31 Jan 2022

PropTech: Why tokenized real estate needs KYC

Real estate has traditionally been considered one of the safest investments out there. While property values can fluctuate in the short term, in the long term the trajectory is generally up. 

The problem is, investment in real estate can also be prohibitively expensive - and legally complex. These issues are what have made it a largely illiquid asset class - that is, one that has limited in- and out-flows of capital. 

These are some of the elements of real estate investing that the emerging Property Tech (PropTech) space is trying to overcome. 

By tokenizing real estate assets, real estate owners/controllers have found a way to take advantage of blockchain technology by making real estate investing faster, more secure, and more accessible to larger pools of investors. 

However, the process is far from simple - both from a technical and legal perspective. 

PropTech companies seeking to tokenize real estate assets and use them for investment in real properties need to consider numerous, complex different implications - one of the most important of which is ensuring token issuance is not exploited for money laundering or other forms of criminal or terrorist financing. 

Before we explore how automated KYC can be used to vet prospective investors, let’s take a closer look at how real estate tokenization works (and some of its risk factors).

What is Real Estate Tokenization?

Tokenization essentially involves digitizing an asset, usually on a blockchain. When it comes to property tokenization, the process essentially involves converting a property’s value into digital tokens, which are then held on blockchain-based PropTech platforms. 

The PropTech concept is largely based around cryptocurrency fundraising, which essentially involves investors exchanging their fiat or cryptocurrencies for tokens.

When digital tokens represent a stake in an asset, they are generally considered security tokens - as opposed to utility tokens, which are used to purchase or perform different actions, such as exercising voting rights in a company, or acquiring its services. 

Acquiring security tokens in a blockchain-based real estate asset is essentially the same as acquiring shares in the property, which can then be sold or traded at the owners’ discretion, just as they would with other cryptocurrency.

This marks a significant step-change for real estate investment: whereas previously, trading in real estate involved large and arduous amounts of paperwork, compliance checks and bureaucratic processes - as well as steep monetary entry points (read high prices), tokenization allows investors to buy and sell stakes in a piece of property with much greater ease. 

This process is largely facilitated through the process of fractionalization. When developing the technical infrastructure of the tokens, the developer will determine to what extent a token can be divided into separate shares. 

So, depending on the asset owner’s preferences, a piece of property could only be traded as a whole, or could be divided into two, three or countless other pieces. 

The more extensive the fractionalization, the more the asset can be divided, opening up to larger pools of investors. Fractionalization therefore allows for:

  1. Greater liquidity - by dividing an asset into larger amounts of shares,the entry point for acquiring a share in an asset is lowered, facilitating larger trading volumes. As property prices soar and interest rates around the world begin to catch up, having lower entry points into the real estate market is essential if the sector is to remain open to medium and lower net-worth individuals. 
  2. Standardization & Optimization - smart contracts effectively override the need for case-by-case and manual negotiation on prices; potential investors either accept the payment terms or look elsewhere. This can significantly reduce the time and costs associated with traditional real estate transactions.
  3. Transparency - by using blockchain technology, each transaction is recorded in a transparent ledger that is accessible to all users of the platform, allowing investors to have a clear view of a token’s trading history and value. 
  4. Security - due to its decentralized nature, blockchain-based information is largely immutable to manipulation and fabrication. In an era where digitel identity fraud is widespread and increasingly used to falsify ownership and credit records, blockchain-verified ownership presents a powerful tool for bringing credibility to transactions. 

PropTech KYC

While there is much to gain through the tokenization of real estate assets, there are also complex legal and regulatory issues that need to be considered and negotiated. 

As real estate tokens are considered securities, trading them needs to comply with the relevant laws and regulations governing usual normal securities, such those outlined by the U.S. Securities and Exchange Commission (SEC)

Unlike regulations governing utility tokens, laws governing securities are well established - and violating them can bring serious fines or even criminal convictions. 

In parallel, the attractiveness of digital transactions, including investments, to criminals for money laundering has already been well-established. 

As such, the need for PropTech platforms to institute robust KYC processes is absolutely essential, if they want to prevent criminals from exploiting their networks - and opening themselves up to potentially severe sanctioning from regulatory authorities.

So what would KYC for a PropTech platform look like? 

Put simply, PropTech platforms should be carrying out KYC checks on both real estate owners and investors as a standard registration process for using the platform. 

The details of the KYC process would be configured according to the prevailing requirements of the platform, and the laws of the jurisdiction(s) it operates in. 

1. Establish whether the user being onboarded is:

  •  A business - this will launch a Corporate KYC process that involves checking a business’ name against global corporate registry databases, ensuring that the company is real, licensed, has a verified address/place of business and is active, or
  • An individual investor - this will establish an individual user’s identity using ID document verification (IDV) checked against government databases.  the name against ID documentation and government databases

2. AML Watchlist screening – The second step involves vetting the business or individual for known involvement in illicit financial activity, as well as assessing the risk that they might be involved in such activity. For companies this involves checking its registered principals and Ultimate Beneficial Owners (UBOs) against global sanctions and watchlists, including global lists of Politically Exposed Persons (PEPs) and adverse media.

3. Crypto wallet screening: Investors’ wallet addresses can also be screened against possible association with money laundering, terrorist financing and other AML risk indicators to proactively prevent and combat financial crime.

4. Establish Risk Profile – Once these elements of a business and individual’s identity have been established, the potential investor can be assigned a risk profile based on risk assessment procedures.

PropTech platforms are already contributing to substantial changes in the global real estate industry. However, as we’ve seen with other blockchain-based innovations such as DeFi, NFTs and the broader crypto market - regulators will be paying close watch on how it develops. 

As more and more actors enter the space, it will be critical that PropTech companies take regulation seriously, while also embracing technology that can make onboarding investors seamless, effective and safe. 

There are already numerous KYC solutions and tools available that can be customized to meet needs of the PropTech companies to ensure investor KYC and compliance - and ultimately build trust within and beyond the PropTech ecosystem. 

KYC-Chain is one of them. If you’d like to find out more about how our end-to-end workflow solution can be integrated with your platform, let us know and we’ll be happy to discuss it. 

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