Ten years ago, if you heard about blockchain you were one of the few. Nowadays, however, you are truly the exception if you have not yet picked up on the term. While many have heard of it, few really know what it is and what the endless possibilities are. So, what is blockchain? And perhaps even more importantly, what can it be used for?
In this article, we will attempt to explain the above mentioned while putting the focus on the application of blockchain in real estate.
What is blockchain?
In short, blockchain is a digitized, decentralized, and distributed public ledger that records transactions. For a transaction to be recorded on the blockchain, a user must request a transaction to be recorded. This request is broadcast to a peer-to-peer network of computers (nodes) which uses algorithms to process the request. Subsequently, the request is verified by the nodes. Once the request is verified, the ledger is updated by adding a new block of data to the blockchain. The transaction is now complete and stored on the blockchain.
Source: Cloud Credential Council
Each time a transaction takes place a block is created and linked to the previous block in the blockchain, hence the name blockchain. Each block contains data (information) of the transaction, a hash and the hash of the previous block (this hash is used to link the block with the previous block). A hash can be seen as a fingerprint; it identifies a block with all its content and is always unique. Once a block has been recorded inside the blockchain, the block cannot be deleted or altered. This is because tampering with a block causes the hash of the block to change as the hash is unique to the data of the block. That change makes the following block, which originally pointed to the first block’s hash, invalid. In fact, changing a single block makes all the following blocks invalid. This setup gives the blockchain a strong level of security. If one would want to tamper with the data of a block, they would have to calculate all the hashes of the following blocks to hide the tampering of the block.
What real-life applications can blockchain be used for?
There are many ways blockchain can be applied in real-life cases. Think for example about money transfers. The original concept behind the invention of blockchain was to solve this problem. Bitcoin was created to cancel out the middleman in any transaction, thereby reducing the transaction cost and increasing transaction speed while preserving anonymity. The company Ripple built on this idea by introducing XRP, a cryptocurrency used to facilitate cross-border transactions with the idea to replace the outdated 1973 SWIFT system.
Aside from purely monetary transactions, Blockchain has shown to have other purposes. It is a way to more safely store and retrieve valuable and private information. Adding blockchain technology to a data storage solution can provide greater security and integrity. Furthermore, using blockchain in the voting system can be a game changer with regards to avoiding election fraud. Using blockchain technology can for example make sure that nobody votes twice, only eligible voters are able to vote, and votes cannot be tampered with. It could also increase the accessibility by making it as simple as pressing a few buttons on your smartphone. This could increase vote turnup thereby enhancing the chances of a fair election.
While blockchain can have many functionalities, we would like to put the focus of this article on the role of blockchain in real estate.
The role of blockchain in real estate
Blockchain applications go far beyond cryptocurrency. Asset tokenization and smart contracts are technology that also have important real-life applications and use blockchain in their functionality. Real estate is a sector where this kind of technology has a promising future. The global real estate market is one of the largest markets on earth and was valued at 260 trillion euros in 2021.
In simple terms, real estate involves the buying and selling of properties. In reality, however, it is far from simple. The technical and administrative process with multiple parties involved makes transactions in this sector very complex. Blockchain has the potential to solve this problem and make the process much easier. For this, the concepts of asset tokenization and smart contracts need to be introduced. Let us first start with tokenization
Tokenization is a technology that divides the ownership of an asset (such as a building) into digital tokens. In other words, these digital tokens are used to fragment the asset into different shares and ownership.
Now, how exactly can tokenization change the landscape of real estate?
With tokenization, anyone can invest in any real estate asset by simply purchasing digital tokens of the tokenized asset. As previously explained, a token is a digital representation of an ownership stake in an asset (e.g. a 10% stake in a 20-unit apartment building). Your token, representing your stake in the asset, is recorded on the blockchain and the blockchain documents, stores and verifies that you are the owner of a token (giving you undeniable proof of ownership). Once the token is on the blockchain, this allows you to trade or sell your token outside of the normal arduous real estate process as it automates the process. Transfer of ownership could be settled between only the buyer and seller without involving agents and banks who act as middlemen.
Source: Blockchain Capital Partners
In this way, practically everyone will be able to participate in the real estate market without needing a large amount of capital. For instance, in 2019, a €6.5 million luxury villa in Paris was tokenized and split into 1 million pieces, valued as low as €6.5 each. A prospective buyer can therefore determine how much he/she is willing to invest. This enables any investor, regardless of their financial wealth, to add real estate as a new form of investment in their portfolio, thereby diversifying the portfolio at minimum cost. It also increases the liquidity of the investment. After all, real estate, in its traditional sense, is very illiquid. A 2021 study by Josh D. Morton showed that only 3% of the global population has invested in real estate, but over 80% view real estate as a good investment. Real estate might soon no longer be an investment that can only made by wealthy individuals or institutional investors but will be available for everyone. Increasing the number of participants in the market will subsequently make the market more efficient, thereby resulting in market prices that are more in line with intrinsic values.
