NFT’S TOKENISATION OF PROPERTY – DOS AND DON’T’S
NFT Real Estate
Property Companies Leveraging Technology
You’ve decided that you want to help more people benefit from the relatively safe risk-adjusted returns provided by the property sector and you see the tokenisation of property as a golden opportunity.
Companies worldwide that are programming digital assets to represent virtual property holdings in the form of non-fungible tokens are increasing daily but that does not mean it is being done with the right structure for success.
The concept of property tokenisation is a relatively simple one. Each token represents a fraction of the property written in a smart contract.
So, for a single property, you can create one token, ten tokens, hundred tokens, and so on.
If you decide to create just one token for a specific property when the buyer purchases that token, they will acquire the rights of ownership of the whole property.
Suppose you create one hundred tokens for one specific property (fractional) when the buyer purchases ten or twenty tokens, they will acquire the ownership rights of that fractional part of the property.
If the buyer purchases one hundred tokens, they will acquire the ownership rights in the whole property.
Although the above concept is straightforward in theory its implementation is far more complex in practice and needs careful thought before launching the business.
Understanding the many legal and regulatory pitfalls that can hinder or bring your project to a grinding halt will greatly enhance your chances of success.
Below, we’ve got the dos and don’ts to help.
Do
Where to incorporate?
Consider whether there is a real need to incorporate the business in so-called offshore jurisdictions including Cyprus, the British Virgin Islands or Curacao. There may be tax advantages but there are good reasons for incorporating in the UK for example such as contributing to the UK economy. You will also be working with the Financial Conduct Authority (FCA) and other competent institutions that can give clear guidance in engaging with businesses on the blockchain. Choosing a jurisdiction like the UK will provide investor confidence.
Real property or the bundle of rights that attach to the property
There is a critical difference between tokenising the physical property itself or the bundle of rights that attach to the real property. Alternatively, you could choose to tokenise the real property and the rights attached to that property. Examples of the type of rights that may attach to the property include: Easements – (the right to use part of another’s property even though you do not own it); Leases and Licences – right to lease and license property collecting rental income; Mortgages and Security – right to borrow money in return for a charge over the property; Covenants – right to impose restrictions over the property; Planning Permission – right to an interest in the planning permission granted by the local authority attached to the property; Profit a Prendre – a right to take something from another person’s land. You need to consider who is responsible for the burdens that come with ownership of a fraction of the property.
Utility or Security Token
Do consider whether you are issuing a utility or security token. The difference is of crucial importance as utility tokens might fall outside the regulated perimeter. However, security tokens are regulated. To clarify, the utility token might fall outside the regulated perimeter if the NFT offers the holder the rights to a specific service, including building access, the use of meeting rooms, and cloud storage. The property token may also be classified as a hybrid token. For more information on hybrid tokens please contact us for a consultation.
The classification of an unauthorised NFT as a utility token is critical because partners such as custodial wallets will not support security tokens unless they are authorised. Custodial wallets are important because the private keys are held by the service provider. They help to facilitate the safe storage and trading of crypto assets. The NFT holder can have confidence that their crypto assets are safe which increases confidence in the NFT issuer particularly if the NFT issuer is relatively new in the crypto asset space.
Well-known custodial wallet providers include: Trustology; 5ire; WireX; Copper; Fireblocks; Digiwallet.
Collective Investment Scheme or Special Purpose Vehicle
Do consider the most regulatory advantageous structure for the project.
a. Special Purpose Vehicle (SPV) (a legal entity created for a limited purpose. SPVs are used for a number of purposes including the acquisition and/or financing of a project, or the set up of securitisation or a structured investment vehicle. They are usually used because they are free from any pre-existing obligations and debts, and are separate to the parties that set them up for accountancy, tax and insolvency purposes);
b. Collective Investment Scheme (S.235 of the Financial Services and Markets Act 2000). Under section 235 (1) FSMA, a collective investment scheme is any arrangement with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangements (whether by becoming owners of the property or any part of it or otherwise) to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income.
Which you choose will depend on the ultimate purpose of the business. If the purpose of the business is to provide investors with the ability to buy, sell and trade tokenised fractions of real estate for profit then it is best to structure it as a CIS which is regulated. Typically, property token offerings are structured as an SPV if there is no yield. SPVs are unregulated and should be used for tokens that solely unlock services and benefits for the user.
