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Real estate and blockchain: a promising deal

Updated: May 1

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Topic of the month_Asset tokenization
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There are more and more use cases of blockchain aiming to transform sectors other than finance. Mainly due to its intrinsic characteristics that improve and optimize the way certain industries operate. The real estate industry is no exception. Blockchain innovation could improve the real estate industry in a number of ways, including through its underlying technology and smart contracts that could make the transaction process more efficient by tokenizing the underlying asset, but also with the fractionalization of real estate through tokens.

According to Baum (in The Future of Real Estate Investment, 2020), the tokenization concept refers to “the generation of digital blockchain-based token that represents a security". While the concept of fractionalization refers to the process of fractionalizing an asset into small investable tokens that are stored in a decentralized blockchain, which could create a new path for real estate investment

A market which needs improvements

In their January 2023 report, the Canadian Blockchain Consortium mentioned that the current buying process of real estate is slow, expensive and carries a high risk of human error. In fact, settlement times for new buyers to finalize a home transaction are 30 to 60 days. “Every element of the deal has a small chance of an error, and it only takes one to cause a loss”, explains for instance the Canadian insurer LawPRO. “Real estate transactions deal with hundreds of thousands, often millions of dollars in value. Even a mistake that causes a small percentage error can result in a significant real loss.”

This quote is symbolic of what today's real estate industry is, profoundly: a complex system that rests on the shoulders of many humans. As the Canadian Blockchain Consortium points out, the five biggest limitations that plague the real estate market are:

  • Illiquid market: The real estate market is a very illiquid market because the assets involved are physical, which makes transactions much smaller than in the securities market, for example;

  • Barriers to entry and difficulty of access: as it is a capital-intensive business and difficult to access foreign markets;

  • The processes are complex: as they require several stakeholders;

  • Involves significant transaction costs: The transactions imply additional costs because of all the intermediaries involved;

  • Lack of transparency: The agreements reached are not always in favor of the buyer, and the latter does not always have full visibility on the transaction.

So, it is not without reason that some countries and many organizations are beginning to show more interest in real estate tokenization or the use of blockchain in improving processes in the real estate sector: these innovations could potentially solve many of these challenges by providing automation, greater accuracy and fraud reduction.

Real estate tokenization: a game changer

Better: the benefits it could bring to the real estate sector - as presented in Figure 1: Main benefits of tokenization - have the potential to change the face of this industry. The intrinsic characteristics of blockchain - decentralization, transparency, consistency, immutability and real-time - make it possible to overcome the aforementioned limitations of the real estate sector.

Although the technology itself and the use cases specific to the real estate sector are still rather nascent, several benefits of tokenization and blockchain have been glorified by market players and academics:

Business model transformation: Blockchain in real estate could introduce new business models and transform existing ones through the tokenization of real estate, for example. This technology also allows the introduction of new structures in organizations, new forms of governance, automation of shareholder dividends or even transforming the way voting is conducted within organizations, to name just a few examples.

Globalization and accessibility: Because of the decentralized nature of the blockchain, the applications are not limited to any jurisdiction, but can be accessed digitally anywhere in the world. It allows individuals to access markets that would otherwise be much more difficult. In addition, the fractionalization of assets allows a larger number of investors and younger generations to be able to enter the market since the capital requirements are much lower.

Transactions 24/7/365: One of the main advantages of decentralized finance is its 24/7/365 availability allowing investors to trade at any time via online platforms, such as RealT or SolidBlocks. This is a significant improvement on the current system, which, even for securities, operates roughly from Monday to Friday, from 8am to 4pm.

New types of products and services: New products and services are being introduced to the real estate market through blockchain and tokenization. These products and services include:

  • Security token offerings (STOs), which represent digital tokens issued on a blockchain in the form of regulated securities;

  • New online platforms and applications (i.e. RealT, SolidBlocks, etc.) available for everyone to purchase a fraction of a property;

  • Digitization of land records through blockchain land administration, which is a system used to locate and identify real estate, as well as to keep records and data. The blockchain allows, among other things, to improve the transparency and efficiency of the land administration process since all stakeholders in the network have a copy of the data, but also through the automation of this process.

