By Timothy Chan and Kelvin FK Low

There’s a new subject for debate in the blockchain world: asset tokenization. More specifically, the conversation is around whether asset tokenization – the process of turning ownership rights in physical things into tradable digital tokens – actually does what it promises.

One camp believes it does. A joint report co-authored by Liquefy, Sidley, KPMG, and Colliers claims the usual benefits: lowering barriers to entry, efficiency, transparency, and so on. They say tokenization is ‘quickly gaining traction in the real estate sector.’ A Singapore-based company called Fraxtor Group, for instance, has been offering fractional investments in real estate – or, as they put it, seeking to ‘democratize real estate’ – since 2019.

Perhaps most tellingly, a recent feature in the Financial Times on real estate tokenization in the US seems cautiously optimistic about its prospects. At least, it takes tokenization seriously. ‘Can it find its feet beyond the crypto crowd?’ the publication asks.

The implication is that tokenization works. It is legally effective. That is, you can actually buy a ‘slice’ of a ranch in California or a cabin in Vermont over the blockchain, facilitated by a platform. This picture of real estate tokenization, unfortunately, jumps the gun.

Brass tacks                                     

Whatever else you can do with blockchain technology, you cannot use it to transfer legal ownership in real estate. An extensive survey by Cornell law professor Yun-Chien Chang shows that the vast majority of countries in the world require some kind of registration for transfers of real property ownership. In other words, registration exists in the real world, not on the blockchain. Just as blockchain transactions ‘will not move trucks or build houses,’ they won’t affect registration either.

So if tokenization platforms like Lofty, RealT, and HouseBit do not actually get token holders registered as legal owners, what do they do? They use a clever method: they insert a company or a trust as a middleman.

Let’s say someone’s just bought a token in a piece of real estate. The title is transferred to an entity – in this case, a company or trust – and token holders get a fractional interest in that entity. Tokenization platforms claim that token holders ‘legally have ownership’ of real estate or ‘effectively have ownership,’ but that’s simply not true. Of course, it does make for better marketing. By relying on the intermediary structure, investors have to take the platform’s word that the intermediary entity actually owns the property in question and that the token transaction validly transfers legal title in the entity to them. Even then, owning an interest in an entity that holds property is quite different from owning property outright, particularly when the legal frameworks governing these company and trust structures are new and untested.

What happens in the event of a dispute, say over property management or repair? How does one call for a company meeting? Do the standard quorum requirements apply? Are there minority protection remedies? And problems involving property management are really only the tip of the iceberg. Exit options ought to be of greater concern for investors.

For instance, the Financial Times reports anecdotal evidence on a lack of secondary buyers. According to one token holder: ‘The secondary market is so thin that it’s hard to get a good price.’ We are told that tokenization will ‘democratize’ real estate and make it accessible to the masses. The truth is that fractionalizing an illiquid asset will not necessarily make it liquid.

In reality, any brief appearance of liquidity comes from people jumping on the bandwagon of the tokenization hype. Once the craze passes, there is no guarantee it will ever be possible to exit on the secondary market. The only way to exit the investment is for the property itself to be sold. But this raises two further concerns.

First, what happens if the other token holders don’t agree to sell? Second, even if there is an agreement to sell, on what terms? Who instructs the property agent?

Presumably every single decision has to be taken by vote among far-flung token holders, making this more difficult than existing mechanisms for en bloc condominium sales. Worse still, internal governance problems could make negotiating a price difficult, making it harder to obtain the best price for the property on the open market.

Reinventing the wheel

The funny thing is that despite all of this trouble, real estate tokenization isn’t really doing anything new. Condominiums and the strata title system effectively fractionalize land, albeit for owners of individual units.

For the purposes of investment, REITs – managed trust structures which acquire      income-producing properties and offer units or shares for sale – have been around since the 1960s. The difference between a traditional REIT and non-traditional tokenization platforms is that traditional REITs are heavily regulated and are subject, for example, to base capital and business conduct requirements. The marketplace for trading interests in REITs is also more mature and hence more liquid.

Still, the differences between tokenization and more traditional regulated collective investment schemes, of which REITs are a subset, can be difficult to discern beyond the unorthodox manner in which returns are generated. For example, Fraxtor is licensed to provide capital market services in Singapore. While it claims to use blockchain technology and calls its units ‘tokens,’ most of its offerings are structured as collective investment schemes. They are also limited to accredited investors and it does not pretend to create a secondary trading market.

Fraxtor is really a traditional investment scheme dressed up in the guise of a sexy new blockchain concept, and a risky one to boot, which perhaps explains its eligibility being limited to accredited investors. In the end, blockchain technology in the hands of a player like Fraxtor is really just marketing.

That said, this is still less harmful than platforms like Lofty, RealT, and HouseBit, which are far less regulated. In trying to reinvent the fractionalization wheel, they are setting themselves (or rather their investors) up for disaster.

This post first appeared on Tech in Asia and has been republished with permission.

Keywords:  Cryptoassets, tokenization, real estate, property, fraud

AUTHOR INFORMATION

Timothy Chan is a Sheridan Fellow at the Faculty of Law, National University of Singapore (NUS).

Email: chanwxt@nus.edu.sg

Kelvin Low is a Professor at the Faculty of Law, The University of Hong Kong (HKU).

Email: fklow@hku.hk