The Ultimate Guide to Investing in Tokenized Real Estate

Tokenizing real estate combines the financial advantages of owning real estate—historically the best way to hold and increase wealth—with the immense transactional advantages of blockchain technology.

Updated
July 20, 2022
by

HoneyBricks is on a mission to unlock the potential of real estate investing. We are rebuilding the real estate investment experience, making buying, earning income, and selling income-producing real estate instant, low cost, and enjoyable.

Tokenization will revolutionize real estate investing over the coming years while providing digital asset investors with opportunities for cash flow and leverage that are limited or nonexistent with other cryptocurrencies. 

This article will help you find out what tokenization is and how it works. You will gain an understanding of the opportunities and challenges that investors should consider before investing in tokenized real estate. 

In this article:

What is tokenized real estate investing?

Tokenized real estate is real property with a blockchain-based fractionalized ownership structure.

Investing in tokenized property is structurally equivalent to buying into a syndicated real estate deal—otherwise known as a private placement or Regulation D offering. But instead of receiving a paper certificate signifying a membership interest in the underlying LLC, a tokenized real estate investor receives a crypto token that represents that same membership interest.

The real estate token is stored on a blockchain and can be bought, sold, or traded (following an initial holding period) much more easily, unlike the typical syndication which usually must be held until the sponsor of the project refinances or sells. 

Tokenization enables investors to diversify

The tokenization of real estate enables investors to diversify their property investments geographically to take advantage of strong markets across the U.S. and the world.

Investors in tokenized real estate can allocate investment dollars to different types of real estate, such as:

  • Multifamily housing
  • Self-storage units
  • Office buildings
  • Undeveloped land
  • Commercial development projects 

Tokenization opens up quality real estate to more investors and at smaller investment amounts. Investment sponsors receive access to a new investor pool and retail investors have more choices and more flexibility.

Investors often wish to rebalance their investments at regular intervals, and investors holding real estate tokens can more conveniently rebalance their portfolios to maintain their desired mix of real estate assets.

How tokenized real estate investing works

Both traditional and tokenized real estate offerings use special purpose investment vehicles (SPVs), usually structured as limited liability companies (LLCs), to invest in real estate.

For blockchain-based real estate deals, the ownership of the LLC is fractionalized into security tokens.

Because the offering is a security, it is usually registered under an exemption from the detailed and expensive process of creating a public security.

One requirement of obtaining the exemption is that a private placement offering (PPM) is created that details what the investment is, all the potential risks of the investment, the sponsors of the investment and other relevant information. There is also a subscription agreement and an operating agreement for the SPV that specifies the investors’ rights and obligations as well as those of the managers.

Real estate security tokens are programmed by underlying smart contracts to ensure compliance with securities laws. Smart contracts can automatically enforce applicable purchase and sale restrictions as mandated by securities regulators around the world. Holding times for tokens and restrictions on who can purchase them can also be mandated using smart contracts.

To enforce these regulations, tokenization platforms perform know your customer (KYC) and anti-money laundering (AML) checks, as well as checks for investor accreditation. These checks result in particular buyers being ‘whitelisted’ or pre-approved to purchase.  

Tokenized real estate deals typically involve three main parties:

1. Real estate operators: The owner (or purchaser for new acquisitions) provides the real estate and manages it for the benefit of the investors. Known as ‘Sponsors’, they may also be responsible for raising the capital necessary to invest in real estate

2. Tokenization platforms: Real estate tokenization platforms like HoneyBricks use software to issue tokens and manage both the initial token sales and secondary token exchanges. Tokenization platforms also help to manage investor communications and distributions and provide an environment for investors to find real estate offerings and sponsors to raise money

3. Investors: Real estate token investors use tokenization platforms to access investment opportunities. Investors purchase digital tokens to become part-owners of specific properties.

Why tokenize real estate assets?

Many benefits can arise from tokenizing real properties. Unlike stocks and bonds, real estate is not typically fractionalized or owned in shares. Most real estate is owned by wealthy individuals and their companies.

