The Next Level: Smart Contracts and Real Estate Deals

Editor’s Note: The authors of this post are attorneys at Holland & Knight and are writing a series of articles on blockchain technology and its potential application to the legal industry. Below, the first article sets out basic concepts and terminology.

By Joe Dewey, Partner, and Shawn Amuial, Associate, Holland & Knight

In our last two articles, we illustrated, using simple examples, how cryptocurrencies (like Bitcoin) are transacted over a blockchain and how such transactions lay the groundwork for smart contracts (e.g., the sale of my Toyota Prius to my friend Alex).  While those examples were impressive given our current payment and contracting systems, in this article we want to delve deeper into how entire industries can be disrupted.  There is no shortage of literature about how the blockchain is impacting FinTech, but FinTech is just one of many areas ripe for radical change.

In this article, we discuss how real estate transactions could be consummated with far greater efficiency and certainty using blockchain technology.

Unlike the financial services industry, which has long embraced technology as a means to generate better bottom line profits (think algorithmic trading), real estate is an industry that has remained largely unchanged for over half a century (or several centuries in certain respects).  By way of example, we will illustrate how blockchain technology has the potential to radically improve the real estate industry — and in doing so, create enormous efficiencies, which will thereby reduce transactional costs and informational risks.

The first step to unlocking many of these cost efficiencies is to replace our common law system based on recording deeds, mortgages and other instruments in public land records (or an alternative government run repository for those countries that use a Torrens land based system) with the blockchain.

The common law system requires a time consuming examination of these records each time a parcel of land is transferred from one person to another. This process is both timely and costly and inevitably results in search errors, which generate transactional risk. Our current system relies heavily on title insurance to mitigate against this risk — but this further increases transactional costs. Furthermore, in many developing countries, the reliability of government records is highly questionable — due to incompetence, corruption or both. None of the existing systems employed around the world can operate as efficient as one operating on a blockchain.

Does it sound too far fetched to put our land records on the blockchain? Well, in some places it is already happening.

The country of Honduras has hired a Texas-based company, Factom, to replace the government’s current system with one based on the blockchain.

Even in larger countries like the U.S., this is not an insurmountable task. Existing title companies already maintain large databases of land ownership information, which are in addition to government records. Rather than fight this movement, astute title companies will inevitably support these initiatives for several reasons, not the least of which is that there may still be a need for title insurance to protect against certain external risks that the blockchain does not eliminate, and title companies are logical strategic partners to help develop any viable blockchain alternative.

So let’s use our knowledge of the blockchain and smart contracts to see how a transaction for the sale of an office building might occur with blockchain technology.

Perhaps our friend Alex is interested in purchasing an office building and engages us to represent him in the transaction. In order to fully appreciate the blockchain scenario, let’s quickly walk through how we would accomplish this transaction, today.

First, you must draft a purchase and sale contract, which are often long and complicated.  As we discussed in our last article, each party will try to minimize their own risk in order to ensure that they are indeed receiving what they intend to receive (be it the property or the money). This means that you and your counterpart (seller’s attorney) are likely to exchange several drafts of the contract contemplating an array of representations and warranties, covenants (both pre and post closing), detailed descriptions of the to-be transferred property, lists of the current leases encumbering the property, escrow instructions and other mechanisms to ensure the trusted transfer of monies and property, and a vast array of other factors that may include studies, financing contingencies and the receipt of title insurance (which we mentioned earlier).

Even after the parties agree upon a contract, there is often an extensive due diligence period, which involves boxes of leases, contracts, financial statements, title exceptions, lien reports, and so on. These items will likely be left for a junior associate or paralegal to review and he or she will spend countless hours (which will not go unnoticed by Alex when he receives his legal invoice) combing through these documents to ensure that the current state of the property is indeed as our client Alex believes it to be.

On closing day, you and seller’s counsel scramble to make sure that your long list of closing documents (Deed, Assignment of Leases, Assignment of Contracts, etc.) are properly executed, that you have properly prorated all paid and unpaid, rents, contracts, taxes, etc., and then, finally, the property belongs to Alex at last. Seller sends notice to all its tenants that Alex is the new owner and to send him any future rent checks.

