In this article, we will explain how illiquid investments work, some of the reasons why people use illiquid investments, and how to determine if an illiquid investment is right…
Understanding illiquid investments are key to building a well-balanced and diversified investment portfolio.
To be sure, the idea of tying up investment capital for several years can be discouraging for many beginning investors, especially those who have short-term cash needs or people who are not comfortable with passive investments held for the long term.
While it is always nice to be able to quickly convert an asset into cash, there are some very good reasons why an experienced investor might choose to place some capital in an illiquid investment.
In this article, we will explain how illiquid investments work, some of the reasons why people use illiquid investments, and how to determine if an illiquid investment is right for you.
What Are Illiquid Investments?
Let us begin this section by discussing the concept of “liquidity.”
When an asset or item is liquid it can easily change hands because there is little friction to the trading process and little or no price discovery. Some examples of liquid assets include cash, bitcoin, publicly traded stocks, many exchange-traded funds (ETFs), and most municipal and government bonds.
On the other hand, illiquid investments are ones that require some extra effort to exchange, where the fair market price is not easily ascertained or a combination of both. Examples of illiquid investment assets include penny stocks, rare art, and classic cars, capital placed with a hedge fund, and private equity real estate.
How Do Illiquid Investments Work?
The fact that an investment is illiquid is not necessarily a negative, especially in regard to real estate. As The Wealth Report 2021 from Knight Frank reveals, the pandemic has created a growing demand for rural and coastal properties.
Although overall property investment volumes declined last year, capital deployed by private investors was still 9% above the 10-year average, a trend that is projected to continue this year.
The pandemic is also driving real estate innovation, with a growing number of investors interested in environmental, social, and governance (ESG) investments such as green and energy-efficient buildings.
Understanding investment risk
There are three types of risk most investors are familiar with:
- Interest rate and credit risk related to the fixed-income market, such as bonds or dividend-paying stocks.
- Equity ownership, when the price of an asset like a stock or real property enters a cyclical decline.
- Liquidity, which involves the inability to trade an investment when you want.
Illiquidity risk vs. reward
In exchange for not being able to trade an investment when desired, investors will expect a higher return or an “illiquidity premium.” For example, if you invest in an asset that cannot be sold for five years or more you would expect a higher potential return compared to an asset that trades daily, weekly, or monthly.
Why investment is illiquid
There are several reasons why investment is considered to be illiquid:
- Shares in an equity fund or debt securities may be restricted by the private equity firm or by state and federal securities laws.
- Absence of a public market means that the lack of buyers may affect the price of an illiquid investment, compared to publicly traded securities.
- Securities are “passive” by design, such as real estate investments where the private equity firm determines when the project should be sold, and an investor’s capital (along with any potential gain) should be distributed.
Why Do People Use Illiquid Investments?
In order to gain the most benefit from an illiquid investment, the asset must truly be illiquid. The last thing you would want to do is invest in a project where other people could pull their capital on short notice, forcing an asset sale before the time is right.
There are some very good reasons why an experienced investor might choose to place some capital in an illiquid investment.
When you invest in real estate with a private equity firm, you provide the fund manager with long-term capital to see the project through to completion. The asset should be one you are comfortable holding in your portfolio for five years or more, and the real estate private equity firm is one that has a proven track record of success.
With that in mind, here are the top three reasons why people use illiquid investments:
Passive cash flow
One of the main reasons people use illiquid investments is for the passive cash flow they can provide. Although passive cash flow investments like real estate are less liquid than stocks and bonds, they are ideal for people who want to hold an investment over the long term.
When a property performs as expected, cash flow from real estate investments can be relatively stable because speculative short-term price movements seen with stocks are non-existent.
Debt securities are at the bottom of the real estate capital stack and have a high degree of certainty. Equity investments in real estate are at the top of the capital stack and, in addition to inflation-adjusted income streams, have the potential for appreciation in property market value and tax-reduction benefits such as depreciation deduction passed through to each individual investor.
In REIT Beta by Property Type, Nareit (National Association of Real Estate Investment Trusts) notes that the diversification benefit has been called “the only free lunch in investment management.” Diversification can be measured with the beta, which shows how much real estate returns fluctuate relative to the broad stock market.
The REIT market overall has a long-term beta of 75% relative to the broad stock market. Generally speaking, investors look for a beta of less than 100%, which means that assets with a lower beta should reduce the overall volatility of an investment portfolio over the long term.
While investors can diversify by buying shares of a publicly traded REIT, other investors prefer to place capital in a real estate private equity firm with the goal of out-performing both the broader market and industry-specific REITs. For example, between 2008 and 2018, residential real estate has provided a beta of less than 100% in every year except one, and most recently betas of 61% and 54%. The industrial property also has performed well, generating an average beta of 88.5% over the past few years.
One of the reasons why an illiquid investment like real estate has a low beta is because real estate returns are driven by the real estate market cycle and not the business cycle that affects the returns of many companies in the stock market.