Individual investors have other options for owning fractions of real estate—including investing in real estate investment trusts (REITs), traditional private placements, or timeshares, or participating in crowdfunding—but each of these arrangements has its challenges. Tokenization can potentially solve many of the challenges traditionally associated with fractionalizing real estate.

A major reason to tokenize real estate is to increase the accessibility of the asset class. Several limitations have historically put real estate out of reach for many investors, and real estate tokenization can remove these limitations while conferring advantages to all parties.

Here are some of the challenges traditionally facing real estate investors and how tokenization can mitigate many of the issues:

Tokenizing real estate can remove many limitations for the average investor, providing access to the largest asset class in the world. There is over $300 trillion of real estate globally — more than four times the size of the stock market.

Tokenization advantages for real estate owners

Tokenization can benefit real estate owners, sponsors, and investors alike.

These are some of the principal advantages for sponsors and owners:

  • Additional capital sources: Tokenization provides exposure for real estate projects to a large number of investors. Many investors might never even hear about a real estate project except if it is tokenized. Real estate tokenization platforms naturally provide additional marketing and raise awareness, improving sponsors’ access to capital
  • Efficiency through automation: Smart contracts that underlay real estate tokens can automate compliance with securities regulations, plus automate investor communications, distributions, purchases and sales, tax accounting, and (when appropriate) investor voting. Automation enables real estate sponsors to manage large numbers of investors and provide a strong audit trail for all property activities
  • Improved investor liquidity: Tokenization allows sponsors to provide greater liquidity to their investors, which may improve investor returns and allow investors to reallocate capital to the sponsor’s next deal. Sponsors can directly benefit from investors having greater liquidity
  • Resolve ownership issues: Tokenizing an asset can be a way for a real estate owner to address thorny issues such as how to dissolve a partnership or divide an estate among heirs. Token-holding owners of real estate can make their own decisions about buying, selling, or exiting. Tokenization doesn’t resolve every property-related conflict, to be sure, but can help with many problems that may arise
  • Equity activation: Tokenization opens up many new options for activating and managing the equity in a property. Owners who tokenize their real estate can sell a portion of the equity (potentially with a buyback option), raise temporary funds, obtain debt secured by their tokens (not the real estate), and trade real estate tokens for other tokens. 

Real estate tokenization example

Imagine an apartment building in your favorite city that’s worth $10 million. The building is owned by a company that’s structured as an LLC, with the only purpose of the LLC being to own the apartment building. Ownership of the LLC is tokenized into 1 million tokens, with every token—worth $10—representing one-millionth of the LLC. 

Now imagine that you paid $10 to own one of these real estate tokens. You would own one-millionth of the value of the underlying apartment building. If the property is sold, you would receive one-millionth (0.0001%) of the sale price. When rents from the apartment building are received, you would earn one-millionth of the net cash flow. If the real estate asset depreciated in value, you could claim one-millionth of that depreciation value on your taxes. 

If the apartment building gains value over time, perhaps because of a rental price increase, the token price would rise above $10 commensurately. After a the initial holding period, you could sell or trade that token to other eligible investors.

Real estate tokenization vs. fractional ownership

Blockchain-based tokenization compares favorably to existing methods of fractional ownership. It inherits the best of properties of typical syndications while adding some of the advantages of REITS and crowdfunding. 

  • Real estate investment trusts: REITs are publicly available as investment funds but are difficult, expensive, and time consuming for sponsors to create. REIT investors only gain exposure to entire portfolios of real estate, not specific properties. For these reasons, returns from REITs are generally lower than returns from other forms of fractional real estate investing 
  • Timeshares: Timeshares are generally only available for small residential properties and have a long history of being a poor investment. They are best suited for vacationers who actually use the property regularly
  • Private placements: investing in private real estate deals is usually the best approach for accredited investors. They typically provide the best returns, best property specificity, and overall best investments. However, most private placement deals are, well, private. Private placement real estate offerings aren’t generally accessible to most investors. And they almost always require the investor to commit funds for the long term (3-10 years)
  • Crowdfunding: Real estate crowdfunding platforms can also offer attractive investment opportunities. The quality of crowdfunding sites varies widely, with many platforms supporting very limited portfolios of real estate assets. Crowdfunding opportunities also require investing for the long term, just like private placements 

The history of fractionalized real estate ownership has dramatically limited the ability to invest. Until the JOBS Act in 2012 it was illegal to advertise any kind of private placement; now, advertising is allowed in certain circumstances.

