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Using NFTs in Real Estate - What’s Real & What’s Not

It’s an issue that might need legislative remedy to work

Justin Lischak Earley
Insider
Justin Lischak Earley
Using NFTs in Real Estate

The application of non-fungible tokens (NFTs) and the tokenization of digital and physical assets continue to garner attention across industries, businesses, and governments, while prompting excitement among early adopters, and also confusion among many consumers. Both the interest and the confusion are warranted, as the technology has the potential to enhance the process of exchanging assets, but it remains widely misunderstood.

While NFTs of digital assets (like digital art) tend to receive the most attention, NFTs and tokenization are increasingly discussed as a mechanism to convey ownership of real estate – both ownership of an entire property and fractional ownership of a property – and to enhance the real estate transaction process. In fact, there have been a handful of examples of property supposedly being auctioned off as a NFT.

Startups focused on the application of tokenization and NFTs in real estate are beginning to attract early-stage investor interest in real estate circles by touting the possibility that NFTs can reduce friction in ordinary real estate transactions. First American is a leading innovator and is focused on creating a faster, cheaper, and easier transaction experience for all real estate market participants. Justin Lischak Earley, chief innovation underwriter at First American Title, shared his view of the promise and challenges posed by the use of tokenization and NFTs in real estate transactions.

 

Can you transfer U.S. real estate using a NFT?

The short answer is maybe, but only in a quite limited and fairly complex way. For the longer answer, you’ll need a little bit of real estate law, a little bit of corporate law, and a little bit of tech.

First, real estate title law in the U.S. does not work the way that many people believe it does. An American real estate title typically isn’t a single piece of paper that can simply be pulled from government files and digitized. Instead, in most of the U.S., deriving title to a piece of real estate (let’s call it “Greenacre”) is a research and reasoning process: someone has to read through a bunch of documents in county government offices, and reach a judgment-call conclusion about title to Greenacre. There generally is no “golden record” you can just pull out that will tell you all you need to know about Greenacre.

Now, the tech piece. You can think of a NFT as being like a digital piece of paper that’s really hard to replicate. Imagine an old-fashioned piece of parchment with a wax-seal, signet-ring impression on it. Can you copy the text on that piece of parchment? Sure. But can you replicate the wax seal on it? Almost certainly not, unless you have the same signet ring and wax used to make the original. NFTs are kind of like that, but in a digital context rather than a physical one. In this sense, a NFT can be “digitally unique.”

But just because a NFT is unique, that doesn’t mean that it “represents” Greenacre in a legal sense. Owning a NFT about Greenacre is not the same as owning Greenacre, just like owning a photograph of Greenacre is not the same as owning Greenacre. Figuring out who owns Greenacre involves paging through records in a county land records office—a NFT has nothing to do with that. Some legal scholars call this the “tethering” problem: there is nothing in current U.S. law that “tethers” Greenacre to the NFT.

OK, but haven’t tokenization and NFTs been used in real estate transactions already?

Sort of, but in a different sense than most people think. When you look closely at what we’ve seen, those transactions didn’t directly involve buying Greenacre. Rather, they involved buying something else that in turn owned Greenacre. This sounds like a technicality, but it’s a distinction that makes a difference.

Real estate practitioners sometimes talk about having a “vehicle” that holds title to real estate. Let’s put it in automotive terms. Imagine a pickup truck with some cargo in the bed. The cargo isn’t for sale by itself, but you can buy the truck and get the cargo along with it.

In the instances we’ve seen where real estate was purportedly “tokenized,” Greenacre was placed into a title-holding legal vehicle, and somebody bought the vehicle as a way to indirectly buy Greenacre. The “vehicle” is often a limited liability company (LLC), and the cargo in the bed is the real estate. So, in those transactions, the NFT is meant to represent ownership of the LLC, not Greenacre.

So what’s wrong with that?

Buying and selling interests in LLCs (and similar legal vehicles) that hold title to physical real estate has been around in commercial real estate for years. Using NFTs to represent the ownership of an LLC is new. Here’s where the corporate law I mentioned comes in: you can argue that using a NFT to represent ownership of an LLC is just fine under the way LLC law works, and you can also argue that it’s not.