You can also structure the business as an SPV which is a CIS.
Furthermore, deciding whether your tokens are classified as utility or security tokens is crucial, as it determines the regulatory requirements and investor protections needed. Utility tokens might bypass certain regulatory hurdles but must be clearly defined to avoid misclassification. Security tokens, on the other hand, require strict regulatory adherence but provide a higher level of investor confidence. Choosing the appropriate structure, whether a Special Purpose Vehicle (SPV) or a Collective Investment Scheme (CIS), depends on your business goals and the nature of the token offering. An SPV might be suitable for service-based tokens, while a CIS is better for profit-driven tokenisation models. Expert legal advice is indispensable in navigating these complexities, ensuring your tokenisation project is legally sound and poised for success.
Don’t
Do not start issuing tokens without first considering the above dos. If you do and you needed authorisation you are breaking the law. It is better to find the right structure for the project first. You may not need authorisation for the first phase, but you need to consider the structure of the token carefully.
Do not just assume that a token can only be issued in return for security investment. You can also issue an NFT in return for a loan. The buyer is deemed party to a loan agreement. An unsecured debt.
Consider getting expert advice first by way of an initial assessment of your white paper before offering tokens.
NFTs in the real estate industry:
Virtual Real Estate Versus Physical Real Estate NFTs:
Virtual Real Estate: In the expanding metaverse, developers create virtual worlds where users can explore cities, socialize, and even buy and sell property. Virtual real estate refers to land or property within these digital environments. You can invest in NFT houses or apartments within these virtual spaces. Some virtual real estate NFTs are tied to physical properties in the real world, while others are replicas of real-world locations.
Physical Real Estate NFTs: These NFTs represent real-life assets (such as houses, offices, or business premises) registered on a blockchain. By doing so, they create an irrefutable history of ownership, recording every transaction associated with the property. Smart contracts within NFTs automate actions, making real estate transactions more efficient1.
Impact of NFTs on the Physical Real Estate Industry:
Programmability: NFTs are programmable through smart contracts. This feature streamlines processes and ensures transparency.
Ownership Records: Each NFT maintains a clear record of ownership, simplifying peer-to-peer transfers.
Legal and Regulatory Considerations for Property Tokenisation
When venturing into property tokenisation, it's crucial to navigate the legal and regulatory landscape carefully to avoid potential pitfalls. One key consideration is the jurisdiction in which to incorporate your business. While offshore jurisdictions may offer tax advantages, incorporating in the UK, for example, can provide regulatory clarity and instill investor confidence, especially when dealing with blockchain-based businesses. Working under the oversight of institutions like the Financial Conduct Authority (FCA) ensures compliance with local laws and regulations, which is essential for long-term sustainability and credibility in the market.
Venturing into the realm of property tokenisation demands a meticulous understanding of legal and regulatory frameworks to ensure smooth operations and compliance. Incorporating your business in jurisdictions like the UK, rather than offshore locations, can offer significant advantages. The oversight of bodies such as the Financial Conduct Authority (FCA) provides clear regulatory guidance, fostering investor confidence. Compliance with local laws not only safeguards your operations but also enhances credibility and trust in the marketplace, which are essential for attracting and retaining investors in the long term.
Another critical aspect is understanding what exactly is being tokenised: the physical property itself or the rights associated with it. Tokenising rights such as easements, leases, mortgages, and planning permissions requires clarity on who assumes the associated obligations and responsibilities. This distinction impacts the legal framework within which the tokens operate, influencing issues such as ownership disputes and financial liabilities that may arise from these rights.
Determining whether to tokenise the physical property or the associated rights is another critical consideration. Tokenising rights such as easements, leases, and mortgages requires precise legal structuring to clarify ownership and responsibilities. This differentiation influences the legal and operational framework of your tokens, affecting aspects like ownership disputes, financial liabilities, and the enforceability of rights. Properly defining and managing these rights ensures that both the token issuer and holders are clear on their obligations and benefits, minimizing potential legal conflicts.
The writer is a specialist in blockchain-related digital assets including NFTs and Cryptocurrency. For an initial consultation please contact: peter@pailsolicitors.co.uk or +44(0)207 305-7491. Charge rates will apply at the prevailing hourly rate and may vary.