Security Tokenization – An Emerging Trend in Real Estate Markets
Audrey Rogers and Claire Alexander
The real estate industry is dealing with transformation on multiple fronts. The emerging trend of security token-based financing is the latest wave in commercial real estate disruption and involves the use of security tokens, built on blockchain technology, to “tokenize” equity or debt of real estate assets.
In this article, we examine the emerging trend of security tokenization and consider its implications in the commercial real estate industry.
Tokenization is made possible by blockchain, the decentralized ledger software that underpins cryptocurrencies such as Bitcoin or Ethereum. Blockchain is a database that is distributed amongst multiple parties with each party storing a complete record of all the data. New records are stored in blocks, and once cryptographically validated, linked to the previous block to create a chain.
The wave of initial coin offerings (“ICOs”) in 2017 and 2018 was a source of great controversy in the crypto sphere, with China and South Korea banning the practice entirely and the U.S. Securities and Exchange Commission investigating a number of ventures and founders over purportedly illegal activities. As regulators continue to crack down on non-compliant ICOs, security tokens have emerged as an alternative platform.
Security tokens are digitized financial instruments attached to underlying tangible assets. They tokenize traditional financial instruments (i.e. equity, bonds or stocks) as well as tangible assets such as real estate and fine art. The key distinction setting security tokens apart from other cryptocurrencies is that security tokens are asset-backed and fall within existing regulatory parameters.
Tokenization is a fairly new development in the crypto industry, but several players have already made significant strides in this area. For example, in early January, DX.Exchange, an Estonia-based crypto firm, launched its trading platform that allows investors to purchase shares of popular Nasdaq-listed companies, such as Apple, Tesla, Facebook and Netflix, indirectly through security tokens. Each token is backed by a share of the chosen Nasdaq-listed company and entitles the investor to the same cash dividends.
The World Economic Forum projects that $8 trillion worth of securities will undergo tokenization in the next 10 years and that 10% of the world’s GDP will be tokenized in the next 20 years. While the variety of potential assets that can be tokenized is expansive, one asset class that appears ripe for tokenization is real estate.
APPLICATIONS IN THE REAL ESTATE MARKET
Historically, investors in real estate markets have faced the industry’s large capital requirements, illiquid investments, costly third-party intermediaries and slow transaction times. Therefore, the real estate industry presents the perfect use case for tokenization, as security tokens reduce the need for intermediaries, automate the execution of contracts, and provide greater liquidity through easy access to secondary markets and fractional ownership.
Two recent experimental projects illustrate this emerging trend. In October of 2018, the St. Regis Aspen resort completed its security token offering. Investors received “Aspen coins”—representing shares in Aspen REIT, the single-asset REIT that owns the hotel—to denote their partial ownership in the project. The crowdfunding campaign, via Indiegogo, started in August and concluded on October 1st, raising $18 million. In November of 2018, blockchain startup Harbor launched its institutional-grade platform for tokenizing private securities. The first offering on the platform was a tokenized REIT from Convexity Properties—a subsidiary of DRW Holdings LLC—representing $20 million of private equity in The Hub at Columbia, a premier off-campus, student housing high-rise of the University of South Carolina.
Just as investors in traditional real estate investment trusts can purchase shares that represent an ownership stake in a portfolio of real estate assets, a security token offering functions much the same way. However, for security tokens, distributed ledger technology is used to record the transaction and any subsequent transactions on the blockchain.
Security token offering issuers have a variety of securities exemptions available, including Regulation D, Regulation A+ and Regulation CF. Both the St. Regis and Hub tokenizations were structured as Regulation D 506(c) offerings, which allows the issuer to raise an unlimited amount of capital, generally solicit or market the deal, but restricts the issuer to accepting capital from verified accredited investors.
The St. Regis and Hub tokenizations may prove to be harbingers of disruption in commercial real estate from tokenization. In the current market, REITs and index funds bundle thousands of different properties and assets, which can restrict investors’ choices. Fractionalization, using security tokens, will allow investors to customize their portfolio and leverage their long and short term positions. Further, this unbundling concept may lead to new investment products, such as the bifurcation of rental income stream and property appreciation cash flows in commercial real estate.
Market frictions to buy and sell (such as high spreads, lack of market depth and high settlement costs) can cause real estate assets to trade at a discount to net asset value. Building on blockchain’s infrastructure, tokenized securities reduce these frictions by providing divisibility, low cost of transfer, and automated compliance. Accordingly, real estate assets are attractive tokenization opportunities. This area is evolving and we will continue to see how stakeholders use tokenized securities to tap new sources of capital in real estate markets.
