How to tokenize your Real Estate Syndication?

Real estate tokenization continues to see significant growth and increased share of the capital formulation market for private investments.

Driving the industry’s transformation, there are a number of companies building the infrastructure and tooling for investment managers to take advantage of the benefits. If you're a real estate syndicator doing traditional private placements, what steps should you take now to prepare for the inevitable conversion to digital assets and future proof your private securities?

This article is going to give you the playbook on how to tokenize a new or existing real estate syndication. If you're interested in boilerplate boilerplate legal docs - get in touch with our team and we can share them with you along with draft communications that you can use for your limited partners (LPs).

What is real estate tokenization?

As a quick reminder, tokenization is the process of converting the ownership rights of an asset into digital securities that can be bought and sold as digital assets running on a blockchain. 

In the context of real estate, tokenization allows for the buying and selling of the fractional interests of a real estate investment. 

“All of the traditional processes of managing subscription transfers, escrow, settlement, manually updating the cap table, and agreeing on the updates between different parties are automated, streamlined, recorded permanently on a blockchain, and simplified.”

Structurally, it's very similar to a traditional private placement, with the addition of two things:

1. A smart contract that tokenizes the membership interests, and 
2. Security tokens which are issued from the investment entity (normally a Special Purpose Vehicle).  
   

The benefits of real estate tokenization are many - but for real estate syndications specifically, tokenization provides increased liquidity, more accessibility and greater transparency through the use of blockchain. 

You can learn more about the benefits here.

How to tokenize your real estate syndication 

The process of tokenizing a real estate investment is quite simple. 

The process basically takes the membership interests of an LLC and issues them as security tokens specific to the property, which are then held in digital wallets by investors - either through their own digital wallet or a custodial wallet.

When creating these digital securities, the smart contracts that run on distributed ledger technology (i.e. a blockchain) ensure the cap table operations and compliance controls perform as intended. These legal agreements and requirements become coded in the software, and an always up to date version of the cap table ensures that the ownership rights are transparent, secure, and trusted. 

These contracts also enforce SEC regulations like holding periods, accreditation of investors, and any restrictions on future sales. This removes the burden of knowledge and compliance from the syndicator and prevents mistakes.

Once the digital securities are created, formally requested and then accepted by investors, they represent ownership - and can be bought and sold by eligible investors, without the need for many traditional, slow and cumbersome processes that plague traditional syndications.

The creation of a new tokenized syndication can be simpler than converting an existing one, but the requirements depend on the content of the operating agreement. For example, in some operating agreements passive investors have some voting rights for substantial changes. If that is the case, the investors would have to vote to adopt a tokenization plan. If, however, the managers have full discretion for decisions of this type, you can make the changes and just provide the updates to the investors.

How to update or convert your syndication legal documents

There are three foundational documents in any real estate syndication (the private placement memorandum (PPM), the operating agreement, and the subscription agreement). Adapting them for the creation of digital assets is relatively straightforward. 

“90% of the documentation should be the same except for the addition of a tokenization clause in the operating agreement, member disclosures if they choose to participate outlined in the subscription agreement, and general risk disclosures which are incorporated into the PPM.”

While there are several correct ways to adapt the documents, we’ll review the method we use for tokenizing investments at GP Flow. Here are the key pieces to understand.

1. Addition to Operating Agreement

The first change to be made is in the operating agreement. 

This gives the manager the ability to tokenize the syndication and deliver digital assets (i.e. tokens) to members or alternatively hold them in custody for the investors.

This can be covered in a 'Tokenization Plan Notice' in which a series of steps can be followed by the manager to convert the membership interests into security tokens.

The steps are:

1. Delivering written notice to the investors that the Manager (i.e. the General Partner) intends to have all of the Interests represented as tokenized securities
2. Outlining the Blockchain (i.e. Ethereum, Polygon, Solana) selected by the Manager for creating the digital securities
3. Setting the maximum total supply of the digital securities (i.e. how many tokens) this should be related to the existing shares (e.g. each share receives one token)
4. Providing any other such information as determined by the Manager
   

The manager can then request that each investor who intends to receive the digital securities let the Manager know within a certain period (i.e. sixty days).

This reply should be memorialized formally in a Token Receipt Notice that details:

1. The investors intent to receive such number of tokens of the digital securities representing the Member’s Interest 
2. The digital wallet address that is owned and controlled by the investor and to which the manager shall deliver the security tokens.
   

The last thing to note is that not all investors will be comfortable with digital securities, and may require the manager to provide escrow or custody of the assets. This is relatively easy and most platforms (like GP Flow) provide custodial solutions for their customers.

In this case the operating agreement should have language so that the manager can hold in escrow, in such a manner as determined by the Manager in its sole and absolute discretion, any and all digital securities that have not been delivered.

If the syndication is already in existence and this process is a conversion to tokenization, the ability of the Manager to make these changes may be absolute or may require investor approval. Companies like GP Flow can help you understand if there are additional steps you need to take based on the actual wording of your operating agreement.

2. Addition to Subscription Agreement

The second step in updating your legal documents to tokenize your real estate syndication is adding language around members' understanding of real estate tokenization if they choose to participate in the tokenization (versus having the manager custody or not issue their tokens).

This commonly outlines risks around the:

1. Applicable Blockchain or the tokens underlying any Tokenized Interest will not function as intended; 
2. Smart contract for creating the tokens underlying any Tokenized Interest will not be completed, deployed, free from defects or bugs, or usable; and 
3. Digital securities underlying any Tokenized Interest will not be usable on or in connection with the Applicable Blockchain or in any manner whatsoever.

