Asset Tokenization in the Real Estate Industry and Possible Opportunities in the Financial Services Industry

Background

The International Financial Reporting Standards (IFRS) defines an asset as “a resource controlled by an entity with the expectation that it will generate a positive future economic benefit.”

When one mentions “assets” one conventionally perceives real estate, infrastructure, stocks and bonds, precious metals, commodities, intellectual property and cash etc. However, technological advances in the financial services sector have recently redefined how we perceive assets through the process defined as “asset tokenization” (hereinafter “tokenization”)

This Article expounds further on tokenization, with particular emphasis on the real estate industry, and the possible opportunities in the financial service industry.

Introduction

What is Tokenization?

Tokenization is the process of digital transformation of asset accounting and management in which the ownership of an asset is repre­sented by a digital token backed by blockchain technology.[1] Simply put, it is digital representation of ownership and management rights of real-world assets.

A token is an accounting unit used to represent user’s balance in a digital ac­counting system which allows proving ownership of a corresponding asset. Tokens may either represent tangible assets or intangible assets and represent a share or entire ownership of a digital asset.

There has been an increased activity in relation to the digitization of real-world assets globally. Research and surveys from institutions such as the World Economic Forum (WEF) & McKinsey predict that up to 10% of the global Gross Domestic Product (GDP) will be digitally stored and transacted with the help of blockchain technology by 2025–2027.[2]

Tokenization offers a wide array of prospects in how real-world assets can be used, exchanged and managed and presents an opportunity for the financial services industry to adopt blockchain technology.

Tokenization in the real estate industry

It is estimated that the real estate industry contributes to approximately 10% of Kenya’s GDP.[3] However, the real estate assets generally pose the challenge of illiquidity to the owners/developers and hinderance to investment due to the high initial cost of purchasing such assets.

Further, the transactions in the real estate sector involve various intermediaries such as agents, valuers, lawyers and government lands registries hence there are various transactional costs in addition to the significant amount of time taken to complete the processes.

The process is, however, gaining traction globally. For instance, in 2018, Regis Aspen Resort, a luxury resort in Colarado became the first tokenized commercial property in the United States of America through Aspencoin which raised $18 million for the resort’s owners under stewardship of the asset management firm, Elevate Returns.[4]

Ever since, many owners and developers of high-end commercial properties in other regions have embraced real estate tokenization as a means of democratizing the investment pool and as a means of crowdfunding. Various online platforms allow such as Securitize, tZero, Polymath etc. for tokenization of real estate and other real-world assets

How Does it work?

Tokenization involves a tokenization platform, which is a registry of property rights and is not fundamentally different from a traditional centralized accounting system or a paper record like the physical land registries.  

A smart token that contains or is related to data associated with the asset can be used to represent the property. An issuer creates tokens to indicate  the users’ ownership rights in the Property. Users need trusted third parties to validate legal facts that they ordinarily cannot accomplish themselves, such as births, deaths, and notary acts .

The tokenization process entails:

1. Asset identification – identifying the asset for tokenization, considering its market value, potential liquidity and regulatory compliance
2. Token design – determining the token standard to be followed such as ERC20 or ERC721
3. Blockchain integration – choosing a blockchain network for issuance of the tokens
4. Offchain data integration – use of verification services to ensure the accuracy and reliability of information relating to the tokenized asset.
5. Token issuance – minting and making the token available for utilization

Advantages of tokenization

1. Enhanced liquidity of rather illiquid assets.
2. Democratization of ownership through fractional ownership of the tokens.
3. Improved transparency of the tokenized asset which is maintained on the blockchain that ensures auditable asset management and immutability of transactions.
4. Increased accessibility through fractional ownership which increases the potential user base through the use of blockchain based applications.
5. Lower transaction costs as the use of smart contracts[5] streamlines processes such as transfer of ownership and asset management for the asset owners and potential investors.

Possible challenges in tokenization.

1. Security vulnerabilities in the blockchain network which may be susceptible to cyber-attacks and hacking.
2. Regulatory compliance. Tokenized assets may be considered as securities and as such the CMA will have to give further guidance and regulations behind dealing and trading in tokenized assets.
3. Integration & interoperability of other related systems such as records at the lands registries on the blockchain is yet to be effected and as such hinder efforts to undertake tokenization.

REITs vis-a-vis Tokenized Real Estate

Real Estate Investment Trusts (REITs) have emerged as a popular investment vehicle in Kenya’s real estate market. A REIT is a regulated collective investment vehicle that enables people to contribute money’s worth as consideration for the acquisition of rights or interests in a trust that is divided into units with the intention of earning profits or income from real estate as beneficiaries of the trust.[6]

Investors contribute money or buy units in a REIT in similar manner to shares in a company, in exchange for rights or portion of the income generated by a portfolio of real estate. The People investing in a REIT, like shares, do not have the day-to-day control over the management of assets of the REIT as assets are managed by a professional and licensed REIT Manager. 

There are three type of REITs in Kenya:

1. Development Real Estate Investment Trusts (D-REITs): A type of REIT in which investors pool their capital together for purposes of acquiring real estate with a view to undertaking development and construction projects.
2. Income Real Estate Investment Trust (I-REITs): A type of REIT in which the investors pool their capital for purposes of acquiring long

term income generating real estate including housing, commercial and other real estate.

1. Islamic Real Estate Investment Trusts

A unique type of REIT that only engages in sharia compliant activities.