It was historically also challenging to manage large numbers of investors - but with the creation of blockchain, automation of compliance, distributions, and communications is well within reach. It is only now that the technological and regulatory environments have evolved so that true fractional ownership is feasible. And only via real estate tokenization.

When these advantages are combined with the ability for liquidity of real estate investments, real estate tokenization becomes a huge advance for real estate investors and sponsors alike.

Security token offerings vs. non-fungible tokens

Tokenized real estate uses security token offerings (STOs), which are explicitly securities in accordance with the U.S. Securities and Exchange Commission (SEC). Security token offerings are fungible tokens, meaning that one STO for a given real estate property is just like any other for that asset. 

Non-fungible tokens (NFTs) can also digitally represent real estate ownership, but are not the same as STOs. The non-fungibility of NFTs means that every NFT (i.e., every property) has only one owner, and no NFT is exactly the same.

NFTs may or may not be securities in compliance with the SEC and investors should be cautious as NFTs are sometimes also described as tokenized real estate and might be confused with tokenized fractional real estate platforms such as HoneyBricks.

Disadvantages of tokenizing real estate

Tokenization does require sponsors to think about real estate differently.

Here are some potential drawbacks for sponsors of tokenized real estate:

  • Reduced control through automation: Tokenization automates many processes, which may be disconcerting for sponsors who prefer total privacy and control 
  • Less investor loyalty: With investors more easily able to swap tokens, sponsors may worry about losing a stable investor base. But good sponsors can still maintain a relationship with investors and their track record may attract even more capital. There are also mechanisms for rewarding loyal investors (early purchase, for example) that support sponsors’ ability to create and grow their own investor base
  • More investors to manage: Some sponsors may be daunted by managing larger numbers of investors, which requires different approaches to communication. Sponsors can leverage the support of a tokenization platform to maintain investor communications at scale 
  • Need for stricter privacy controls: Sponsors need to define and maintain strict controls over what information is released to investors and the secondary market. Primary investors require detailed information, which may not be appropriate for a larger audience. A good tokenization platform can facilitate and automate these controls to help sponsors strike the right balance between privacy and transparency.

The future of real estate tokenization 

Any asset can be tokenized - including pieces of art, cars or boats. The future of tokenized real estate is just beginning to take shape.

Currently, very few properties are tokenized and limited opportunities exist for the secondary trading of real estate tokens. But as the immense advantages of property tokenization become more widely known, and more properties become available on tokenization platforms like HoneyBricks, real estate investing is likely to start resembling stock investing.

With further development of tokenized real estate, investor demand for new offerings will increase based on the expectation of a liquidity premium once a deal is fully subscribed. Real estate investors may use tokenized assets to more easily diversify their portfolios, perhaps choosing to spread their investments geographically or by type of real estate. Investors can leverage the convenience of completing token transactions to regularly rebalance their portfolios.

With blockchain technology providing additional transparency into real estate operations, real estate investors may enjoy increased access to property and operator ratings. Integration with the metaverse may allow investors to virtually tour properties at any time. Real estate, fully tokenized, could become a much more efficient market.

Tokenizing real estate will also have positive social ramifications. Community members can collectively own the buildings around where they live, building stronger community bonds and creating a virtuous feedback loop with local operators. If you owned a small piece of every building on Main Street, wouldn’t you feel a stronger connection and desire to improve the community? Ultimately, decentralized and literal ownership of the community may be the greatest benefit afforded by real estate tokenization at scale.

About the Author

Steve Streetman

Streetman is an avid investor focusing on acquisition of commercial cash flowing properties. He is the President of StreetSmart Investments, LLC, a real estate investing company, and leads the acquisition, property management, and business development for the company.

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