Liquidity creation: Blockchain technology allows for the tokenization of tangible, physical assets, which typically come from a highly illiquid market, such as real estate. By fractionalizing these assets into small tokens, blockchain technology makes them more easily transferable and traded, which has the potential to improve liquidity, which refers to the concept of an organization's ability to convert rapidly into cash at a fair value.

Reduction of transaction costs: The reduction of intermediaries can reduce transaction costs since the blockchain is spreading its operations across its network. Thus, this ensures that transactions are recorded and replicated by all users on the blockchain network, enabling everyone to own a copy. In addition, the use of smart contracts allows the automation of many processes and therefore eliminates activities that were previously performed by intermediaries (see below). Notwithstanding, it would also create other needs for organizations to be compliant, such as code/smart contract auditing.

Increased transparency to processes: As mentioned previously, all information is stored in the blockchain and is accessible to members depending on the access configuration, allowing for greater transparency. For example, property information (e.g. land purchase records, title registry, expenses, revenues) could also be included, which in turn would facilitate cost verification and compliance.

Reduction in transaction time: Unlike the 30 to 60 day settlement time for real estate transactions for first-time buyers in Canada and the T+2 for traditional securities transactions, blockchain would allow for near real-time settlement.

Automation of processes: Notably through the use of smart contracts (see the definition above), processes are automated which allows for greater operational efficiency, but also reduces the number of human errors and simplifies and standardizes the procedures in place. Here are some processes that can be automated: compliance checks, AML/KYC, automatic profit distribution, interest payment and reporting systems. Other areas of automation include the fields of capital-forming models, financial structuring models and token structures (on that subject, see Blockchain and the Token Economy: Theory and Practice, Mary C. Lacity and Horst Treilblmaier, 2022).

Those on the path to transformation

Although few in number, there are already some cases in the world that are taking advantage of these characteristics to improve processes in the real estate sector through its technology itself or through tokenization.

One of the most recent projects is a Canadian joint initiative designed in partnership with the Toronto Regional Real Estate Board (TRREB). It aims to introduce "tokenize" blockchain solutions for real estate boards across Canada. As Canada's largest real estate board, the TRREB and its 70,000 members would benefit from this new solution through its integration in the REALM system (the new multiple listing platform for real estate). This project intends to meet the needs of TRREB members by making the transaction process more reliable and secure, while automating it with smart contracts - computer programs that run by themselves on the blockchain. In the long run, this type of partnership, concluded between the country's largest real estate boards, real estate leaders and technology companies, could have a significant impact on the way real estate is traded in Canada.

But more advanced projects elsewhere in the world have been leading the way for many years.

Unsurprisingly, several of them aim at the same objective: developing a blockchain-based system for the land administration. That is because land ownership is a critical aspect of the real estate industry, it is the foundation of property rights, and it is essential for buying, selling, or transferring real estate. As such, the use case can be seen as one of the foundational steps to building the real estate token economy. The following table outlines some of the jurisdictions that have experimented or implemented blockchain in land administration:

However, other use cases are even further ahead, offering tokenized real assets, in different forms, and using different vehicles. Some of the most prominent examples documented are presented in the following table:

Many obstacles remain but none are insurmountable

While the aforementioned benefits of blockchain-based real estate tokenization have the potential to revolutionize investment in this traditionally illiquid asset class, the timeline for the realization of these benefits may depend on the regulatory and legal environment, as well as on the time it takes to build the necessary infrastructure or ecosystem and market demand to grow to a certain threshold.

For instance, the promise of real estate investment democratization and global accessibility is highly contingent on the legal and regulatory framework of each country, which remains uncertain for the vast majority of jurisdictions globally. That is the regulatory and legal systems must first recognize the digital representation of asset or asset rights on a blockchain-based token so as to enable the cross-border passporting of the tokens.

The greater and global accessibility also depends on the fractionalization of the token / no or minimal investment amounts as well as the creation of a secondary regulated marketplace / exchange, where these tokens may be liquidated. As of now, this critical infrastructure is missing, and OTC (over the counter) or peer-to-peer transactions are mostly used. And once again, regulatory constraints or uncertainty might in all likelihood have an impact on the pace of development on this front.

And as for real-time settlement (Lacity and Treiblmaier, 2022, p. 189), the “time” to settle may ultimately reflect the level of dependencies on the traditional system and requirements of the process (if non-adjusted to acknowledge the use of blockchain technology), such as the number of intermediary steps/approvals (e.g. lawyer) and the nature of these steps (time needed, physical vs electronic approval, etc.).

