Illiquidity can be a daunting concept for novice investors. The idea that invested capital may be tied up for years, or for an indeterminate amount of time, can be a non-starter for investors who need more immediate access to cash, or who lack the experience to truly get comfortable with longer-term holds. Illiquid assets represent a new dimension for diversification – a necessary next step from a traditional “60/40” portfolio of stocks and bonds – that generally becomes feasible for individual investors upon reaching ‘accredited’ status. This article takes a look at illiquidity, and specifically the liquidity (or lack thereof) of real estate assets.
When choosing individual assets, three key considerations are top-of-mind:
- Risk tolerance
- Expected rate of return
- Your personal return on investment timeline
For a more comprehensive discussion of asset allocation strategy, please refer to this article.
These parameters may seem reductive, but they are foundational to constructing a well-balanced portfolio and investment strategy. Each investor holds a unique set of investing objectives, and it is essential to have a clear understanding of your financial priorities prior to making any investment decisions.
These three concepts will guide you in determining which assets are suitable for your portfolio and those that are not based on their liquidity. Once you have determined your priorities, it is critical to consider how illiquidity can affect the return potential of your portfolio in both the short term and the long term.
Understanding Illiquid Assets
Liquidity refers to ease with which an asset or security can be transformed into available cash without losing market value. Essentially, liquidity defines how fast an asset can be bought or sold while still retaining inherent value. Cash is commonly considered to be the most liquid asset due to how easily it can be converted into other assets. Other liquid investments include publicly traded stocks and some exchange-traded funds, as well as government bonds (such as U.S. Treasury bonds, which trade on an accessible secondary market). These kinds of investments are significantly regulated, as they are publicly traded securities.
Tangible, private assets – such as real estate, fine art, and collectibles – are considered less liquid, or “illiquid”, while equities to partnership units (LPUs) may fall within various places on the liquidity spectrum. Additionally, private equity funds, hedge funds, and other private investment vehicles are traditionally recognized for their lower liquidity.
Although most illiquid assets share a degree of similarity in being hard, tangible assets, this is not the main contributing factor as to why they are considered illiquid. Illiquidity comes from supply and demand within an asset’s market, as well as the ease of valuation and ability to transact. Transaction costs, demand pressure, and inventory risk, as well as an inability to find buyers and sellers, all contribute to the illiquid nature of real estate.
While these alternative investments offer portfolio diversification benefits, they may not be suitable for every investor as they may not align with their personal risk tolerance, rate of return, or horizon timeline.
Pros of Liquidity
Investing in highly liquid assets carries several benefits. For example, publicly traded investments offer transparent pricing and the flexibility to sell, making it easy to convert to cash when necessary. For an investor with a short-term investment timeline, publicly traded investments are the most advisable option. They are customarily open to all investors, regardless of net worth or available investable assets, and minimums to invest are traditionally feasible for accredited and unaccredited investors.
Cons of Liquidity
Due to the public-facing nature of these securities, liquid assets are invariably affected by and vulnerable to the fluctuating market and the shifting winds of investor sentiment. Global news headlines can cause a steep descent in the value of highly liquid stock. The reaction of public equities markets worldwide to COVID-19 is one such example.
Additionally, something to consider that is often underplayed is the liquidity premium associated with every liquid asset due to the optionality and flexibility provided by this investment type. This optionality is traditionally forfeited in illiquid assets, which typically limits the investor’s ability to alter their investment strategies as quickly as the markets change and invest elsewhere within a short period of time. Essentially, the market requires that an investor be compensated for the loss of flexibility and additional risk, when investing in illiquid assets. Potentially, this can mean higher returns on illiquid assets (such as private real estate) over a longer timeframe.
Benefits of Illiquid Assets
Considering how susceptible liquid assets can be to volatility, investors with a long-term horizon may prefer an asset allocation more weighted toward illiquid assets. Illiquid assets provide portfolio diversification benefits with a relatively low correlation to the stock market. Typically, these assets remain more stable over time, as their pricing is not adjusted on a regular basis like publicly traded stocks and securities. Allocating capital across various asset classes may help reduce a portfolio’s overall exposure to risk, to ensure that your money isn’t tied up in one particular market or asset type.
Although illiquid alternatives may be good for diversification, they may also involve higher risk and longer lockups. For those interested in participating, the ability to invest in lower liquidity assets has historically been limited. High minimum investment size requirements and legal restrictions made it difficult, for individuals who are not extremely wealthy to invest. This has constrained their availability to most of the population until recently, when changes in investment regulation and the introduction of online investment platforms made private illiquid assets accessible to a broader range of investors.
That said, not all alternative assets carry the same level of illiquidity. In commercial real estate, liquidity risk may be mitigated by preexisting (or near-term) cash flow, a more secure position in the capital stack, or contractually determined and/or relatively short hold periods. While REITs are sometimes referred to as alternative assets, they do not behave as such – public REITs are traded, and so tend to exhibit a higher degree of correlation to the stuck market; illiquid real estate (i.e. real estate transacted via private markets), bears a lower degree of correlation to public markets and thus should be considered an alternative asset.
EquityMultiple’s online platform is designed to allow accredited investors – who previously had little or no access to illiquid commercial real estate assets – the opportunity to diversify a portion of their portfolio by investing across a range of deal types, helping to manage risk while retaining substantial upside potential. EquityMultiple’s technology streamlines the investment process by offering a diverse array of investment offerings that have gone through multiple layers of diligence to ensure they align with your three key considerations and overarching investing goals.
While illiquid investments have historically been marred by opacity – particularly for individual investors – EquityMultiple brings transparency to pricing, risk factors, and other elements of illiquid real estate investments.
The Bottom Line
Conventional wisdom goes that illiquid assets are best-suited to investors with a high risk tolerance. However, due to the slow-moving nature of private markets, lack of public trading, and tangibility of assets, illiquidity has historically meant less volatility – and hence less risk – over longer timeframes. As your investment strategy evolves, understanding illiquidity is paramount when choosing the balance and diversification of your portfolio, as illiquid assets may be beneficial due to relatively low volatility and stock market correlation, but could take years to see returns, and carry little or no opportunity for mid-term exit. It is important for every investor to understand their asset allocation strategy in the context of liquidity, risk, return objectives, and time horizon.