But regardless of who’s right about that debate, the “NFT an LLC” approach doesn’t actually make transferring real estate faster, cheaper, or easier. In fact, for most people, that approach would make it harder, slower, and more expensive.

How so?

Well, using legal vehicles to hold real estate titles is sophisticated. There are rules and requirements for setting up and maintaining an LLC. There’s paperwork to file. You have to know what you’re doing, or you need to hire others who do. So that takes time from you, or money to hire knowledgeable people like lawyers or accountants. And LLCs have setup costs and annual maintenance costs that you have to pay. There can also be tax-planning, estate-planning, and other legal complexities that pop up when holding real estate title in an LLC.

Some of these minutiae could make it hard to get an ordinary residential mortgage.

That’s why using LLCs to hold title is generally a commercial real estate thing. The LLC setup and maintenance costs are part of running that business, and typically there are a lot of lawyers and accountants already involved in the business anyway.

Now, there are some wealthy individuals who use LLCs to hold title to their residences because the time and cost involved is worth it for them. But they have the funds to hire lawyers and accountants to deal with the complexity. Most ordinary consumers don’t.

How would real estate law need to change to support direct tokenization of real estate?

Well, a new law would have to address the “tethering” problem. That might sound simple, but it opens up a lot of issues. It’s not clear that tethering real estate to NFTs would be better for ordinary consumers.

For example, NFT transactions are usually irreversible, and there are plenty of strange stories about NFTs being stolen. Deed fraud is already a significant problem today, but at least in the current legal system, a forged deed generally conveys no title and is void. With typical NFTs, once it’s transferred, it’s gone—whether the transfer was authorized or not. How would a NFT-based land title system handle that challenge without fundamentally changing the irreversible certainty that is touted as an advantage of NFTs?

Another big challenge is that title to Greenacre is more than just “who owns it,” and more than just “right now.” There are lots of other real estate interests that can affect Greenacre, both at the time of tokenization and in the future: things like homeowners’ association covenants or power line easements, for example. Without getting too technical about the way U.S. real estate law works, those things that affect Greenacre are stored and kept up to date in the county land records. Capturing that stuff in a NFT without creating a “dual entry” problem—where some things live in the county land records and other things are part of the NFT—would be an immense lift.

And even beyond that, real estate transfers in the U.S. are a state-law issue, so whatever legal changes might happen would have to be adopted by each state, one by one. Getting all of those states on the same page would be daunting.

You sound like a real downer on NFTs.

I’m not anti-NFT. I’m just not sold on this use of NFTs. Can you indirectly transfer a property as a token by putting that property into an LLC holding vehicle and tokenizing the ownership of the LLC? Maybe. But that does not make the average, bread-and-butter residential real estate transaction faster, cheaper, or easier.

The technology behind tokenization and NFTs is fascinating. But the real benefit of technology is when it creates a superior experience for the end-user. Right now, I just don’t think that NFTs do that for the average person who is buying or selling the average house.

If NFTs won’t make things faster, cheaper, and easier, what will?

The existing land title system isn’t perfect. There’s plenty of friction to be wrung out of the process. We’re doing some exciting things at First American to tackle that problem. Our Digital Title Group is working on providing accurate title information to our customers much faster. We are investing heavily in Endpoint®, IgniteRE™, and ClarityFirst® to digitize the residential and commercial closing process. And the Underwriting Innovation team that I lead is developing new tools that will help our underwriters make coverage decisions faster and easier. We believe these investments are the best way to create faster, cheaper, and easier real estate  transactions here in the U.S.

As Paul Ford recently wrote in Wired, blowing up longstanding systems that people rely upon doesn’t necessarily make things better. That’s not the kind of disruption we need. Rather, I agree with Mike DelPrete’s view: “Disruption is going to come from a company that offers a superior experience at a superior price.” That’s exactly what we’re doing at First American.

This article was originally published in the Mortgage Banker Magazine November 2022 issue.
Justin Lischak Earley
Justin Lischak Earley

Justin Lischak Earley is chief innovation underwriter at First American Title.

Published on
Nov 21, 2022
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