Real estate liquidity risk is one of the main risks of investing in real estate. Whether in residential vs commercial real estate Liquidity risk in real estate refers to the time it takes to market a property for sale, unlike stock or bonds where the security can be traded whenever the exchange is open for trading. Every year, the market sees trillions of real estate transactions across commercial and residential real estate and it is some of the world’s biggest market.
Real estate transactions require time, a link up between a buyer and seller and ultimately direct negotiation between the seller and multiple parties to consummate a transaction.
Definition of Real Estate Liquidity Risk
Real estate liquidity risk generally can be defined as the extended time to realize or sell the real estate investment. This can be in the form of direct property or an investment in the real estate fund. In either case, the property is an illiquid investment and requires time to transact and as a consequence to shorten the timeline, the asset has to be sold at distressed prices.
This process takes time with risk at every stage of the transaction process, where even at the best of times, it will take months to complete a deal. Every stage of the process takes time.
- Buyers will require due diligence
- It will take time to negotiate a facility agreement with lenders
- Escrow and settlement period will only come into effect after completion of due diligence.
If something goes wrong, it will prolong the time to complete the transaction. Examples of factors that can affect real estate liquidity include market conditions and credit market, impacting financing and sentiment and leasing market, affecting the cashflow outlook.
How to Manage Real Estate Liquidity Risk
There are multiple steps investors can take to counteract or mitigate the liquidity risk of real estate.
- Investors can allow sufficient time well ahead between when funds are needed and the property’s sale process. Pricing will always take a hit whenever the seller has a sense of urgency.
- Diversify the real estate portfolio between direct property and listed REITs or REIT ETFs. Or even holding a portfolio of property across different locations, asset classes (mixed use, commercial office or industrial etc) can help as there could be pockets of liquidity in different markets.
- Maintain low gearing in the portfolio so if liquidity is required elsewhere at short notice. An alternative option to selling is always leveraging up using the real estate as collateral for a mezzanine loan. Whilst higher leverage usually comes at a cost and greater risk. At least the investor has the option if the asset is lowly geared in the first place. Then it is really an evaluation of whether the trade off is worth it at the time. If the investor is maintaining high gearing at all time, then this is not really an option.
- Invests with a long horizon. By having a long horizon on the real estate investments, investors can bypass any short term volatility in the market and sell at the time of their choosing rather than when required. By holding a long investment horizon, it bypasses any cyclical changes. A critical investment criteria for us is always the asset has to be part of a structural change to benefit from a medium or long term structural trend. This could include a catalyst that can rerate an area i.e new train station or highway offramp or part of the asset class is undergoing structural change for the better, such as industrial assets from the onset of eCommerce.
- Be opportunistic when liquidity is available. When the market is buoyant and pricing favorable, don’t be greedy for the last dollar. Sometimes it is beneficial to take the liquidity knowing that market conditions can change, and sometimes the option value of cash can be just as valuable as the last dollar on the deal.
What is the benefit of liquidity risk in real estate?
Real Estate Liquidity Premium
Like with any investment, if there is a risk, it should be factored into the returns. Real estate returns are known to include a liquidity risk premium in which means the assets should have a higher return vs comparable listed real estate investments.
While the liquidity premium in real estate can be hard to measure, investors typically express the premium through a higher hurdle rate or required return rate. Our experience is that for a similar degree of risk, investing in real estate is much better on a risk adjusted basis.
Take advantage of market distress.
Real estate markets often experience times of bubble and depression. Like any market, it goes through cycles often and in times of distress when there are more sellers and buyers, as we saw during the subprime crisis. Astute investors can take advantage of the asset class’s illiquid nature and be able to step in and pay distressed prices.
Lower Real Estate Volatility
In finance, volatility rightly or wrongly is used as a proxy for risk. One major benefit of real estate is that the assets are not marked to market. This means that ostensibly the portfolio is less volatile as the property’s book value will not change unless a valuation or appraisal shows the change. Consider that the prices of listed REITs are much volatile and arguable that it is a forward discounting mechanism of future expectations.
However, during downturns, the book value’s limited volatility can anchor the wider portfolio. Prices can fall and recover just as quickly and the limited changes in book value can reduce any unnecessary emotional stress.
Ability to increase leverage
We are much more comfortable using higher leverage on an illiquid investment subject to getting comfort on the asset value. In any event, where you use more than 70% margin or LTV on a stock portfolio, there is a good chance of getting a margin call during the investment horizon. This is less likely in the real estate context as the book value will lag any change in market conditions. This lag can provide the investor additional time to come up with the necessary cure capital.
Real Estate Liquidity Risk Summary
As you can see there are always commercial real estate risks but a cleaver investor can leverage the upside from these risks as much as the downside. It really depends on whether you have a glass half full or half empty view of the world.