If you’re like many experienced real estate investors, part of your wealth management strategy is stashing your wealth in real assets. But there may come a time when you need the most liquid asset of all: cash. That’s when you need to understand real estate liquidity.
What Is Real Estate Liquidity?
How liquid an asset is refers to how easily it can be exchanged for cash without affecting its market price. Cash is the most liquid of all assets. Other fairly liquid assets include stocks, fine art and collectibles.
Liquidity exists on a spectrum, with some assets being closer to liquid, or easy to sell at their current value, and others being closer to illiquid, meaning difficult to sell. This spectrum describes “liquidity risk” and is an important factor to consider when making investments.
Real estate liquidity is an interesting term in that regard, as real estate assets are considered among the most illiquid investments. A better name might be real estate illiquidity. But within the world of real estate, each asset class and investment strategy exists on the liquidity risk spectrum, as well.
Before we get into diversifying your portfolio with liquid and illiquid assets, let’s take a deeper dive into real estate liquidity.
An Example of Liquidity in Real Estate
As an example of liquidity, let’s say you need $5,000 to buy a used car. Cash would be the best asset you can use to buy that used car.
However, if you don’t have $5,000 in cash, but you do have a valuable piece of art, you’d have to find someone willing to buy that art for at least $5,000 in order to make the money to purchase the car.
The art would be considered less liquid than the cash because it might take you some time to find someone to purchase it, which would delay you from getting the money to purchase the car.
This same principle applies to your real estate assets. Let’s say you want to purchase a car, but this time it’s a 1969 Ford Mustang 429 Boss. It’s being sold for $300,000 by a private seller who is only accepting cash.
Fortunately, you have an office building in your portfolio that you can sell for about the same price, with a little extra to cover your commercial real estate agents’ fees. Perfect!
Let’s imagine now that your office building is actually in worse shape than when you bought it. It’s also in a location that was once a tech hub, but after the COVID-19 pandemic, remote work has become the norm and traditional office space is no longer in demand.
Suddenly your office building doesn’t seem very liquid, does it?
How Liquidity Operates in Commercial Real Estate Markets
Liquidity in commercial real estate value is the measure of how quickly a property you own will sell at market value.
Because the market changes frequently, you may be able to sell a large asset like our office building in the example above either very quickly or very slowly.
The real estate market is “liquid” when real estate sells quickly and at (or close to) its market value. If the market is “illiquid,” that means your real estate may sell more slowly and for a price that’s different from the market value—either for more or less money.
Certain properties in commercial real estate—specifically highly-specialized properties and “trophy properties” (think: the real estate version of that Mustang) function in a particularly illiquid market.
For these sorts of very expensive properties, there’s often a small number of buyers, which makes it harder to sell properties quickly, and often sellers have to settle at a discounted final price if they want to liquidate the property quickly.
Other terminology that is important to know is a “hot market” vs a “cold market.” When the market is hot, it means prices are rising and people are buying. When a market is cold, it means prices are going down, and people are not as keen to purchase.
High liquidity = hot market, low liquidity = cold market.
5 Strategies to Mitigate Real Estate Liquidity Risk
Now that you understand real estate liquidity, you can start making real estate investments that are right for you. Let’s review them here.
1. Commercial Property Flipping
Just like residential real estate, commercial properties can be flipped. Especially in the case of adaptive reuse, investors can buy a run down multifamily building or even old office space and renovate or completely reinvent it.
As with speculative construction, there is a lot of real estate liquidity risk with this investment strategy. The problem is you just don’t know if buyers will like the renovations you’ve made.
We consider this strategy to be moderately liquid for multifamily properties and moderately illiquid for office spaces, retail, and risky conversions in other asset classes.
2. Buy-and-Lease Rental Property
Just like the buy-and-hold strategy in stock investing, buy-and-lease is when you buy a property and rent it to a tenant.
The nice part of this real estate investing strategy is that you get rental income while you wait for your property to appreciate.
The downside is that you need to wait for your property to appreciate.
In the meantime, the market could go cold, the city could change its zoning ordinances, or any number of disasters could strike your property—all making your investment difficult to sell.
That’s why buy-and-lease strategies are considered close to illiquid. But remember, the market could go hot, the city could expand its zoning allowances in the form of density bonuses, and your property could withstand the test of time.
3. Commercial Property Wholesaling
With wholesaling, you’re buying properties that you believe are currently undervalued and selling them to buyers at market rate.
Because the flip happens quickly, you feel confident that you stand to make money on the property without the risk of any sudden market changes.
Regardless, we consider this investment strategy to be fairly risky and moderately illiquid.
Without the right network of buyers lined up, it can be difficult to flip a property that wasn’t selling quickly in the first place. This strategy is dependent on your network and skills.
4. Real Estate Investment Trusts (REITs)
As mentioned above, stocks are considered the liquid asset. That makes REITs highly liquid. REITs are publicly traded companies that own or finance investment properties.
In general, you can buy and sell shares of REITs anytime between 9:30am and 4pm Monday through Friday.
When a developer doesn’t have the capital to finance their investment, they sometimes use crowdfunding. As an investor, you pool your money with other investors in a fund that goes toward building the development.
While this sounds as liquid as REITs, be sure to read the terms of your offering memorandum. Often, crowdfunding comes with a lock-up period during which time you can’t pull your investment. Lock-ups may last from a few months to several years. After that, it’s easy to divest.
For this reason, we consider crowdfunding moderately liquid. Just be sure you know what you’re signing up for before you literally sign.
Real Estate Liquidity: Know Your Investment
As an experienced commercial real estate investor, you know how important it is to have a diverse portfolio. Understanding real estate liquidity risk is a key diversification factor. There will be times in your life when you need funds fast. But at the end of the day, a wise investor is in it for the long haul. Liquidity brings a whole new meaning to “buying time.”