New Proposed Opportunity Zone Regulations Offer Clarity and Incentives to Real Estate Investors
On October 19, 2018, the Department of the Treasury and the Internal Revenue Service (collectively, the “Treasury”) issued proposed regulations (the “Proposed Regulations”) under new section 1400Z-2 of the Internal Revenue Code, relating to the highly publicized “qualified opportunity zone” (“QOZ”) tax incentive program enacted as part of the 2017 tax reform bill. The QOZ program offers tax incentives to taxpayers for making investments into certain designated low-income areas. Currently, over 8,700 census tracts in all 50 states, the District of Columbia, Puerto Rico, and the Virgin Islands have been designated QOZs based on a nomination by governors and certification by the Treasury. The aim of the QOZ program is to spur investment into these low-income areas, resulting in economic revitalization and the decentralization of innovation across the country.
If properly structured, an investment into a QOZ can provide taxpayers with substantial tax benefits. The QOZ regime allows taxpayers to defer recognition of capital gains by investing such capital gains in a qualified opportunity fund (“QO Fund”) during the 180-day period beginning on the date of the sale or exchange that gave rise to them. The recognition of gains invested in a QO Fund is deferred until December 31, 2026, unless the taxpayer’s interest in the QO Fund is sold before that date. The taxpayer’s initial basis in the QO Fund investment is zero, and the basis is increased to reflect the gain recognized on such date. If, prior to such date, the taxpayer achieves a five-year holding period, a basis increase equal to ten percent of the deferred gain is allowed, and if the taxpayer achieves a seven year holding period by such date, there is an additional increase equal to five percent of the deferred gain. Finally, if the taxpayer holds the QO Fund investment for ten years, then the taxpayer may elect to increase the basis of the investment to equal its fair market value on the date of its sale or exchange, eliminating any gain upon exiting the investment.
In order to access these tax benefits, a taxpayer must invest into a corporation or partnership which qualifies as a QO Fund. A QO Fund is an investment vehicle organized for the purpose of investing in “qualified opportunity zone property” (“QOZ Property”) and that holds at least 90% of its assets in QOZ Property, as measured based on an average of two semiannual testing dates. QOZP generally consists of direct investment in “qualified opportunity zone business property” (“QOZ Business Property”) and certain equity interests in qualified subsidiaries that operate in QOZs. QOZ Business Property is defined as tangible property used in a trade or business of the QO Fund, where (1) the QO Fund acquired such property for cash from an unrelated person in a sale or purchase after December 31, 2017, (2) either the QO Fund is the “original user” of such property or the QO Fund “substantially improves” the property, and (3) during substantially all of the QO Fund’s holding period for such property, substantially all of the use was in a QOZ. A property is “substantially improved” if, during any property’s 30-month period beginning on the date of acquisition of the property, “additions to basis” with respect to the property in the hands of the QO Fund exceed the adjusted basis of the property in the hands of the QO Fund at the beginning of such period. The statute does not define original use in this context.
An equity interest in a subsidiary is QOZ Business Property if the subsidiary qualifies as a “qualified opportunity zone business” (“QOZ Business”). Generally, a QOZ Business is a trade or business (other than certain enumerated “sin” businesses) in which all of the tangible property owned or leased is QOZ Business Property, and which satisfies the following requirements: (1) at least 50% of the subsidiary’s total gross income is derived from the active conduct of such business, (2) a substantial portion of the subsidiary’s intangible property is used in the active conduct of the business, and (3) less than 5% of the subsidiary’s property is attributable to nonqualified financial property (“NQFP”), as measured by unadjusted basis.
The Proposed Regulations offer a number of welcome technical changes, but also raise a host of questions for Treasury to address. For example, the Proposed Regulations provide a needed working capital safe harbor, which provides that working capital assets are not treated as NQFP if the taxpayer provides a written schedule consistent with the ordinary start-up period of a trade or business for the expenditure of working capital assets and designates such assets for the acquisition, construction, and/or substantial improvement of tangible property in a QOZ. However, the Proposed Regulations also leave a number of key questions unanswered, such as whether the original use requirement may be applied to existing abandoned tangible property, the treatment of profits interests and other equity interests offered in exchange for services in a QO Fund, and whether capital gains derived from offsetting financial positions may be used to invest in a QO Fund.
The QO Fund regime presents attractive opportunities for REITs and REIT shareholders to defer capital gains. A QO Fund, or its subsidiary, may be structured as a REIT and grant its investors the benefits of both the QOZ and REIT regimes. REITs themselves can also invest in QO Funds to defer existing gain and potentially eliminate future gain. Finally, REITs that own or which to acquire investments in QOZs may be able to sponsor their own QO Funds to bring in alternative capital to finance these investments. The Proposed Regulations already offer a number of rules that take into consideration the concerns of REITs and REIT shareholders, such as starting the 180-day period in which REIT capital gain dividends may be invested in a QO Fund on the day such dividends are paid. While uncertainties remain (for example, whether a REIT can designate its dividends as capital gains prior to the expiration of a REIT shareholder’s 180-day period to invest these gains in a QO Fund), the Proposed Regulations signify that Treasury envisions REITs and REIT shareholders as key components of the new QOZ regime and is willing to take the necessary technical steps to accommodate such stakeholders.