An article from the Harvard Extension School Blog explains that cycles in the real estate market average about 18 years. The most recent cycle began in 2007, so there are likely several more years remaining in the current cycle, especially considering the multi-trillion-dollar stimulus packages and historically low-interest rates.
Less price volatility
Illiquid assets such as real estate are also more insulated from price volatility compared to the overall stock market. As another article from Nareit reports, the maxim that correlations spike to one during a crisis simply isn’t true.
In fact, some asset classes such as residential real estate can be both procyclical and countercyclical. When the overall stock market is doing well, historically residential real estate also does well. Interestingly, when stock market returns decline, residential real estate may also out-perform as investors seek a safe haven from stock market volatility.
During the 10-year period between 2008 and 2018, the REIT-stock (real estate investment trust) correlation for residential REITs ranged from 36% to 65%. That is why residential real estate such as single-family and multifamily properties are rated among the most “defensive” sectors to invest in. Industrial real estate is also considered a good defensive, countercyclical investment, with a correlation ranging from 45% to 72% over the same time period.
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What Are The Categories of Investments?
The concepts of liquidity and illiquidity can be somewhat nebulous. In part, that is because an illiquid asset may be sold quickly, but you may have to significantly discount the price to raise cash fast.
Liquid and illiquid assets are easier to understand when you classify them into one of three categories of investments:
- Highly Liquid Investment
Highly liquid investments include cash and cash equivalents that can easily be converted into cash with little or no charge to the value of the asset when sold. Examples of highly liquid investments include low-risk and low-yielding money-market funds, U.S. Treasuries and bonds, stocks and marketable securities, and mutual funds.
- Medium Liquid Investments
Medium liquid investments are those that are somewhat liquid, provided you can take the time to wait to realize the full market value. Examples of medium-liquid investments include assets such as precious metals, classic cars, rare art, fine wine, watches, and jewelry.
Single-family homes and small multifamily properties are also considered medium-liquid investments. In most real estate markets across the U.S., the demand for housing significantly outpaces the available supply.
New construction on single-family homes could exceed 1 million this year. But as Forbes reports, construction hurdles such as limited developable land, restrictive zoning laws and expensive permits, and increased lumber prices and labor costs mean housing inventory will still remain below-needed levels.
- Highly Illiquid Investment
Crowdfunds and private equity real estate can also be highly illiquid investments until the project is developed, leased up, and eventually sold. If a project takes several years to complete your money is also tied up for several years. You may be prohibited from selling, or only allowed to sell at specified times, and most likely at a discount because there are no secondary markets for these types of illiquid investments.
While illiquid real estate investments can provide beta and low-price volatility, those aren’t the only reasons to invest in illiquid assets. The biggest benefits of investing in an illiquid asset such as real estate are gained when low correlations are balanced with risk-adjusted returns.
Before choosing to put money into an illiquid investment, it is important to consider your liquidity needs over the investment timeline, the expected rate of return over the holding period, and your individual tolerance for risk.
Long-Term Benefits of Illiquid Investments
Illiquid investments are assets that cannot be quickly converted into cash, at least for their fair market value. Although illiquid real estate investments can be more valuable over the long term than liquid assets, they should be placed in the long-term, buy-and-hold section of an investment portfolio.
By participating in illiquid investments,
Real estate investors can diversify part of their overall portfolios
across a wide range of property types.
While it might seem that illiquid investments are a better match for investors willing to accept a high level of risk, oftentimes the opposite is true. Because real estate private equity moves slowly and lacks public trading, illiquid assets can also be less volatile over longer timelines.
One reason illiquid real estate investments can be more stable over the long term is because their prices are not constantly adjusted like publicly traded stocks and securities. With real estate private equity, the potential risk from lack of liquidity can also be mitigated by pre-existing or future cash flows from the property, and by investing in different parts of the capital stack.
By participating in illiquid investments, real estate investors have the opportunity to diversify part of the overall portfolio across a wide range of property types. A private equity real estate investment strategy like this can help to minimize risk with the potential for strong upside performance, even for investors with little or no experience investing in real estate.
Before investing in private equity real estate, it is important to conduct thorough due diligence on the potential investment, the equity fund manager itself, and the real estate private equity firm’s track record of success.
“One of the main reasons people use illiquid investments like real estate
is for the passive cash flow they can provide.”
Smartland was founded in 2008 and over the years has grown into a fully integrated value-add real estate private equity firm. The company is an ecosystem-based organization focused on single and multifamily value add opportunities in Northeast Ohio, the broader Midwest Region, and Miami, Florida.
The company has $160,000,000 in current and exited assets under management, has repositioned over 3,500 properties, and achieved an average investor annual return of 22.3%. We have achieved these impressive results for its investors by keeping everything under one roof.
We manage project design from top to bottom, have an in-house construction team that knows how to deliver measurable results to help achieve your investment goals, property managers who spring into action during the construction process and once the property is repositioned, and an in-house marketing team skilled in digital marketing and tenant nurturing.