Major Problems with Tokenizing Real Estate
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From the Editor: Can you own a part of a building? Yes. Can your ownership be managed through the blockchain? That is a definite "maybe."
According to the Global Tokenized Real Estate Market Guide: 2024 Edition from STM.co and presented by the RWA Foundation, property represents a $375 trillion market. They predict that by 2030 tokenized real estate will be an $8 trillion sector. That seems worthy of exploration. To begin our exploration, we have brought in a guest article from our friends at CuBitREvolution.comTM. If you want to see the article in context, here is the link: https://cubitrevolution.com/tokenizing-fractional-real-estate-ownership/
Tokenizing Fractional Real Estate Ownership
1.0 Tokenizing Real
Estate
Currently,
one of the most popular applications of blockchain technology in real estate is
tokenization of real estate ownership. Tokenization is a form of fractional
real estate ownership. The notion is that each token, an automated contract
called a “smart” contract, represents a fractional ownership share of a
specific property. Since blockchain tokens are non-fungible tokens (NFT), let’s
refer to fractional real estate (RE) ownership tokens as RE NFT.
In
recent years, crowdfunding of real estate has gained popularity. It too
represents a form of fractional ownership, except that most crowdfunding
projects put the participants in the role of lenders, rather than being owners
of fractions of a property. For any crowdfunding project that cedes a portion
of ownership to participants, generally the same points below about RE NFT
apply.
1.1 Fractional Real Estate Ownership
Isn’t New
Fractional
ownership of real estate is nothing new. It is recognized in law through joint
tenants in common (JTIC) and in business in the form of real estate
syndications. It is arguable that most real estate investment trusts (REIT) are
a form of fractional ownership.
REITs
are distinct from JTIC and most syndications because REITs often contain a
portfolio of properties, rather than being tied closely to just one, or two,
properties.
1.2 Democratizing Real Estate
Fractional
ownership of real estate is attractive to many people. It is attractive to
professional real estate investors because it shifts the burden of capital to
fund deals from them to a herd of “silent” investors, each with a small stake.
These other investors are silent because they aren’t involved in the details of
making the project successful. They are limited to contributing money and
receiving proceeds.
For
people with modest amounts of cash to invest, fractional ownership gives them a
chance to enjoy the benefits of real estate investing without requiring them to
invest large amounts of capital and without requiring them to become real
estate investing experts.
Spreading
capital requirements for real estate investing from professional investors to a
host of small investors is often referred to as “democratizing” real estate
investing. The name alone sounds like a good idea, and democratizing real
estate ownership (letting even the ‘little people’ get a piece of the action) isn’t
a bad idea. The terminology is often used as a sales point for fractional
ownership offerings.
To
graphically illustrate the target buyer for democratized real estate, envision
a white-haired, retiree, a grandmother living on a fixed income. She cashes in
a banking certificate of deposit (CD) from her retirement nest egg and uses the
money to buy a fractional real estate ownership share. Sales literature tells
her she will receive steady monthly income, sometimes beginning the same day
she puts in her money. She invests, hoping this will make her life easier and
help her retirement nest egg last longer than it would if she left it in the
bank. Don’t forget Grandma. She will show up a little later in this discussion.
1.3 Securities and Fractional Ownership
Crowdfunding
has recently been carved out for a special place in securities laws to allow it
to function without the massive oversight of a public stock offering or limiting
investors to “Accredited Investors” who can prove by their current wealth that
they are sophisticated enough to understand the risks they are taking when they
invest. However, there has been no such carve out by the SEC for RE NFT.
The
Securities and Exchange Commission (SEC) is currently taking a very aggressive
approach to everything crypto. They are categorizing almost anything in the
blockchain world as securities, often with very good reasons.
Regardless
of the aggressiveness of the SEC, most people who have even a little knowledge
of securities laws can look at RE NFT and see that they meet the criteria of a
security. Reputable Offerors should handle them as securities and issue the
appropriate documentation. Appropriate documentation ranges from certain required
crowdfunding disclosures to a private placement memorandum (PPM), all the way
up to the small library of documents required for a public security offering.