Since a subscription agreement is a formal agreement to acquire shares in the private placement, the Manager is not able to unilaterally change this agreement after it has been executed. But having this information in the agreement for new investors is very important. 

3. Additional risk disclosures in the PPM

The third step in updating your legal documents to tokenize your syndication is adding general blockchain related risks to the disclosures in the PPM.

These may include things like:

• Changes in regulation may impact related blockchain technologies
• Digital securities could fail to comply with regulations
• A secondary market for investors may not develop
• The Smart Contract being exploited

Similar to most other risks outlined in the syndication documents, the probability of these things occurring when appropriate policies and procedures are put in place is low - however it is important to ensure that all possible risks are disclosed for investors.  

How real estate lenders view tokenization  

Due to their strong durability and cash flows, most commercial real estate investments are financed with debt and debt packages are a key part of the economic profile of most deals.

With that in mind, lender relationships are critical and most commercial real estate lenders want to ensure they have appropriate protections and understanding of both the GP, and key LP stakeholders. The GP will always be on the loan, and the lender may also look for LPs that have more than 20% - 25% to be on the loan as well, however importantly this is based on a ‘look-through’ basis.

A ‘look-through’ basis means if a LP entity owns 20% of the investment entity equity, however that LP entity has two shareholders with 50% each - this means that each LP only owns 10% of the investment entity equity and continuing our case above - would not need to be on loan.

There are other constraints that need to be managed for, such as no more than 10% of the tokens changing hands within a 12 month period - all of which can be managed through the smart contract.

Tokenized real estate - what does success look like?

The amount of technology, compliance and accounting systems that a syndication gets access to when tokenizing can't be understated. Blockchains provide verifiable detail on every transaction that has ever occurred, between which parties, for what amount, at what time etc. all out of the box.

As an example, when a piece or an entire limited partnership stack of a real estate syndication is tokenized, the cap table typically moves to be managed on the blockchain - which enables the benefits that include transparency, easier transfers and efficiency.

“The blockchain basically provides an always up-to-date, online and transparent cap table. Why is this important? The biggest hurdle to transfers amongst syndications is the need for trust and verifiability of positions, their performance and their compliance. Having a single source-of-truth for everyone removes the need for a lot of intermediaries. .”

To view this ‘cap-table’, there are many different Blockchain Explorers that allow people to explore the transactions and holdings of an individual security contract. GP Flow currently uses the Polygon Network, which is an Ethereum compatible blockchain.

With over +2,000 investors and a growing number of tokenized syndications, you can view these directly online on Polyscan (which is a Blockchain Explorer for the Polygon blockchain).

The cap table contains a list of all the transactions related to the cap table, including the digital wallet addresses of the security holders. 

While the transactions and wallet address are publicly visible, the underlying identity of the wallet holders is only known to the investment manager and not shown in the public domain.

Next Steps

The process of creating and managing real estate security tokens can be a complex process and it's important to consult the right legal and financial experts to support your compliance with securities laws and regulations. 

These experts can also help you navigate any challenges or obstacles that may arise during the tokenization process. If you’d like to tokenize your syndication, get in touch. 

Frequently asked questions

How much does it cost to tokenize a syndication?

• The cost to tokenize a real estate syndication consists of two components - the cost of the legal fees for the syndication documents, and secondly the cost of the technology to support the tokenization
• The cost of a syndication is typically $5k - $15k, while the cost of the technology is typically charged as a annual subscription fee of $3k - $10k depending on the size of the assets and number of investors supported on the platform 

Is tokenizing a real estate syndication legal?

• Yes. A tokenization follows all the same rules and regulations as a traditional private placement syndication. In fact, since the smart contract enforces securities regulations, a tokenization is more likely to be in compliance than a typical syndication!

With tokenization, are investors taking any blockchain or crypto risk?  

• No, investors do not take any entity/ blockchain/ or crypto risk outside of the basic operating agreement. 

What if investors lose access to their digital wallets?

• GP Flow provides white label custodial wallets, and tokens are bound to underlying subscription agreement. 
• If investor takes self custody and loses keys, we can reissue (although requires some backend work from us) 

Does the tokenization process involve the creation of GP Flow coins?

• No, there are no coins created in the tokenization process
• Coins are native to their blockchains (for example Bitcoin) are are typically ‘mined’
• Security tokens are created on existing blockchains, and are typically a digital unit of value that represents an asset or utility 
• Unlike coins, security tokens do not have their own blockchain and are issued on top of existing networks

Do investors still have paper documentation to support their ownership of member interest?

• Yes - the primary offering is always done through the standard private placement process, with subscription documents issued
• The tokenization aspect is if investors ‘opt-in’ to the tokenization process and convert their subscription units into security tokens
• If these security tokens are then compliantly and intentional moved from one investor to another, the underlying blockchain transaction and records (which shows wallet ownership, intent, timestamps etc.) serves as a record of the transfer of the securities

How does the liquidity of the digital assets work?

• The GP Flow Secondary Market is an electric bulletin board that allows eligible investors to post private sales offers, which can be seen by other eligible investors.
• The transfers are completed through a smart contract that clears and settles the transaction on a wallet-to-wallet basis, directly on the blockchain, and does not require a third-party custodian.
• Alternatively, issuers can pursue a Alternate Trading System platform that provide an order book and market making for securities tokens