Illiquidity Premium in Real Estate Investments

What is liquidity?

Liquidity is classified as a form of investment risk, since an investor’s ability to liquidate an asset provides him with more control and less risk.

What are illiquid investments?

Illiquid Investments refer to investments such as assets or securities, which cannot be liquidated easily for cash, without suffering a significant drop in value.

Since they cannot be sold quickly or exchanged for cash at short notice, illiquid investments tend to have a paucity of investors who are able and willing to purchase them. Thus, illiquid investments are typically held over a longer investment horizon.

However, the illiquidity of certain investments does not necessarily make them an unwise investment choice. The lack of liquidity is fairly unimportant and is often overshadowed by the benefits these investments may bring. This is certainly the case for real estate assets, with a high level of investment in real estate, in spite of its illiquidity.

For illiquid investments, investors tend to expect an “illiquidity premium”, i.e. higher expected returns in exchange for its illiquidity.

Illiquid investments are a bane during periods of financial crisis when investors need liquid cash due to market or credit freezes during volatile times. This could create a liquidity crisis where investors throughout the market have too much capital invested in illiquid assets and are unable to liquidate them.

What types of assets are illiquid?

Illiquid investments include real estate assets, cars, antiques, interests, private companies and some debt instruments.

The most frequently used example of an illiquid investment is real estate. Real estate assets are typically held over a longer period of time, where they usually hold their value over time. The process of selling real estate also takes a while, from finding a buyer, to the seller making an offer and the approval process. However, if the investor needs to liquidate the real estate asset quickly, he would likely have to lower the price significantly below its market value.

Other assets such as antiques or interests, may be more difficult to sell because of its niche market. Whilst these assets may hold their value well, it could take time to find an appropriate buyer who is willing to pay the price for the value of these assets.

Some debt instruments and securities are considered illiquid if they cannot be publicly traded. In such instances, trading these instruments and securities may be illegal depending on the jurisdiction they are held in. In addition, the fact that they cannot be publicly traded and thus do not have a public market hinders the liquidation process, since the investor has to seek out a willing buyer, which may force the seller to significantly reduce the price.

What is the typical holding period for an illiquid investment?

Most illiquid investments are intended to be held long-term. Long-term illiquid investments refers to investments that are held over at least 10 to 20 years. Whilst this means that a significant portion of the investor’s capital is tied up in the illiquid investment, the risk associated with market fluctuations is also correspondingly reduced in the short term.

Entering and exiting investments typically entail transaction costs that could add up, diminishing the profits of the investor.

What does illiquidity entail - how to cope with the downsides?

Whilst illiquid investments cannot be readily converted into cash, they are not without benefits, which make them attractive to investors.

In the case of real estate, most assets tend to be illiquid. However, these investment properties are projected to generate excess capital returns for a projected investment period.

Depending on your risk profile, investing may be a journey fraught with emotions. Illiquidity can be used as a form of “forced saving” to keep the investor away from easily accessing cash locked away in less liquid investments. Given the opportunity where the investor can easily sell or buy liquid investments at periods when market sentiments run high, the investor risks making short-term fear-based decisions and forgo long-term rational decisions that may be more beneficial to the investor’s future financial well-being.

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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.