2.0 Good Points of Tokenization
From
a profit and administration perspective, RE NFT is a marvelous opportunity.
Smart contracts reduce friction by automating many of the most onerous parts of
administering fractional ownership returns. The contract documents the capital
contribution of each participant along with their ownership stake. As cash
flows from the property into the contract, the proceeds are automatically
distributed according to the terms of the contract.
Since
the contract and transactions are recorded on the blockchain, there is potentially
excellent transparency and easy reporting of the project. This transparency is
limited, however. Whatever is not contained in the contract, i.e., the actual
real estate and the cash flows outside of the contract, is invisible to the
blockchain.
3.0 Problems with Tokenization
Unfortunately, RE NFT has three major flaws which are like three icebergs converging on the path of the Titanic:
1)
RE NFT ownership is not legally recognized
as a proof of ownership in any jurisdiction.
2)
Fractional ownership is nearly always a
lawsuit waiting to happen. RE NFT puts this risk on steroids.
3)
RE NFT scaled across multiple offerings is
a RICO[i]
case waiting to happen.
3.1 Legal Recognition
The
short version of this problem is that fractional owners can’t use the courts to
enforce their property rights. Only the owners listed on the deed filed with
the local government have that privilege. In most cases, the name on the deed
for a fractionalized property is a trust or an LLC, with no mention of the
fractional ownership interests. The trust or LLC is usually owned or controlled
by another LLC.
Although
there may come a day when governments accord legal rights to RE NFT it is not
done today. Until then, lack of legal standing for RE NFT is a fatal flaw
that makes this a stellar opportunity for fraudsters who may be able to use
this loophole to confuse, delay, and possibly dismiss prosecutions.
3.2 Lawsuits
Every
fractional ownership of real estate is always a lawsuit waiting to happen.
Returns to owners depend heavily on the actions of the party managing the
offering (Offeror). If the expectations of investors aren’t fully met one or
all of them may decide to take the Offeror to court to get satisfaction.
Litigation
risk is escalated dramatically when fractional owners are consumers instead of
sophisticated investors. Marketing efforts to democratize real estate (i.e.,
Crowdfunding and RE NFT) consistently target consumers. Remember Grandma (from
above)? She and dozens more like her are important participants in successfully
funding every RE NFT offering.
When
Grandma gets upset with the Offeror, she calls her attorney. Unfortunately, her
attorney is going to tell her that her RE NFT is worthless and she can’t take
the Offeror to court to get satisfaction.
3.3 Negative Cash Flows
Experienced
real estate investors know there are many circumstances when a real estate
investment has negative cash flows. If cash reserves are insufficient, the
result is what the investing industry terms a “capital call.” Instead of
receiving money, participants are required to put more money into the
investment. In contrast with investing professionals, consumers are conditioned
by the stock market to put money into an investment only when they buy in.
Capital calls are alien to them. To consumers, the need to put in more money to
resume an interrupted flow of returns looks like a scam.
When
Grandma puts her money into RE NFT, she buys her share of the deal with the
expectation that she will be receiving a steady cash flow every month. In fact,
many sites hawking RE NFT advertise that the cash flows begin immediately. If
Grandma’s cash flow suddenly stops and she is told that to get it restarted she
needs to put in more money, she calls her attorney. A savvy attorney will
quickly realize that this client is merely one among many RE NFT buyers. That
immediately opens the prospect of a class action lawsuit against the Offeror.
Fractional
ownership is a form of direct real estate ownership. “Reality TV”
notwithstanding, many real estate deals require subsequent capital calls which
interrupt and may even reverse cash flows. Negative cash flows will always
catch unsophisticated investors off guard. Angered and confused by this
unexpected reversal they will likely take their grievances to regulators and to
court. Given the numbers of fractional investors in any given property may
exceed twenty people, a class action status is ready-made.