In order to keep our example simple, we have assumed Alex has purchased the property with cash and has not financed his acquisition with a mortgage — but that too would be easily handled by blockchain technology.

Now let’s walk through the same transaction using blockchain technology. Before we get to the meat of the transaction, it is important to note that any object can be assigned a unique identification code (like a vin number) on a blockchain (and thus become “smart property”). As such, a blockchain that maintains information regarding the ownership of real property will assign a unique number to each parcel of land.

So, in our example, let’s assume the office building has been assigned “A123” as its unique identification. As a result, we can instantly verify that the seller of the building is in fact the owner by simply making an inquiry to the blockchain requesting the identity of the owner of parcel A123 — we could do this in a matter of seconds on our smartphone. In addition, all mortgages, easements and other encumbrances relating to the office building will also be immediately available because they will all be associated with parcel A123.

It’s also important to consider that the state of parcels or tracts of land are not static, but rather dynamic inasmuch as they are combined and subdivided frequently. This dynamic mutation of land is easily handled by the blockchain as new unique identification numbers can be issued to newly created parcels — but maintaining information about its relationship to its parent tract.

So, if parcel A123 were to be divided into two parcels, each new parcel (say B112 and B113) would include within their data on the blockchain that they are each “children” of parent parcel A123. In fact, there is no limitation on what data that can be associated with each parcel — whether it be a link to a survey of the property or the amount of real estate taxes due.

But once a part of the blockchain, this information becomes immutable and tamper proof — making fraud exponentially more difficult to accomplish.

Alright, back to our hypothetical transaction. Because so much information about parcel A123 is available on the blockchain, Alex will be able to complete his due diligence of the property much more quickly and cheaply.

This efficiency will continue to grow as more and more “objects” become part of the blockchain (remember our prior discussion of the Internet of Things). While all transactions are unique, and therefore, require some tailoring, because smart contracts will need to be ultimately converted into machine code, our practice will involve more industry standard templates, which will do two things — stop lawyers from arguing about largely academic issues and focus their attention on those provisions that truly effect the economics of a transaction.

So now, rather than several versions of a contract going back and forth, we will agree upon a contract in one or two exchanges of comments. If Alex and the seller agree upon the economics of the transaction, then the contract will be digitally signed by both parties, converted to machine code of some sort and loaded onto the blockchain.

The conditions that must occur in order to complete the closing will be included in the smart contract uploaded. Immediately thereafter, the blockchain nodes will broadcast the smart contract to its peer nodes and ultimately it will be mined and become part of a block on the blockchain.

Let’s say the only condition to closing is the payment of an agreed purchase price — say $10,000,000. This purchase price could be paid by a cryptocurrency (which can easily be pegged or hedged to any fiat or digital currency of choice) using the same blockchain. Accordingly, as soon as Alex transmits the $10,000,000 in appropriate cryptocurrency on the blockchain per the smart contract, this transaction will be mined and the prior smart contract will be notified, and thereafter, the owner of parcel A123 will be reflected as Alex.

Did we mention that smart contracts can talk to each other on the blockchain?  We’ll save that discussion for a future series of articles.

By now, many readers have hopefully begun to appreciate the potential impact of blockchain technology on the legal profession.

Nevertheless, many of you are probably wondering what all this means for the day to day activities of practicing law. Most of us are accustomed to turning on our computer or iPad each morning and creating and revising contracts in Microsoft Word or Google Docs. So, while the above examples we’ve discussed sound great conceptually, they are not going to be implemented by tools like Microsoft Word or Google Docs. We are still missing a bridge that takes us from the traditional world of contract drafting we as lawyers understand to a digital world of 1s and 0s that can reside on the blockchain. We’ll address that bridge, or at least what it might look like, in our next article.

 

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Ragnar

I'm an entrepreneur, advisor, and public speaker in the application of Bitcoin / Blockchain to real estate. I have 10 years of real estate experience including development, title insurance, and investing. I bought my first bitcoins in 2012. I founded the non-profit International Blockchain Real Estate Association (IBREA) in 2013. My nascent startup, velox.RE, will bring transparency and liquidity to real estate transactions.