We often hear that real estate is an illiquid asset. But what exactly does that mean? In simple terms, illiquidity refers to the state of an asset that cannot easily be sold or exchanged for cash without a substantial loss in value. While stocks and treasury bonds are highly liquid assets, real estate falls under the category of illiquid assets. In this article, we will explore the science behind why real estate is considered illiquid and uncover the benefits and risks associated with these types of assets.
Real Estate as an Illiquid Asset
Illiquidity in real estate stems from various factors. While the fact that real estate is a hard and tangible asset contributes to its illiquid nature, it is not the sole reason. Illiquidity primarily arises from the depth of supply and demand within the market and the nature of the asset itself, including ease of valuation and ability to transact.
Real estate development and operation contributed $1.0 trillion to the U.S. GDP in 2018, reflecting a healthy level of supply and demand. However, the illiquid nature of real estate becomes apparent when we consider the following factors:
-
Lack of Public Markets: Unlike securities that are traded on public markets with transparent pricing and extensive consumer knowledge, most real estate transactions take place in private markets. Private market pricing is done on an "as-needed" basis, and the lack of transparency makes it harder to access these markets, requiring credibility and status to enter into.
-
Difficulty of Transacting: Real estate closings involve multiple parties and extensive paperwork. From structuring an offering to arranging financing and gathering due diligence items, the process can take weeks, making it challenging to convert real estate into cash quickly.
-
Access to Capital: Real estate transactions often require significant pooling of capital in the form of equity and debt. This slows down the transaction process. Additionally, equity owners may face difficulties finding buyers for their interests, while lenders can place restrictions on how the property is managed financially.
While these factors explain why real estate is considered illiquid, there are other elements that contribute to its illiquid nature, such as transaction costs, demand pressure, inventory risk, and the difficulty of finding buyers and sellers.
DSTs and Illiquidity
Even fractional 1031 investors in Delaware Statutory Trusts (DSTs) face the same illiquidity challenges as other real estate investments. In fact, one could argue that DST investments may be even more illiquid than direct property investments, as investors lack control over when to sell. However, there are platforms like Realized that have established DST resales, where investors can seek assistance in finding buyers for their seasoned investments. This provides an opportunity to receive offers for their DST interests, although there is no guarantee of a sale.
Is Illiquidity All Bad?
While illiquidity has a negative connotation in the investing world, it can actually be a beneficial strategy to consider in an investment portfolio. Here's why:
-
Illiquidity Premium: Illiquid assets often offer a premium compared to liquid assets. This premium goes beyond a higher required return on investment and stems from the skill and expertise of fund managers in managing illiquid assets. Historical data shows that illiquid assets tend to generate higher returns than their more liquid counterparts.
-
Limited Price Volatility: Private markets, such as real estate, are insulated from price volatility. While the stock market experiences highs and lows, real estate values have historically remained stable. The difficulty in accurately determining the market value of real assets due to infrequent transactions further supports the notion that real estate can help manage portfolio volatility.
Source: “Expected Returns” by Antti Ilmanen, 2011. Scatterplotting average asset returns 1990-2009 on (subjective) illiquidity estimates.
-
Downturn Protection: Private real estate valuations respond more slowly than public valuations during economic downturns. This lag in valuations can help balance a portfolio by providing stability during turbulent times.
-
Diversification: Illiquid assets offer diversification from publicly traded assets like equities. Allocating capital across various asset classes helps balance a portfolio and reduces the risk of being overly exposed to a single market or asset.
In conclusion, while illiquidity may seem like a drawback, it can offer unique advantages in an investment portfolio. Real estate, as an illiquid asset, can provide an illiquidity premium, limited price volatility, downside protection, and diversification. Understanding the nature of illiquid assets allows investors to make informed decisions and maximize the potential benefits that illiquid investments can offer.
SOURCES
- https://www.investopedia.com/terms/i/illiquid.asp
- https://www.naiop.org/en/Research/Our-Research/Reports/Economic-Impacts-of-Commercial-Real-Estate-2018
- https://www.naiop.org/en/Research/Our-Research/Reports/Economic-Impacts-of-Commercial-Real-Estate-2019
- UBS. The value of illiquidity: the case for alternative investments.
- https://www.reit.com/news/blog/market-commentary/comparing-real-estate-values-liquid-and-illiquid-markets
- Diversification does not guarantee returns and does not protect against losses.