3.4 Racketeering
When
discontented participants occur in multiple fractionalized properties, a
racketeering charge (see RICO note at the end of this document) is likely to
arise alongside the class action lawsuit.
For
rental properties the probability of negative cash flows is 100%. They will
occur sooner or later. When they occur, Grandma is going to sue. In fact, it
was exactly this sort of scenario that led to the infamous case of the SEC v
Howey which resulted in the so-called “Howey Test” where the US Supreme Court
identified key characteristics that define a securities offering.
To
protect themselves from lawsuits, the RE NFT Offeror wraps each offering in a
limited liability corporation (LLC). The Offeror assumes this will limit
damages from any lawsuit to one property.
As
Grandma’s attorney digs deeper, it quickly becomes clear that the seller of the
RE NFT has done this for many properties. With a phone call to the local
District Attorney, or a state Attorney General, the attorney passes along prima
facia evidence suggesting the Offeror is engaged in a pattern of behavior
(which is a fact). This pattern of behavior across multiple offerings and
multiple LLCs looks a lot like what criminals do to hide their ownership and
protect their illicit gains. The legally prudent behavior of putting each
offering into a separate LLC gets twisted into an indictment.
The
Racketeer Influenced and Corrupt Organizations Act (RICO) provides for
especially large criminal and civil penalties when actions are judged to be
part of an ongoing criminal enterprise.
Regardless of the intentions of the Offeror, scaled across multiple
properties, tokenizing fractional ownership is a racketeering charge waiting to
happen.
When
the offeror ends up in court, sitting across the courtroom, the plaintiff is
Grandma. When the judge, jury, and prosecutor look at Grandma and then look at
the Offeror, all sympathy will is with Grandma.
Compared
to Grandma’s fixed income, the Offeror has deep pockets, or appears to have
deep pockets. Regardless of the intentions of the Offeror, regardless of the
ultimate facts of the case, the jury will find in favor of Grandma. So will the
court of public opinion.
3.5 Selling a Bridge
For
a variety of reasons, real estate investing is very susceptible to fraud. The
iceberg sized risks already mentioned are made worse by the reality of real
estate investing. The phrases, “I have a bridge I’ll sell you,” and “I can sell
you waterfront real estate in Florida,” have moved from actual incidents and
lawsuits into our lexicon as cautionary phrases about investing in real estate.
Some approaches to investing in real estate are more susceptible to fraud than
others. RE NFT is one of the riskiest ways to invest in real estate and most
prone to fraud.
Recently,
an investor asked the CuBitREvolution™ team to informally investigate an
RE NFT offering they found on the internet. Since we have some human resources
in the same geographic market where the Offeror claimed to hold properties,
they were tokenizing, we agreed to independently verify some of their
offerings. The results were shocking.
First,
the non-shocking parts.
3.6 Unverifiable Ownership
Not
surprisingly, it was impossible in many cases to verify if the Offeror was the
legal owner of the advertised property. As mentioned above, the Offeror usually
holds title to the property in the name of a trust or an LLC, rather than in
their own name. For someone buying the RE NFT this means you may be buying a
share in a property form someone who doesn’t have the right to sell you that
share.
3.7 Unverifiable Incomes
The
Offeror’s website touted the rents currently being received for specific
properties. These rents were explicitly woven into the offering of cash returns
to the buyer. The only way to verify such rents involves several distinct
actions:
1)
Obtain a copy of the executed rent
agreement.
2)
Talk directly with the renter to verify
the rental numbers shown in the agreement.
3)
Obtain bookkeeping records from the
Offeror showing the payment of rents.
4)
Obtain bank records showing the deposits
hitting the Offeror’s business bank account reflecting the same values shown in
the Offeror’s bookkeeping records.
