Real Property NFTs – Bricks-and-mortar to blockchain-and-token

NFTs could change how we transact real estate, linking property ownership to a digital representation of those rights, better enabling fractional share of property ownership and accelerating transfer efficiency and lowering certain transaction costs.

In this article we look at the nascent and emerging use of digital tokens to represent real estate transactions. Like many real world assets, land and property ownership can be represented by unique digital tokens, often in the form of non-fungible tokens (NFTs), that can evidence transactions in respect of the linked land in question, and hence support claims of title and ownership.

Tokenising land ownership

In the virtual world this process is relatively straightforward. By way of example, the Sandbox metaverse, home to Snoop Dogg’s Snoopverse, sell NFTs, appropriately named LAND tokens, that give the owner various rights in respect of a virtual plot of land. The ownership of a LAND token in the Sandbox allows the owner to transform and reshape the pre-built terrain to construct buildings and other features and, in effect, control how the virtual land is used. LAND owners can also rent or stake their land and, in an apparently feudal fashion, participate in the metaverse’s governance. 

However, tokenising real-world land ownership is more complicated. Land or real property ownership is typically tied to government-run title registries or intricate physical title deed systems. To transfer land and real property by NFT is not as straightforward as scanning title documents and incorporating them into the NFT’s metadata, as suggested by some enthusiastic crypto advocates. Nevertheless, there are examples of land and real property sales using NFTs.

NFT Apartment

The world’s first real property sale by NFT took place in Ukraine in 2017, when an apartment was sold for 36 ETH (the native currency of the Ethereum blockchain – then equivalent to US$ 93,000). The transaction involved the transfer of ownership of shares in a US limited company registered at the Ukrainian land registry as the owner of the apartment. The NFT’s metadata included an image of a QR code that, when scanned, allowed the purchaser to complete the necessary documentation to effect the transfer of the shares in the US holding company from the seller to the purchaser.  This approach was necessary because the Ukrainian land registry could not transfer the title of the apartment directly as a result of the parties having transferred the NFT between digital wallets. 

Key challenges and use cases

The Ukrainian transaction underscores a key challenge – NFT transactions that tokenise land or real property do not directly link to the government land registries to effect legally effective transfer of ownership. While Australian land registries have considered moves to adopt blockchain technology as the mechanism to officially record property ownership, those proposals have not yet been adopted.

For a real property transfer to be implemented through an NFT or other digital token, that token must be linked to legally enforceable documentation that formalises the transaction represented by the transfer of the digital token within the relevant jurisdiction. These transactions are possible but require significant legal groundwork and integration between the documentation and the digital token. One constraint is that NFTs have limited storage capacity because of the need to economise data on the underlying blockchain that stores the NFT. Consequently, it was necessary to rely on the QR code in the Ukrainian example above to link to other documents. This process is likely to evolve until more and more of the legal requirements become digitalised.

NFTs can also be applied to other property-related rights, such as leases, licences or ancillary rights that attach to the use of a property. Projects are underway in Europe to implement the use of NFTs for car park reservation and licensing. The ability to easily transfer a car park licence makes the asset liquid, especially for long term car parks. Pop-up shops, markets or storage centres could also benefit in the short term. We look forward to observing the evolving use cases over time.

One prominent use case for NFTs for real property is fractionalised ownership, where each NFT represents a share in a property, whether it’s 1/100^th or 1/1000^th of a share or any other fraction. This enables small scale investors to acquire an interest in large property assets that would not normally be available to those investors. As well as democratising property ownership, such a model reduces transaction costs on the basis that transfers of NFTs are much faster than transfers of a property. The increased fluidity has the potential to offer increased liquidity around the ownership of property assets. The Kunang Kunang Tent Resort in Indonesia is an example of a project backed by tokenised fractional ownership of the resort. The resort is fully operational and delivered its first dividends to NFT holders last year. Jurisdictionally specific laws will need to be considered on a case-by-case basis. Real estate is often a heavily regulated sector, and restrictions can apply to cross-border investment in real property, and depending on the structuring of the project, investment activities may trigger financial services regulation. See table below for further analysis.

Financing the NFT-based real property transaction

In another use case for NFTs, advocates of NFT-based real property dealings propose that using NFTs representing shareholder interests as collateral for property purchases, rather than traditional mortgages, could streamline real estate transactions, making them more cost-effective, efficient, and secure. However, it assumes that an NFT can legally represent a share in the holding company, a determination that would need to be made based on the specific laws of a given jurisdiction.

In a typical real property financing scenario, the buyer (mortgagor) grants a real property mortgage to the lender (mortgagee). Legally, the mortgagee is recognised as a secured creditor, granting them the authority to seize and sell the real property to settle the mortgagor's debt if it is not repaid.

In an NFT-based real property transfer, it is proposed the need for a mortgage on the property is not required. Instead, the lender takes a security interest over the all the shares in the holding company represented by the NFT. This security interest is documented in a security agreement. In case of default, the lender can enforce its security interest in the NFT and sell the holding company.

On its face, the two above-mentioned security options may seem to accomplish the same objective. However, each has distinct implications for the lender and the buyer in terms of their rights, responsibilities and risk.

Regulatory frameworks

To successfully offer property-backed NFTs, it is crucial to navigate and comply with over-arching legal and regulatory frameworks that apply to both the real property asset class and crypto-assets. The table below outlines some key areas relevant to property-backed NFTs under Australian law.

What next?

We expect to see an increase in the tokenisation of real-world assets in the future and the combination of blockchain and real estate transactions demonstrates significant potential to transform how those assets are managed and exchanged.