We have decided to make this post as a summary of the experience gained giving legal advice to companies engaged with tokenization of real estate projects. Even though different projects seem to “offer the same”, they differ in many aspects (mostly “under the hood”). In this sense, a thorough legal analysis is essential when we are thinking of making an investment.
What exactly does tokenization mean?
It is the digital representation of a real-world asset and the safest way to do it is on blockchain technology. A real asset may be a real estate or the rights related to such property (such as the right to a deed once the project is over, or to the use of a unit). Blockchain allows investors to access its public data to check the assets with no need of intermediaries, extra costs or delays.
What could be the difference between one token or another?
The difference lies on “quality” and content; it is not the same a $100 Monopoly bill, then a $100 US dollar bill. Beyond the programming virtue of each token (that ultimately depends on the applied code), each token (as a representation) represents something different. It may be a financial asset (offering a yield), a digital representation of an agreement, a real estate right, economic rights, political rights, a combination of several rights and obligations… endless possibilities. We always recommend investors to get acquainted with the project involved and to find out what they are buying behind the token (because the token itself has no value, but value lies on what it represents).
Regarding quality, we are not referring to programming quality or to blockchain safety. In this case, it refers to the legal backing of the represented asset. It is important to check that whoever issues the token has right to the underlying asset, is authorized to tokenize it, cannot sell it several times, the asset exists, etc. In this sense, Casa Token, a product from our client Pala Blockchain, for example, brings enhanced security and trust by using a notary public as validator. This means that the notary public intervenes in the whole process before the project goes on sale and tokens are only issued upon approval of the pertinent documentation by such professional.
How does it affect the real estate market?
Real estate tokenization emerged 5 years ago approximately, starting a new era in property management. The purchase of housing and other real estate (mostly in markets with under-developed mortgage loans) is nearly impossible for people depending on their current income. Tokens emerged as a solution since they allow to fraction the rights over properties, offering a lower investment ticket, helping more people to access this market.
On one side, save for some exceptions, the real estate market tends to move “in block”, where those properties of similar level and location go up and down in price at the same time. This fact may hamper investors’ prospects due to the economic or financial situation they may be going through. In fluctuating markets such Argentina, to buy real property is quite a challenging matter.
Let’s suppose an investor is able to buy the 50% of a property he likes, and projects to save for the balance. By the time he managed to gather the money, he is likely to be unable to buy the 100% due to price fluctuation (may be exchange rates, new market values, etc.). The token brings a solution to this issue since, unlike cash, its value should raise and drop according to the property’s value.
On the other side, developers and real estate companies have the possibility to sell their ventures with lower tickets and, therefore, to broaden its target public. Tokens can be quite attractive for people aiming to diversify investments or for someone who rents and has some extra money (though not enough to buy 100% of a property).
Does this mean that you can buy a property without having the total amount to carry out the transaction?
Exactly. Tokens are issued based on the guidelines of the issuing entity. In some cases, parameters are defined by the software company and, in other cases, by the developer itself. This means that an investor could manage to buy “the 12% of the 4ºC apartment of such building” if permitted by the conditions of the project tokenization.
What about the legal framework?
This matter is controversial and subject to legal rulings and opinions. It is essential to understand what is being purchased since conditions vary according to the type of asset we are tokenizing.
Rules shall apply according to the type of transaction that is being represented by the token. In a simple way, tokenization is like “uploading” a transaction on the blockchain, but the legal framework shall be governed by the underlying asset and transaction.
Whenever a legitimate and existing business is being tokenized, tokenization shall be valid and legal. It is important to bear in mind that, according to the type of transaction, tokenization could be subject to specific regulations such as those governing stock exchanges, tradable assets, financial investments, exchange regime, etc. It always depends on the regulation applicable to the underlying business.
But real estate in Argentina is traded in cash today. How this paradigm shift will be achieved?
Ultimately, the change will be achieved (or not) by the market. We believe that this model will benefit more potential clients/buyers, thus resulting in a successful business model, bringing more transparency to the real estate market and democratizing access to real estate ownership. Developers aim to finance their ventures and to profit from them. If more clients/buyers are capable to invest, developers shall have achieved their goals (whether through cash or new technologies). In many platforms, tokens can even be purchased with credit cards or cryptocurrencies.