Without
all four of these facts, it is impossible to verify that stated rental incomes
match the Offeror’s claims. Unscrupulous Offerors may create rental agreements
for non-existent tenants. They may be clandestinely subsidizing renters by
charging them less than the contract shows. This inflates the value of the
property. It is also an opportunity for the Offeror to launder money from
criminal enterprises by using it to make up the difference between the actual
rent paid and the contract rent which is deposited.
3.8 Unverifiable Expenses
Verifying
expenses, which reduce incomes to deliver net cash flows is as difficult as
verifying the incomes.
1)
Obtain Offeror records showing costs for
repairs and maintenance for each unit offered.
2)
Talk directly with occupants to ensure the
repairs and maintenance have occurred.
3)
Talk with the providers who carried out
the repairs and maintenance to ensure the Offeror records match theirs.
4)
Obtain the Offeror’s banking records
showing the expenses paid and match them to the bookkeeping records.
It
is an unfortunate reality that bogus and inflated maintenance and repair costs
are often used by property managers to steal money and hide profits. It is also
an opportunity for an unscrupulous Offeror to launder money through fictitious
repairs and maintenance.
3.9 Shockers
Our
team visited properties the Offeror showed on their website as current
offerings and past successful offerings. What we found was shocking.
In
one instance a property listed as being fully occupied and rented for more than
$1,000 per month turned out to be the shell of a building. Looking through a
window, investigators could see a fifteen-foot tree growing toward the missing
roof in the back of the building.
In
another instance, the picture of the property on the website was of a different
property than the one offered. The property shown was around the corner. Both
buildings were identical construction. However, the offered property was vacant
and derelict. Windows were boarded up. The only reasonable conclusion is this
was a deliberate deception. The Offeror asserted that this building was fully
rented.
In
a third instance, the property was vacant although the Offeror claimed it was
rented.
In
a fourth case, the address in the offering turned out to not exist. The picture
was of a nearby house. The actual address was for a vacant lot.
Mathematics
says that two points are needed to define a straight line. A third point
confirms the straight line. In this case we found four tangible points
confirming the conclusion that the Offeror was deliberately defrauding people.
We found all this without ever dealing directly with the Offeror. We didn’t
even need to look at their books to uncover the fraud. If we had invested
solely based on their website and the allure of RE NFT benefits, the investment
would be lost.
If
any RE NFT buyers received payments, it is likely those were the result of the
Offeror operating a Ponzi scheme, using investments from one person to pay
returns to another.
We
believe this Offeror is acquiring derelict properties for small amounts of
capital. Then they take steps to make it appear that they have fixed up and
rented the property. They then sell fractional ownerships up to the fair market
value that is reasonable for that type of building in that area if it were
fully repaired and rented out. Given that they were listing more than twenty
units, their total fraud exceeds four or five million dollars to-date.
This
real-life RE NFT should serve as a cautionary tale to anyone enticed by “real
estate on the blockchain” as a RE NFT.
4.0 The CuBit™
Difference
Due
to the inordinate risks associated with RE NFT, the CuBitREvolution™
team made the choice to make a radically different approach to the intersection
of blockchain and real estate than what most other blockchain proponents are
currently pursuing.
The
CuBitREvolution™ team is committed to significant levels of
transparency, compliance with applicable regulations, and strong risk
mitigation for everyone involved in our deals. We know that most reputable real
estate investors and crypto investors will recognize the merits of our approach
and imitate it. Our formula isn’t patentable, and that is a good thing. If it
were patentable, it would likely also have lots of hidden parts.
The
first part of our model is to create a funding pool. We are doing this through
the Universal Real Estate Stable Coin (URESCu™ or CuBit™). Within the
limits set by US regulations relating to Know Your Customer (KYC), Anti-Money Laundering
(AML), and the Office of
Foreign Assets Control (OFAC), anyone can deposit US dollars (USD) or their
crypto equivalents, into the CuBitDAO™ Asset Ledger. For approximately
every $120 USD depositors receive one CuBit™. CuBit™ is fully
fungible. They can be exchanged one for another, and will undoubtedly become
available on many cryptocurrency exchanges, although the only official way to
obtain or redeem them is at the Teller Window of the Universal Real Estate
Wealth Protection Solutions™, LLC (UREWPS™, the Company) website.