Nonetheless, some benefits could be achieved more rapidly and are non-negligeable, including the realm of benefits derived from leveraging blockchain technology and smart-contracts for automation. Although once again, the maturity and state of the ecosystem may act as a limiting factor. For instance, the automatic dividend payment through blockchain would require the acceptance of the smart contract by the bank (Lacity and Treiblmaier, 2022, p. 200).

The literature is also rich in lessons learned from blockchain implementation and pilot projects in land administration, that showcase the negative impact of both regulatory uncertainty and coexistence of many systems in hybrid solutions (referring to the combined use of conventional database technologies integrated with blockchain technology). The Swedish blockchain land administration pilot project epitomized particularly these caveats.

On the one hand, the experience proved that hybrid solutions, rather than replacing the current system and making it more efficient, actually add the cost of blockchain’s operation to the current structures, increasing the charge of the whole. On the other hand, the application could not even move into production for the most trivial but profound reason: electronic signatures were not considered legally valid.

These feedbacks can be very useful for any project - such as the TRREB project mentioned above - which might have to deal with the regulatory framework and the coexistence of several systems. In any case, these obstacles don’t have to appear as insurmountable! As Liechtenstein demonstrates, since October 3rd 2019, it is feasible to set a legal framework for tokenization and transactions based on what they called “trustworthy technology” (TT) in the law on “Token and TT Service Providers” (TVTG). As a result, this small country now “acknowledges the technology as trustworthy enough to allow equity share transactions to happen without any additional approval by a notary or lawyer” (Lacity and Treiblmaier, 2022, p. 187).

In the patient waiting for similar legislation elsewhere in the world, testing and experimentation are the only way to move the sector forward on this matter.

Now or later?

Given the current state of the legal and regulatory environment, the immaturity of the ecosystem, and the aforementioned limitations, organizations might question whether to explore and experiment with real estate tokenization and other use cases of blockchain in real estate today.

There are a number of elements to consider in answering this question, including the following:

Innovation takes different forms and is a multi-step process

Recognizing that the realization of all potential benefits derived from blockchain and tokenization is a longer-term play is essential. But at the same time, the potential for disruption through blockchain technology is present, particularly when considering real estate tokenization. And as Harvard Business School professor Clayton Christiansen warned a few years ago: “Disruptive innovation creates new markets and reshapes existing ones” (see our paper about how to regulate a disruptive technology like digital assets). Seen from this perspective, real estate could be on a path of a turning point.

Keeping this in mind, organizations can focus on nearer-term problems, objectives and use cases that are relevant to the organization and the future of its industry. As Greg Satell wrote in Harvard Business Review: “Innovation is, at its core, about solving problems — and there are as many ways to innovate as there are different types of problems to solve.” Ultimately, the process is unique to each organization and must reflect both internal and external environments. But one wants to avoid being disrupted.

Innovation informs future legislation and regulation

From a regulatory and legal perspective, these tend to evolve more slowly than innovation itself. While greater regulatory clarity is expected from several jurisdictions globally in the next 12 to 24 months, including the European Union (MiCA), the United States (Biden Executive Order) and Canada, projects of different scale and that respect current laws and regulations are not only possible, but will allow the regulators and the industry alike to learn from these experiences and to inform regulators so as to promote balanced innovation (see Figure 2 below). The interplay between regulated incumbents (who have an established relationship with the local regulator), tech start-ups and crypto-native organizations, notably in the context of an internal pilot project or regulatory sandbox, can provide a path to fast-forward the innovation, building the ecosystem that is required, while promoting safe, sound and ethical development of that innovation.

Innovation takes place globally

As briefly touched in this article, governments, and public and private organizations globally have already begun to tackle the various blockchain use cases in real estate. And these companies and initiatives are not only happening in jurisdictions that lack regulation or that are crypto-friendly. In that sense, exploration and experimentation is already underway. As epitomized in the Figure 2 below, in all cases, exploration is necessary to make informed decisions.

The real estate tokenization project depends on several intrinsic and extrinsic factors that must be carefully evaluated in order to determine the next steps and ensure its success.

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Topic of the month_Asset tokenization
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