Real Estate Investment Trusts (REITS) and crowdfunding platforms have helped bring some amount of liquidity, but they comprise a very small part of the overall real estate market.
Tokenisation offers a way to increase the cash flow of a real estate asset, bring liquidity and make the process of investment easy, and in smaller ticket sizes. Transaction and administrative costs are reduced, thus reducing the “illiquidity premium” that is a dominant feature of this asset class. A single asset, or a smaller portfolio of assets can benefit from tokenization, providing fractional ownership and liquidity.
The lead time for a tokenization workflow can range from two to four months, following which investors can be onboarded and tokens traded within marketplaces.
Tokenization is quickly gaining traction in the real estate sector in developed markets, and we see the same potential in the Middle East, especially in the UAE. Real estate is a prominent sector and attracts a large amount of investment, and we anticipate that a lot of real estate developers will seek to tokenise at least part of their holdings, in conjunction with technology providers. This in turn will give a wider base of mass-affluent investors access to quality real estate purely as an investment class, and make it easier and more economical to conduct secondary transactions in the marketplace.
(i) the same as those conferred by a share, debenture or futures contract (Investments); or (ii) substantially similar in nature, purpose or effect, to those conferred by Investments.
In effect, a Security Token is a token that behaves as a security (equity, debenture, convertible, future, option etc.) and is hence considered by the DFSA as a specified investment.
Tokenisation has the potential to significantly change real estate investment. Currently,
Trading in real estate involves comprehensive paperwork, high costs and compliance checks, besides a steep entry point and additional payments on exit. Tokenisation now allows investors to buy smaller stakes in multiple properties without the inefficiency of the current processes, and with much greater ease.
1. Fractionalisation leading to unlocking liquidity – Real Estate is traditionally a fixed, illiquid asset. Through tokenization, it can be broken down and represented as tokens, thereby fractionalising the underlying asset and offering new investment opportunities and nearly eliminating illiquidity discounts.
2. Access to global markets – Investors can buy tokens representing a shares in assets in any part of the world, thus adding more depth to liquidity, and more diversified investment portfolios. An example would be of an investor in Bengaluru holding tokens of underlying real estate in Dubai, or an investor in Ghana holding tokenised debentures of an SME in Sharjah, all within a few clicks.
3. Operational efficiency - Smart contracts are programmable actions on the blockchain that facilitate the automation of processes such as compliance checks, investor on-boarding, and post-issuance matters including dividend distribution and exit. For example, a tokenised crowdfunding platform can automatically release dividends on a pre-determined basis and assign voting rights based on tenure of holding of the token.
4. Reduced settlement times – Tokenised products are settled in almost real-time, as compared to T+2 or T+3 settlement times in conventional markets. Platforms that deal in tokenised offerings operate 24/7, unlike conventional markets that are closed on the weekend.
5. Potential interoperability of assets – As Stephen McKeon explains – one can hold ownership claims to a commercial building, early-stage equity, corporate bonds, family residences and a DLT application on a single platform.
6. Data Transparency and Security – DLT-based applications are known to be resilient to cyber-attacks, as opposed to data on centralized servers. Transaction information is trackable and publicly visible on the blockchain.
7. Automated compliance – KYC/AML measures can be baked into the token itself, using smart contracts. A case in point being Polymath working in tandem with tZERO and other exchanges.
8. Flexibility – Tokenisation assists in construction of flexible portfolios and deeper diversification, and more insightful analyses to make better investment decisions.
Security tokens are typically issued through a Special Purpose Vehicle. They provide the holder of the token certain rights on the underlying real estate asset, such as ownership, share in dividends or profit, and in case of bond tokens – repayment of monies. In effect, real estate tokens can act as shares or bonds, or a combination of both.
Issuers should consider the objectives of tokenization in designing the token structure. A bond token may have a shorter time to maturity than a fund token. In case of the bond token, designing the smart contract for robust corporate actions and distributions will be critical, whereas in a fund token, the options of liquidity and secondary trading may take prominence.
The prevailing regulatory framework also plays an important part in the jurisdiction scoping – where to tokenise and list the token (if required). The location of the target investors is crucial here, given that cross-border regulations on virtual assets are still nascent, as is the case with the primary regulations.
The regulatory frameworks in the UAE (DIFC, ADGM and Emirates SCA) all call for enhanced risk monitoring, technology governance and reporting requirements for issuers of tokens, investors and service providers such as exchanges and Alternative Trading Systems like MTFs and OTFs.
Tokens are usually classified as payment tokens (crypto), utility tokens, fiat tokens or security tokens. Tokenised real estate is likely to be classified as a Security Token, if they represent ownership in the underlying property. However, there may be instances where real estate tokens fall outside the definition of securities, and so they will have to be analysed on a case-to-case basis.
The core components of tokenization are the Distributed Ledger Technology (DLT), commonly called blockchain, and smart contracts. A digital Register Of Members (ROM) for the asset is minted onto a blockchain protocol, as a complete record of ownership. This ROM is typically of the SPV that holds the underlying real estate asset.
Digitisation allows for near-instant verification and recording of transactions, on an immutable blockchain, traceable but protected by encryption. Smart contracts are coded on protocols such as Ethereum (ERC 1400 and it’s derivatives are commonly used) and these contracts can execute KYC/AML procedures, settlement of transactions and post-issuance governance mechanisms such as corporate actions, dividend distribution and voting.
An SPV is used is also responsible for the management of the property (rentals, maintenance etc.) and this is usually different from the issuer SPV.
An offer of Security Tokens will have to be authorised by the regulator and comply with relevant prospectus requirements, unless it is an Exempt Offer.
An exemption may apply if the offer is for professional investors only, via private placement and directed towards fewer that fifty individual investors in a year, and denominated in an amount of at least US$ 100,000 or equivalent.
Case study – Real-estate bond tokens
The issuer SPV tokenises an underlying real estate asset, and issues bond tokens to investors. These are fixed-income investments, much like conventional bond offerings.
The Issuer information is recorded onto the blockchain and smart contracts are coded with the terms and conditions of the bond issuance. The bond token is then issued to investors.
One of the main features of tokenization of real estate is the creation of a secondary market, thus in effect providing liquidity to a traditionally illiquid asset. Crowdfunding platforms address the fractionalization of real estate, but property crowdfunding platforms in the DIFC are not permitted to allow secondary trading of these shares. Tokenisation can potentially solve this problem.
This solution can also be extended to real estate funds, where tokens representing carries are issued to the fund manager and rights to dividend and profits of the fund are issued to investors.
A token bond issuance comes under the purview of regulation, given that it creates an underlying obligation and behaves like a conventional bond.
Challenges
The field of tokenization is new, and there are many unanswered questions and some ambiguity on some aspects of the process, particularly concerning data transparency and secondary trading. While tokenization offers cross-border investment opportunities (an example would be of an investor in Bengaluru holding tokens of underlying real estate in Dubai, or an investor in Ghana holding tokenised debentures of an SME in Sharjah, all within a few clicks), in practice, how these transactions are treated by local regulators remains to be explored.
There is also the issue of liquidity, given that there are not too many real estate asset tokens currently available for trade on international exchanges and MTFs.
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