Everyone
who holds CuBit™ is a member (Member) of the decentralized autonomous
organization (DAO, or in this case the CuBitDAO™). CuBitDAO™ controls the CuBit™ supply
just like the Federal Reserve does for USD.
By
agreement with CuBitDAO™, the Company uses an agreed upon
portion of the money deposited in the CuBitDAO™ Asset Ledger to fund real estate
deals and buy real estate in cities and towns across the USA.
To
manage the risks of fraud, the Company establishes a Distributed Regional
Affiliate (DRA or Affiliate) in each major city where we do deals. We sell a
limited number of ownership shares in each DRA to successful local real estate
investors (REI) who meet the SEC standards for Qualified Investors. In exchange
for some of the profits from each deal, members of the local Affiliate provide
independent verification and validation services for every deal and property we
buy in their area.
Along
with our Affiliate, we work with local associations of real estate investors
(REI). REI are always making real estate deals and almost always need money to
make the deals happen.
CuBitDAO™ members have money which they want
to protect and grow. REI money-making real estate deals that need money to make
them happen. The Company and a DRA provide the connection between CuBitDAO™ and REI in a way that manages risks
and creates win-win situations.
Together
with the REI and DRA, the Company, according to the laws of each state, forms a
joint venture company (JV). Each JV is an LLC. Each LLC has Articles of
Incorporation and an Operating Agreement. An operating agreement specifies the
rights and obligations of each member of the JV. At the heart of each JV is a
smart contract, recorded on a blockchain. The terms of JV Operating Agreement
are encoded into the smart contract. The smart contract automates the
administration of the JV, dramatically reducing operating costs, and room for
human error or fraud within the JV.
The
JV acquires the real estate using money provided by the Company. The Company
gets this money from the CuBitDAO™ Asset Ledger, under the terms of
that management agreement. CuBitDAO™ is not a member of the JV.
During
the process of acquiring the real estate, DRA members verify and validate all
the relevant parts of the deal. Most especially, they verify everything about
the real estate property (Property). The property is bought into a trust. The
trust is the legal owner of the property.
Within
the trust, the Company, or its delegate, is the Trustee. The JV is the
beneficiary of the trust. Each trust is recorded on a blockchain using a smart
contract.
The
REI does all the work on the property to make the deal profitable. The DRA
verifies the work. The Company funds the work. Profits are split three ways.
The
Company divides its share of the revenues with CuBitDAO™ according to the terms of the
management agreement. Specifically, CuBitDAO™ receives the increases in equity
while the Company receives fees generated from the REI who have enjoyed the use
of the CuBitDAO™ money.
Using
smart contracts to manage the trust and the JV is the best intersection of
blockchain technology and real estate. Trusts and JVs have long legal
histories. Their legal standing to own real estate is recognized in nearly
every jurisdiction in the world. Using smart contracts to reduce administrative
friction and blockchains to record transactions helps to dramatically reduce
the administrative time and expenses, leaving more profit for all parties.
4.1 Protecting CuBitDAO™ Members
As
soon as the Company is fully operational and has a portfolio of real estate to
back the value of CuBitDAO™ Asset Ledger, the Company will begin
doing several things to protect the interests of CuBitDAO™ members.
We
require annual, third-party verification of market value for every property in
the portfolio. We contract with licensed property appraisers to provide
independent property appraisals and perform a Comparative Market Analysis (CMA)
for each property, just as though we were considering buying each property
anew. These CMA will be stored on the blockchain, linked to each property.
Twice
each year the Company will enlist a reputable outside auditor to verify and
validate that the interests of the CuBitDAO™ members are being protected, as
agreed. The outside auditor will be allowed unrestricted access to Company
records. We will pull back the legal veils of the trusts and joint ventures,
giving them an unimpeded ability to identify every property in the portfolio.
