When people think of the possibilities available to real estate with the introduction of tokenization, their mind starts to run wild.
“What if tokens could be created to represent ownership of real estate?”
Since every piece of real estate is unique, NFTs could be a great way to represent them. If a token represents a property, you have digital proof of ownership in your wallet. That can be plugged into another smart contract to help with the following:
- Mortgage / Refinance — it can takes months to secure a typical mortgage and it requires all sorts of documentation + good credit score. In DeFi, you can get a loan in seconds if you have the collateral to back it. If you have a token to represent a property, that can be used as collateral to get a loan.
- Invest anywhere in the world — people can pool capital together to invest in specific properties, not limited by geographies, and can invest with small amounts of capital.
- Price and title history of a property — once a home’s info is on the blockchain, any transfers in title or ownership are publicly available, getting rid of the need of title insurance over time and providing price transparency on previous sales of the home
- Trade properties completely online — instead of having to work with traditional brokers and paying 6% in commissions for each sale, imagine being able to sell your property NFT on a marketplace and have the transfer of ownership happen completely online
What people often ignore when thinking of the possibilities is that the reason many of these features haven’t been built out yet is due to the current restrictive policies set in place by the SEC and the local governments where the property resides. Tokenizing real estate is difficult — not only is there technical complexity to set up the contracts — but you need to register the token as a security which has high costs associated with it. To help in the adoption of tokenized real estate, we want to lay out some of the legal and regulatory frameworks that currently exist that you will need to navigate if you want to tokenize real estate.
When tokenizing a property, ask yourself what you plan to do with it. If you plan to sell it in the open market or to a subset of investors, the use case likely passes the Howey Test. If it does, you need to register the property as a security.
Under the Howey Test, a transaction is an investment contract if:
- It is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party
There are a few companies today that are fractionalizing real estate via tokens or NFTs that pass the Howey Test, but are not registering the offering as a security. That’s scary for a few reasons.
As a founder, or a person selling tokenized real estate but not registering it as a security, you may be committing investment fraud whether you realize it or not. Selling unregistered securities is considered a felony by the SEC and opens you up to legal action from the people who purchase the tokens that you sell. This is applicable to the general NFT space as well. We’re beginning to see the SEC more actively involved in the NFT space with their recent action against the former PM at Opensea who was charged with committing “insider trading” for buying up NFTs ahead of them being featured on Opensea’s front page.
Okay so your real estate token offering passes the Howey Test, what are your options? Luckily private placement options exist so you don’t need to do a public security offering.
Let’s explore the options available.
Private Security Offerings Available
Regulation D Offering
Regulation D provides two major exemptions from registration for some offerings.
Under Rule 504 of Regulation D, a company can offer and sell its virtual tokens to an unlimited number of investors, but the offering is limited to only $5 million during any 12-month period.
In comparison, under Rule 506, a company can offer and sell an unlimited amount of its virtual tokens. Rule 506(b) permits sales to up to 35 purchasers who do not qualify as accredited investors, but prohibits general solicitation. Rule 506(c) requires that all purchasers qualify as accredited investors, but permits general solicitation.
Regardless of which rule is used to exempt an offer of virtual tokens under Regulation D, the tokens will be subject to transfer restrictions. In general, those restrictions prohibit the tokens from being resold or transferred for at least one year after purchase.
Regulation CF Offering
The most commonly used exemption for tokenizing real estate is Regulation CF Offering. This exemption allows a company to raise up to $5M million through crowdfunding offerings in a 12-month period.
Regulations CF creates a streamlined registration process for smaller real estate developers, operators, and funds to experiment with real estate tokenization and secondary market trading of tokenized securities. The set-up process for launching a tokenized real estate Reg. CF offering could take as little as 5–6 weeks.
Real Estate companies can use Regulation Crowdfunding to offer and sell tokenized real estate securities to the investing public giving the public the opportunity to participate in the early capital raising activities of early-stage real estate projects.
Anyone can invest in a Regulation Crowdfunding offering, including unaccredited retail investors, and the offering is required to be listed on a crowdfunding platform.
Regulation A+ Offering
Requirements for Reg A+ offerings are relaxed as compared to a registered IPO, still Reg A+ allows U.S. and Canadian companies to publicly advertise investment opportunities and raise up to $75 million in a 12-month period from an unlimited number of unaccredited investors.
Also this exemption provides immediate liquidity to investors, meaning that tokenized Reg. A+ securities can be traded on day 1 of issuance on regulated Alternative Trading Systems (ATS) both in the US and overseas.
For these reasons, Reg A+ offering is often referred to as a mini-IPO. Tokenized Reg A+ offering is an excellent fundraising tool for real estate developers and operators, startups and existing companies
After deciding which pathway to take, you will need to make sure that the standardized token offering is setup in a compliant way, has a governance structure, and has shares that are able to be traded on secondary markets called Alternative Trading System platforms in the US.
The Future of Tokenized Real Estate
Modernizing an industry that is operating as if it is still the 1980s is difficult. Many incumbents are happy keeping the status quo since they’re the ones currently benefiting from the system. These companies are the title insurance companies, traditional banks whom underwrite the majority of property loans and large institutions who benefit from siloed information of real estate. Not only that, but government institutions are slow to change their processes. For example, when purchasing a property, you need to go to the county clerk’s office in person to transfer a property deed in many counties in the US.
For crypto and DeFi to truly disrupt the real estate industry, it will be important for web3 companies to partner together to push for wider adoption. The benefits of tokenizing real estate are clear: more liquidity, faster transactions, price transparency for homes and transactions completely online. It’s a question of whether companies can navigate through the strict regulations to still create use cases for real estate that benefit from DeFi. That or current regulation need to change to make the tokenization of real estate easier to perform.
In the meantime, we’ll keep building towards our goal of democratizing access to real estate investing and driving greater adoption along the way.
Domingo, Homebase Co-founder