In Kenya, REITs may either be listed or unlisted. A listed REIT’s units are traded on the Nairobi Securities Exchange (NSE) like any other company share, offering investors a liquid stake in real estate. 

The Capital Markets Authority (CMA) is responsible for registration and regulation of REITs. REITs operate under the Capital Markets (Real Estate Investment Trusts) (Collective Investment Schemes) Regulations, 2013. The Regulations require REITs to distribute at least 80% of distributable earnings to unitholders.[7] REITs attract various tax benefits such as transfer of Property to a REIT attracts stamp duty exemptions under S96A of the Stamp Duty Act.

Why choose tokenization over REITs

In as much as REITs offer an alternative way of investment in real estate, there are various factors that make tokenization of real estate much favorable as opposed to REITs.

 They include:

1. Ownership structure.

While investing in REITs, it is important to note that you hold shares in the REIT which owns the assets. Accordingly, you do not have direct fractional ownership in the real-world asset which is the case in instances of tokenization.

• Increased Liquidity

By allowing tokens to be traded on the blockchain platform, this offers much additional liquidity as it allows for any person in the world to invest and sell such tokens whereas publicly listed REITs in Kenya are restricted and subject to regulations by the CMA. Further, investors may leverage on tokenization in crowdfunding which in turn would provide alternative sources of raising capital through initial coin offerings (ICOs) instead of relying on financing.

• Increased transparency

Whereas in REITs, the investor has limited control over the activities of the REITs and they cannot directly identify the transactions undertaken, in tokenization, an investor may be able to see the history of transactions in respect to the token which is recorded in the immutable ledger backed by blockchain technology.

Such transparency is likely to curtail the influx of proceeds of crime, terrorism financing and money laundering from infiltrating the real estate industry as the blockchain technology is immutable and available for users in the blockchain to view. Currently, the real estate industry is vulnerable as a conduit for illicit funds through cash purchases of real estate at inflated prices which affects the property market valuations.

• Reduced entry barrier.

Tokenized real estate has a lower minimum purchase requirement, making them accessible to a more extensive and diverse group of investors. However, REITs have varying entry requirements depending on the type of REIT and local regulations.

• Reduced costs/fees and faster transactions

Traditional REITs have numerous fees, including asset management fees, acquisition fees, servicing fees, and other operational expenses whereas Tokenization allows for peer-to-peer transactions on the blockchain, which dramatically reduces these expenses.

Further, transactions involving REITs may take significantly longer than transactions involving tokenized real estate which happen almost instantaneously through leveraging on the blockchain technology and cutting off intermediaries through the use of smart contracts.  

Smart contracts are self-executing codes to undertake certain activities to achieve deterministic outcomes without the use of intermediaries. The use of such smart contracts may greatly reduce the time of handling such transactions.

Opportunities in the Real Estate Industry for Financial Services Industry

High Net Worth Individuals (HNWIs) and the financial services industry are cognizant of the growth of tokenized assets and should be at the forefront in embracing this opportunity to diversify their investments. Larry Fink, CEO of Blackrock, one of the world’s leading investment providers, reckons that the financial services industry should anticipate tokenization of all financial assets.

Accordingly, the financial services industry should seize the opportunity to provide bespoke financial products which embrace tokenization as the same will lead to:

1. Enhanced lending and collateralization through using tokenized real estate as collateral.
2. Introduction of new products such as tokenized real estate derivatives and EFTs for diversified investments.
3. Integrating smart contracts to loan agreements and the due diligence procedures will reduce the legal costs involved in such transactions.
4. Lower transaction costs due to reduced intermediaries such as estate agents, lawyers and other professional services and the blockchain technology that works 24/7.
5. Democratization and removal of the bar to investment ownership and investment of real estate by allowing smaller investments from a larger pool of investors who may invest from anywhere in the world
6. Increased market liquidity arising from a wider pool of investors.

Conclusion

In spite of the above opportunities, there is a great deal of uncertainty and lack of clear regulations to allow the financial services industry to fully explore and exploit virtual assets. As such, players in the financial services industry remain skeptical and reluctant to adopt tokenization.

Nonetheless, a move in the right direction is being made as there is currently a Virtual Asset Service Providers Bill, 2025 which aims at providing clarity in regulation of virtual asset service providers and address risks associated with the misuse of virtual asset products and virtual asset service provider services.

We are constantly following up on the developments of legislation in the virtual assets space and note to keep our readers informed.

DISCLAIMER

This article is for informational purposes only and does not constitute legal advice or opinion. The information contained in this article is based on general principles of law. You should not rely on the information in this article as a substitute for obtaining legal advice from a licensed attorney in your jurisdiction. The author and publisher of this article are not responsible for any actions taken or not taken based on the information contained in this article.

[1] Dr. Pavel Kravchenko, Dmytro Haidashenko, An effective approach to asset tokenization, White Paper, pg 5

[2] Dr. Pavel Kravchenko, Dmytro Haidashenko, An effective approach to asset tokenization, White Paper, pg 6

[3] https://cytonn.com/uploads/downloads/kenya-q12024-gdp-note-v5.pdf

 [5]Smart contracts are digital contracts stored on a blockchain that are automatically executed when predetermined terms and conditions are met.

[6] https://www.nse.co.ke/real-estate-investment-trusts/

[7] Regulation 72, the Capital Markets (Real Estate Investment Trusts) (Collective Investment Schemes) Regulations, 2013.

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