In today’s digital world, technology continues to both enhance and transform traditional processes and real estate is no exception. One exciting technological development is what is known as “tokenization.” This article seeks to provide a plain English explanation of tokenization, its potential benefits and future uses, and legal considerations for investors and issuers.

What is tokenization?

Tokenization is the act of issuing a digital representation of a real world asset. These digital assets are commonly referred to as “security tokens” (and, as the name suggests, subject to federal and state securities regulations that govern the issuance and promotion of tradeable financial assets). Security tokens are issued on a blockchain, a distributed ledger that offers immutability and decentralization and is therefore useful for accurately and safely recording ownership and chains of title without complete submission to one central authority. In addition, security tokens utilize smart contracts which are self-executing lines of code that may help facilitate or verify the terms of an agreement.

What are the benefits of tokenization?

The main potential benefits of tokenization are democratization (the ability to market the investment to a larger pool of investors by lowering the bar to entry), liquidity (how easily the asset can be turned into cash), and efficiency (the reduction of friction caused by middlemen and antiquated systems).

Democratization

Historically, institutional-quality commercial real estate deals have been restricted to a limited few due to minimum investment requirements. One of the benefits of tokenization is the ability to lower the minimum investment and thereby allow a larger class of investors to participate in such offerings. We note, however, that numerous real estate crowdfunding projects already exist that do not utilize security tokens or blockchain technology. In addition, as tokens are subject to securities laws, the act of tokenization in and of itself does not remove the need to adhere to rules and restrictions with respect to accredited investors and other requirements.  However,  since compliance criteria can be baked into the code of any tokenized offering, initial offerings would be more efficiently implemented and secondary trades could be seamlessly permitted.

Liquidity

Tokenization may be able to assist in providing liquidity to traditionally illiquid private markets by helping to develop a more appealing marketplace solution. Regulated alternative trading systems (ATS) operate similarly to a stock exchange without requiring that the assets be publicly listed securities. Although ATS already exist, there are key benefits to trading platforms that are developed specifically for tokens. U.S. markets are open Monday to Friday from 9:30 a.m. -4 p.m. EST. Exchanges developed for the purpose of trading security tokens would conceivably enable trading around the clock, worldwide, and at lower cost (no brokers) with much faster settlement times (within hours rather than weeks as is often the case with traditional brokers and transfer agents). Here again we note that real estate crowdfunding platforms exist that have also launched secondary exchanges without utilizing blockchain technology. There are, however, notable differences: tokenization permits interoperability whereby various assets can be traded via multiple platforms.As the technology improves so do the possibilities.

Efficiency

Efficiency in this context has several meanings. For starters, a real estate developer may find that it is less expensive and easier to present a tokenized offering at a lower minimum investment amount than would be provided through traditional means, thereby bypassing the need to involve traditional lending institutions partially or perhaps even altogether. Fractional owners would have minority ownership interests which could allow a developer to maintain control and major decision rights. Over time tokenization may result in lower costs, given the reduction in paperwork and middlemen.

Tokenization Models

There are various investment structures that may be appropriate for tokenization. The market has already seen examples of tokenized REITS as well as tokenized real estate private equity funds.

The technology platforms that develop the tokens offer various business models ranging from serving as deal sponsors and charging fees and revenue percentages to charging listing or management fees as well as providing data analytics services. All of these models come with their own regulatory concerns and one should consult with appropriate counsel.

Early Days

Tokenization is still in its infancy. Many of the advantages foreseeable with blockchain technology are at least a year or two away. As the industry grows, however, the decentralized nature of blockchain coupled with smart contract technology will allow for a few key advantages such as the systemization of KYC/AML/Accredited Investor verification; encoded compliance; improved cap table management, among other opportunities.

Legal Considerations

There are numerous legal considerations when issuing security tokens.

Structuring the Deal

Traditional syndications of individual real estate projects typically involve the preparation of an offering memorandum, which is then sent to accredited investors who have signed a confidentiality agreement and completed a questionnaire.  If the investor wishes to invest, that investor would sign a subscription agreement for at least a minimum investment on terms summarized in the offering memorandum and fully spelled out in the limited liability company agreement or limited partnership agreement shown to investors. The game-changing contribution made by tokenization is that instead of a paper certificate representing the purchased interest being delivered to the investor, the investor is issued a token which is deposited into that investor’s digital wallet.  A notation is made in the blockchain ledger as to the investor’s title to that token.  When the investor wishes to trade that token, then it can be done electronically in as little as a matter of hours (as opposed to weeks with a traditional transfer agent) to a willing purchaser who has satisfied the gating criteria, such as having already been vetted as an accredited investor and passing anti-money laundering hurdles, and paid the consideration in either fiat currency or cryptocurrency on account at the exchange.  The sponsor would have already established the parameters that govern the trade relating to minimum size and qualifying investor characteristics (in addition to those relating to legal compliance).  For instance, a sponsor may limit investments to only those who have already invested in that same deal or their affiliates.  Or the sponsor may open up the range to other investors “by invitation only.” Or the sponsor may permit transfers to anyone not on a prohibited list of competitors.  The options are endless.  The tokens could also divisible into smaller increments of value, only limited by minimum thresholds that must be maintained.