They will verify our valuations and cash flows and validate that the real
estate and liquid assets in the Asset Ledger are present and properly valued.
Although
the detailed information within their audit will be kept confidential, as it is
with the annual report of every corporation, the assertions and key findings of
the auditors will be posted alongside the publicly viewable CuBitDAO™ Asset Ledger.
5.0 Conclusions
Although
the appeal to play fast and loose to fractionalize direct ownership of real
estate with blockchain technology, the risks to all honest parties are too
great to ignore. Further, our financial analysis has found that the profits
that come with those risks are only enticing to dishonest players who are
looking to pump up real estate values, grab the cash from fractional owners,
and then run away, leaving honest investors hurting and government prosecutors
struggling to clean up the mess.
In
the strictest sense of the word, the JV implemented with each deal done as part
of the CuBitREvolution™ constitutes a fractionalized real estate
ownership. Each party to the JV has legal rights to different portions of the
cash flows. The JV itself has rights to the beneficial interests of the trust.
The trust has legally recognized ownership rights to the Property. And the
interests of all parties are recorded using the distributed ledger technology
of blockchains while automating the administration of cash flows both reduces
costs and the risks of fraud.
The
CuBitREvolution™ approach is
different than anyone else in the marketplace. We emphasize transparency and
using real estate ownership practices which are proven to protect the rights of
all parties involved.
If
you are an experienced real estate investor and meet the SEC criteria as a
Qualified Investor, and are interested in participating in a DRA, please
contact DRA@cubitrevolution.com
for more information.
If
you want to benefit from real estate without taking on the risks of direct real
estate ownership, please visit our website, www.CuBitREvolution.com and
learn how you can become a Member of the CuBitDAO™.
Glossary: CuBit™ Glossary
About the Author: CuBit™ Roots
This
does not constitute an offer to sell or buy a security. Any such offer would be
accompanied by all legally required documentation. CuBit™ is a receipt
currency. Distributed Regional Affiliates shares are regulated under the
securities laws of the United States of America.
Although
the design of C
uBit™ incorporates inherent protections against
volatility and Universal Real Estate Wealth Protection Solutions, LLCTM
(UREWPSTM, the Company) is committed to support the asset-based
valuation of CuBit™, as with any currency there is nothing to prevent
speculators from taking unforeseen actions which might cause the price of CuBit™
to vary without reference to the underlying value proposition. The Company
cannot prevent and is not responsible for the actions or results of such
speculative behaviors.
CuBit™
may lose value. Deposits in CuBit™ are not insured by the FDIC or any
other entity. CuBit™ is not a bank product.
The
graphics utilized the Universal Real Estate Wealth Protection Solutions, LLC™
(UREWPS™) and CuBitREvolutionTM websites and
in the Company and product documentation include both AI-generated images and
licensed content sourced from Deposit Photos and Shutterstock via TechSmith.
While we strive to ensure the accuracy and relevance of all visuals, all
graphics are intended for illustrative purposes and may not fully reflect
actual products or services. The use of AI in graphic creation is subject to
limitations, and we encourage users to verify information independently. The
company disclaims any liability for decisions made based on the content
provided. For specific inquiries or further information, please contact us
directly.
Notes
[i] Racketeer Influenced and Corrupt Organizations Act. Per Wikipedia “The Racketeer Influenced and Corrupt Organizations (RICO) Act is a United States federal law that provides for extended criminal penalties and a civil cause of action for acts performed as part of an ongoing criminal organization.
RICO was enacted by Title IX of the Organized Crime
Control Act of 1970 (Pub. L.Tooltip Act of Congress#Public law, private law,
designation 91–452, 84 Stat. 922, enacted October 15, 1970), and is codified at
18 U.S.C. ch. 96 as 18 U.S.C. §§ 1961–1968.” As retrieved (28 October 2024) from:
https://en.wikipedia.org/wiki/Racketeer_Influenced_and_Corrupt_Organizations_Act
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