How to tokenize real estate and what you should know
- 20.02.2023
We all know the real estate is and always has been a biggest and most important asset class. In addition, real estate has always been considered a profitable and relatively safe investment. Regardless of what happens in the world and in the stock market, people will always need place to live and work. Even though the real estate market experienced growth, the transactions in this field are also complex and expensive, rendering real estate relatively illiquid. Since people still want to invest in real estate, the space has seen some improvements in making real-property interests easier to deal in. But some new methods that appeared seem to go further in allowing exposure to real estate to main street investors. It is called tokenization.
In series of articles, we will explore different business models regarding tokenization. In the first article, we will focus on the most obvious one and that is tokenization of equity. So, are you ready to break some delusions about tokenizing real estate property?
Tokenization of equity
The direct ownership of the real estate itself through the token is not an option, because land registers do not recognize tokens nor operate on the blockchain technology. This means that it is not possible to establish direct ownership of the real estate simply by possesing token. It is reasonably expected that this will become reality in the forseable future, but for the time being, there is an another, more convenient option.
That is tokenization of the company which is the sole owner of real estate. Namely, there are already jurisdictions such as Estonia, Wayoming, Seychelles allowing company’s shares to be tokenized meaning it is possible to store shares directly on the blockchain, and there is no need to report each transaction to regulators, which makes having thousands of investors and an active secondary market more feasible. The procedure is as follows: in the first step company acquires real estate and in the second step, company issues tokenized shares. Bear in mind, that company is a so called SPV (which stands for Special Purpose Vehicle) meaning that company posesses only real estate on their balance sheet. SPV does not perform any other business activity which is not related to given real estate.
In addition there is an option that a company incorporated in a jurisdiction where tokenization of shares is allowed has 100% ownership in a company which is a sole owner of real estate. This could be the case since some jurisdictions stupulate that only a resident company can be owner of real estate. Another variation of this option is where custodian (which doesn’t necessarilly have to be tokenized company) issues tokens on the basis of SPV’s shares previosuly acquired. Token holder has the right to the dividend, but not the right to vote.
Also, it is possible that one SPV has two or more real estate properties in its portfolio. This could be interesting for those who wish to tokenize multiple properties. Instead of incorporating a separate SPV for each property, there can be only one company owning them all in order to reduce the cost. The problem with this model is that it implies a bigger risk. If one property is underperforming and the SPV cannot fulfill its obligations, it would have to use revenue from other properties, which other investors may own.
Solution to this problem could be a vehicle where each property would be part of a separate balance sheet, and assets and liabilities would be calculated separately for each property. This kind of company is called a segregated portfolio company. It was initially designed for investment funds that might have many different portfolios and want to protect investors if one or several of the portfolios are underperforming. This can be used for tokenizing multiple properties where one portfolio would represent one property: issuing separate token for each piece of real estate that will represent the rights to cash flows from it.
Drawbacks of equity tokenization
Since, we saw the benefits of equity real estate tokens, it is time to ask ourselves are there any drawbacks to this model and what would be it? In the first place, cost of incorporating as well as liquidating SPV. Do not forget that once the real estate has been sold (after being commercially used for certain period of time) and after the capital gain from property’s price appreciation, the SPV has to be liquidated, since its sole purpose ceased to exist. Secondly, in most jurisditions when company sells real estate, there is an obligation of capital gains tax which represents the difference between selling and purchase price. Capital gain represents taxable income, meaning it will be taxed with corporate income tax. In case SPV decides to distribut dividend from selling real estate to its shareholders/token holders, shareholders will be subject to dividend tax.
It is clear that this construction is heavily burdened with tax and therefore highly inneficient, except if capital gain is that big so that can cover tax burden. Do not forget another issue to consider. In the case of company liqudation, the difference between the value of the share capital and the liquidation residue is taxable with same tax rate as dividend.
Stay with us for the following articles, where we will talk how tokenization of real estate can be done through debt and revenue-share model.