Some might notice that this concept already exists in the form of Real Estate Investment Trusts (REITs). So, what is the difference?
The difference is that, while it is true that REITs also allow you to own a part of real estate property through owning shares of certain real estate assets, they initially still require you to invest a higher minimal amount of capital to be able to participate. This amount already excludes many investors. Furthermore, investors will need to pay management fees, entry fees, exit fees and so on that are inherent to any investment fund. Also, investing in digital asset tokens gives you the possibility to buy ownership in specific assets while a REIT is a bundle of many types of real estate assets. Because REITs are already diversified, you will pay for this diversification through the fees charged. By having the option to buy ownership in specific assets, you can add this type of investment to further diversify your own existing portfolio instead of adding an already diversified one.
While tokenization sounds great, it must still overcome several hurdles to reach its full potential, most notably he regulatory uncertainties. While REITs are regulated as securities, it is unclear whether real estate tokens will be regulated as securities or property. Besides this, several legal and practical issues could dictate the success of tokenization. Tokenization is still in its early stages and its success will depend on the willingness of investors to adopt this new technology, both from the regulatory agencies and from consumers.
As mentioned previously, in addition to tokenization, smart contracts are a technology used in blockchain to further facilitate real estate transactions. We start by defining smart contracts.
Smart contracts are self-executing contracts in which the terms and conditions of the agreement are written into lines of code which are recorded and verified by the blockchain. Smart contracts could be seen as normal paper contracts that are digitized via lines of code and execute when certain rules, defined in the contract, are met.
The rules can be intimidating, which could make one hesitant about investing in the real estate market. They vary wildly depending on which country you are buying in, what type of property you want to buy and how you are going to buy it. All complexities and regulations require multiple middlemen (agents, banks, lawyers, …) to become involved, resulting in a significant cost to the buyer for completing the transaction. If it were possible to codify housing rules and regulations on the blockchain, smart contracts could be used to drastically simplify the process. A seller could simply send the location, desired price, and some other ownership information to the contract. The smart contract could then use the database of rules and legislation to generate contracts, deeds, tax records and anything required to finalize the sale of the house instantly. A prospective buyer could then meet with the seller, agree on pricing and terms in the contract, send their digital signature to the contract verifying and executing the purchase and updating all the documents as required.
As smart contracts use blockchain technology, they are immutable. No one can rewrite the code. As a result, the contract is only automatically executed when the terms of the contract, that has been agreed upon by all parties, have been met.
Another example of smart contract application is a lease being set up by the lessor and the lessee. The lease agreement could be set up with the use of a smart contract and the contract could then be executed automatically when terms and conditions in the contract have been met. It could go as follows.
The property owner (lessor) initiates i.e. rent, property management fee, payment frequency, ...), into a new smart contract. The prospective lessee then reviews the lease’s conditions through an online platform and once an agreement has been reached, they digitally sign the smart contract using a key that denotes his or her identity, or that of their organization. The lessor also digitally signs the contract, which then turns into a legally binding digital smart contract stored on a blockchain. At every agreed payment date, the smart contract digitally withdraws funds from the lessee’s account. At that time, the money is immediately deposited into the lessor’s account. Rent payments can be automated, so the right amount is always paid on time and is fully traceable. This reduces errors and the cost of human involvement. Additionally, property management fees can automatically be calculated, charged and paid whilst the lessee’s rights are protected by the inherent traceability of transactions.
When the smart contract expires, security deposits will be automatically returned to the lessee (keeping into account possible property damage reports filed on the blockchain) and all necessary finishing documentation will be generated.
Key points to remember
Both tokenization and smart contracts can be used to make real estate investment easier, more accessible, more liquid and more transparent. As this technology allows more people to participate and transactional information to be public and anonymously consultable on the blockchain, we believe this will make the real estate market more efficient, minimizing the gap between market prices and the intrinsic value of property. However, the technology has its limitations and will probably not see mass adoption any time soon. The technology works and there have been real-life use cases, but to put it into full-scale adoption is very difficult in practice. For tokenization and smart contracts to become the future, better regulations need to be put in place. For now, the technology remains in the shadows waiting for the light to shine on it.
Nathan Van Rompuy
Consultant AION Consulting
Josh D. Morton, Blockchain Holds Potential For Commercial Real Estate, Law360 (Jan. 4, 2021)