The ”spread effect” is an important factor as well. If many developers start offering tokens for tiny investors unable to afford the value of the 100% of a property and accepting all means of payment, two things may happen (not necessarily exclusive): a) the market wins because it is the only one; or b) competitors start offering the same thing to avoid being excluded. The third alternative is that nobody trusts the tokens and refrains from buying them, but we believe this is not the case.
What happens if the property is sold for a lower value than the originally planned?
It depends on the type of token. In the case of financial tokens (also referred to as debt tokens since they work as a loan and pay an interest rate for a fixed term), risk and return are allocated to the buyer. In the case of real estate investment trusts at cost or for development (the majority of cases), the risk is taken by investors. If the property price is higher than the invested amount (almost all cases), investors win. On the contrary, if the price is lower than the invested amount, they lose. It works in the same way as the underlying transaction.
What happens if the property is not sold?
Again, it depends on the type of token. Let’s exclude financial tokens from the answer because developers have to pay when conditions are met. In tokenized developments, their aim is not the property sale itself but rather the deed registration.
The registration of deeds can be achieved in several ways: if one investor purchases the remaining tokens from the other pool investors, if deed is registered on everyone’s name, investors’ pool can agree on the sale of the venture and/or venture can be registered as a condominium. Briefly, it depends on the conditions set in the trust (which shall be reflected in the token) defined by the developer. “The exit” is another important aspect to be considered before making an investment.
How those contracts related to real estate tokens are considered fully valid?
Professional advice is essential in this field, either by a lawyer or a notary public or both jointly. The professional involved must be well acquainted with tokenization in order to be able to explain investors, in a simple way, how it works and the duties and obligations involved.
In this sense, tokenization operates like any other transaction and validity is linked to the validity of the underlying contract. That is why we support the approach of Pala Blockchain with notaries public in its staff who are involved with tokens issuance and documentation revision.
What are the legal implications of tokenization in the ownership and transfer of real property?
Generally, in development trusts, tokenization is done on the trustee’s rights, excluding any registration or special regime with the Real Estate Registry. It is simply registered in the name of the trust until further deed registration in the name of the buyers.
How data protection and privacy is managed in real estate tokenized transactions?
Tokenization platforms and/or developers shall have all data related to tokens’ holders, since it is essential for deed registration. Data shall be protected according to the data protection policy of these companies and to the regulation in force in the countries where transactions are carried out. Obviously, there will be public and private data.
What are the legal requirements of real property tokens to be considered valid in different jurisdictions?
Tokenization is subject to local legislation in the same way as the sale and purchase of real estate. In principle, if the token issued is backing a legal and regular activity, legal issues are unlikely to arise. But, anyway, we recommend to be assisted by an expert professional to check the legal aspects in terms of compliance.
How the issuance and trading of real estate tokens is regulated withing the current legal framework?
Regulation varies according to the different jurisdictions but, basically, there is no a specific regulation “for tokens” in terms of issuance and trading. Tokens backing financial transactions shall comply with the regulation stipulated by the corresponding enforcement agency. The same applies to other tokens representing warrants, collective financing, negotiable obligations, virtual assets service processing, if traded in open markets, with public offering, etc.
How are legal disputes connected to the trading of real estate tokens resolved?
In law, there is a principle that says that “the accessory follows the principal”. Since tokenization is the representation of a more traditional transaction, the applicable rules regarding jurisdiction are the rules applicable to the underlying transaction. The innovation brought by this disruptive technology is the possibility to have much more information than in a traditional transaction, backed up by an unalterable, transparent and traceable chain.
What are the tax provisions in real estate tokenization?
This aspect should be clarified by an expert accountant but, in principle, the same provisions apply as if you were joining a trust (following with our analysis of trust at cost). We strongly recommend to seek expert advice before making any investment due to the impact it may have in terms of return.
In a few words, what are the benefits of real estate tokenization?
Tokenization streamlines the real estate market by transforming it into a broader and more democratic market for the middle class with more agile, solid and transparent instruments than the traditional ones.
Diego J. Nunes
Partner