Managers of real estate private equity funds that invest in or lend to real estate projects and developers could also benefit from the tokenization of interests in their funds.  Currently, sponsors usually hire a consultant to market to ultra-high net worth individuals, endowments, family offices, pension funds and funds of funds.  For efficiency, the minimums are generally high as the total targeted raise is usually in the high tens of millions to hundreds of millions of dollars.  The process can take well over a year to reach even the minimum for an initial close.  While tokenization may not speed up the process for this type of fundraising, it can offer a fund manager the opportunity to more easily reach wealthy foreign investors and family offices who have less access to fund investing opportunities in the U.S. and who are attracted to the greater liquidity of tokens, without the friction and cost of an expensive, gatekeeping middleman.  

Project sponsors and fund managers would receive feedback from investors as to the acceptability of their terms, and could adjust course by modifying terms if the fundraising takes too long to achieve minimum milestones.  

The reader should bear in mind as discussed below that tokenization does not, however, excuse the issuer from complying with domestic federal and state registration and exemption requirements, like Reg. D, or foreign laws for offshore issuances governed by Reg. S, and counsel should be consulted from the outset.

Tax Considerations

From creating an investment opportunity that is attractive to investors to managing a project and even facilitating an exit every real estate-related decision and transaction has tax implications. It is the jurisdiction of the investment vehicle and not necessarily the location of the real estate asset which is most important in determining structure for both legal and tax purposes. A well planned tax strategy is critical to the success of a security token offering. Reporting requirements, recent tax legislation as well as international and estate tax considerations all play a key role in planning an offering.

Marketing the Offering: The United States

In the United States Form S-1 is a filing used by companies to register their securities with the U.S. Securities and Exchange Commission. Companies publish a prospectus which contains information required to be made available to investors to consider the merits of the investment offering. As such a filing is extremely costly and time consuming. The SEC provides exemptions from the obligation to file. These private placement exemptions include:

• Rule 506(c) – This rule allows issuers to raise an unlimited amount of money from accredited investors subject to certain rules and conditions. General solicitation is permitted and there is no ceiling on the amount of money that may be raised. There is an obligation to take reasonable steps to verify the accredited investor status of the investor as well as the Know Your Client (KYC) and Anti-Money Launder (AML) requirements that are a critical component of any offering.

• Rule 506(b) — This exemption does not permit general solicitation but allows for up to 35 non-accredited investors to participate.

• Regulation Crowdfunding — This exemption allows small offerings of up to USD 1.07 million during a 12-month period to the general public subject to additional limitations.

• Rule 504 permits a limited offering for eligible companies, where up to USD 5 million in a 12-month period can be raised.

• Regulation A allows for two tiers: tier 1 for offerings up to USD 20 million in a 12-month period and tier 2 for offerings up to USD 50 million in a 12-month period. Commonly referred to as a “mini-IPO,” Regulation A remains an elusive option for security tokens as it requires SEC approval which, as of the date of this article, has yet to be granted for any project.

There are additional requirements that must be taken into consideration with the above such as resale restrictions and state regulations (known as “blue sky laws.”)

Marketing the Offering: Internationally

Security token offerings must adhere to the laws of every jurisdiction in which they are made. Countries have varying laws with respect to securities offerings and, furthermore, some countries have regulations that are specific to security tokens or even restrict them altogether whereas others have developed laws that are intended to encourage blockchain adoption.

Tokenization Platforms

As mentioned previously various tokenization platforms exist with different pricing models. In addition, each issuance platform has its own approach to compliance protocols, post launch support and secondary trading assistance, as well as other considerations. Issuers should compare platforms carefully to ensure the best fit and would do well to bring in a third party auditor at a later stage to ensure that the tokens conform to the issuer’s technical needs.

Conclusion

The above is just an overview of the tokenization process as it pertains to real estate offerings and is by no means exhaustive. There are many legal and business considerations in a successful issuance. It is imperative that real estate developers and fund managers retain counsel experienced not only with blockchain related offerings but with respect to real estate law, finance and taxation as well.

Katya Fisher, Esq., is a partner and practice group leader of the blockchain, digital assets, and technology transactions practice group and Mark Fawer, Esq., is a partner in the real estate practice group at Greenspoon Marder LLP, New York, N.Y.

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