a token representing your share of interest in the company that owns the hard asset, not a token representing the asset itself.
- You may still have all the tax liabilities of property ownership. Depending on the actual property and terms, you might have all the tax issues and liabilities of being a limited partner in a property - but without all the data and resources to help you file your taxes. The IRS doesn't care how ownership is held - if you're a fractional owner of a property, you need to report and pay your taxes.
- You might not be able to find a buyer. Even though the tokenized real state is considered more liquid than actual property, it still might not be as liquid as you’d like. When it comes time to sell your token and potentially profit, you still need to find someone who wants to buy the token.
- Be careful of unregistered securities. Tokenization makes it easier for companies to avoid registering securities with the SEC. Don't get involved in projects where you're investing in unregistered securities. Even if the project is legitimate, the entire project could be tied up in litigation and face fines from the SEC - costing investors money.
- Automation makes it harder to tailor the terms. Finally, smart contracts are created with built-in requirements and parameters. It can be harder to tailor the terms of the deal to your needs with tokenized real estate. Everything is built into the smart contract, giving you a little less control over how the deal works.
Should You Invest In Tokenized Real Estate?
Investing in tokenized real estate can provide you with a way to diversify your portfolio. If you’re looking to add more digital assets to your portfolio, tokenized real estate can make sense. You get exposure to real estate, and you get tokens that aren’t NFTs or cryptocurrencies.
However, there are risks involved. There’s no guarantee that the projects you invest in through tokenization or legitimate. Additionally, you could potentially lose all of the money you invest if you aren’t careful.
Consider how tokenized real estate might fit into your overall investment strategy. You might want to limit your portfolio exposure to this asset class until after you have more traditional assets, such as stocks and bonds in a tax-advantaged retirement account. Do your research and make sure this is the right move for you before you decide to spend hundreds or thousands of dollars on a real estate token.
Miranda Marquit, MBA, has been covering personal finance, investing and business topics for more than 15 years, and covering crypto topics for more than 10 years. She has contributed to numerous outlets, including NPR, Marketwatch, U.S. News & World Report and HuffPost. She is an avid podcaster, co-hosting the podcast at Money Talks News. Miranda lives in Idaho, where she enjoys spending time with her son playing board games, travel and the outdoors.