Ershad ChaganiErshad Chagani
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The contractual elements of real estate transactions can be complex and cumbersome. In order to protect their respective positions and overcome the barrier of lack of trust, parties to a transaction are forced to utilize intermediaries such as lawyers and escrow accounts. Smart contracts are blockchain-based tools that have the potential to transform the process of executing real estate transactions; they reduce the need to trust the transaction partner and enable transactions to be processed without third parties.
Potential Applications of Smart Contracts in CRE
Smart Contracts are agreements, captured in the form of code, that self-execute under pre-determined circumstance. The code is decentralized and distributed across a blockchain network, which ensures that the contract and its terms are transparent and immutable.
Primer on Blockchain:
As described by the World Economic Forum, “blockchain provides a decentralized database, or “digital ledger”, of transactions that everyone on the network can see. This network is essentially a chain of computers that must all approve an exchange before it can be verified and recorded.”[i]
One application of smart contracts in the CRE industry is in transfer of ownership transactions. Real estate transactions are complex, often requiring notarized documents and escrow accounts to provide legal protection to the parties involved. Smart contracts are built on the basis of transparency and protection. As the contracts self-execute, the terms of the deal are acted upon as soon as all pre-determined requirements are met. For example, transfer of ownership (hypothetically – see Barriers to Adoption, below) would occur instantly once payment is made in full. With its distributed nature, the transfer of assets is secure and the legitimacy of the transaction can not be challenged, reducing the need for involvement from legal representation or other external enforcement mechanisms, which would improve the speed of transactions and of transferring ownership. As each additional middle-man brings with it a cost, smart contracts could lead to a significant cost savings on an absolute basis. It has been estimated that the reduced role of brokers, bankers, and lawyers could lead to a cost savings of about 2-3% of the transaction.[ii] Reduced transaction times with smart contracts could also play a role in enhancing the perceived liquidity of the real estate asset class.
A second use of smart contracts in real estate is in leasing. One opportunity would be to use smart contracts to automatically execute rent payments from tenants. If a lease was tied to a smart contract, a landlord could execute payment upon the “completion” of occupation of space each month. Taking this a step further, smart contracts could be used to add transparency to certain rent clauses in a retail or office setting. For example, if in the future retail sales are recorded on a blockchain ledger, this ledger could be connected directly with a smart leasing contract to determine the appropriate percentage rent each period.
Barriers to Adoption
The greatest hinderance to the uptake of smart contracts in real estate transactions is linking real property to a digital crypto-asset that can be transferred over blockchain. The administration of the digital contract must be connected to the subject property in an enforceable way. This would require property to be registered in a system that is either sanctioned by public sector bodies or in a system that is adopted so widely that it is considered legitimate and enforceable. The former, where public sector actively invests in a blockchain-based registry, could significantly improve the prospect of adopting smart contracts in CRE. Globally, many jurisdictions are investigating the prospect of incorporating blockchain in land registry systems. As the first such adoption in the United States, South Burlington, Vermont announced the pilot of a blockchain-based registry in January 2018, though recognizing that a full transition would take time and come with considerable challenges due to the impact on tangent industries such as insurance[iii]. Though there are clear benefits from a real estate transactions perspective, public sector bodies are motivated to investigate this technology due to the benefit of centralized land-use information. Understanding historic uses is of critical importance to many public sector stakeholder groups, and a blockchain-based registry could serve the role of a centralized, infallible record, the value of which increases as cities develop.
One of the attributes that makes smart contracts beneficial is also a deterrent to their widespread adoption. As the contracts are self-executed once the coded requirements are met, there exists the potential for misrepresentation of the underlying asset being transferred. If the challenge of linkage between a crypto-asset and real property were overcome, there would still likely be no way to verify the condition of the property at the time of the contract’s execution. The property’s ownership would be automatically transferred upon the conditions of the contract being met, even if the condition of the property has substantially changed since the purchaser’s due-diligence. This could be overcome with some sort of signoff requirement but is something to consider as smart contracts are adopted in CRE.
A third challenge is the network effect due to the bilateral nature of real estate transactions. In order to utilize smart contracts, both the buyer and seller or the landlord and tenant need to be willing to rely on the new technology. While there are early adopters in every segment, a smart contract transaction would require that two early adopters come together on the same deal – the adoption is not unlike a social network, which relies on uptake by your network to drive value for a user. In addition, equity sources and debt originators may also need to be consulted before smart contracts can be put in place. The conservative nature of these parties and of the real estate industry in general presents a challenge to the widespread adoption of smart contracts.
Benefits of Smart Contracts
In developed markets, smart contracts would increase autonomy, improve transparency, and reduce cost. They have the potential to bring forth a host of benefits to investors and property management firms while reducing transaction timelines and costs. If the public and private sectors are able to collaborate and co-create a legitimate crypto-based vehicle tied to real property, the CRE industry will likely see an increase in the adoption of smart contracts to execute real estate transactions. Smart contracts in leasing should become more prevalent as tenants integrate blockchain technology in their operations. Retailers have begun to adopt blockchain for a range of uses, from Walmart using blockchain to trace food in its supply chain[iv] to retailers using the third party service Warranteer to track and transfer product warrantees[v]. With time, it is expected that blockchain will facilitate many facets of corporate operations.
In developing markets, blockchain and smart contracts have the potential to play a significant role in creating a legitimate “sole source of the truth” for tracking real estate ownership. In many markets around the world, bribery and corruption hinder real estate investment due to the risk of illegitimate changes and challenges to the chain of ownership of property. In these markets, a government-regulated land titles registry is often not trusted. A blockchain-based registry could add a compelling level of security to tracking ownership in these markets and mitigate risk. Due to their decentralized nature, blockchain-based smart contracts can not be modified by a single party independently. Tying smart contracts to such a registry would legitimize the chain of ownership of property and eliminate instances of interference with records of ownership. In addition, smart contracts add a level of consistency and a guarantee of performance in regions in the world where enforceability and accountability can be a challenge.
[i] All You Need To Know About Blockchain, Explained Simply
Rosamond Hutt – https://www.weforum.org/agenda/2016/06/blockchain-explained-simply/
[ii] Smart Contracts and the Real Estate Industry- A Match Made in Heaven!
Rafael Soultanov – https://medium.com/ethereum-dapp-builder/smart-contracts-and-the-real-estate-59e3dfdb5d2c
[iii] A Vermont City Tests Blockchain Technology For Property Deals
Peter Grant – https://www.wsj.com/articles/a-vermont-city-tests-blockchain-technology-for-property-deals-1517351207
[iv] Ibm and Walmart Launch Blockchain-based Food Safety Alliance For China
[v] Blockchain Wave Headed Toward Cpg and Retail Industries