The Importance of Liquidity in Real Estate

By Yousra Basra, Data Analytics and Product Manager, Recognyte

Liquidity is often referred to in terms of the sale of equities such as stocks or bonds, or other hard assets in exchange for cash. The value of liquidity is measured in terms of how quickly an asset can be turned into cash at the current market rate or price. An asset that cannot be sold relatively quickly by industry standards for current market value would be deemed “illiquid.”

Liquidity is an important measure since market values are subjected to numerous forces and conditions and may not remain constant or increase. Often an equity asset can lose value as stock markets experience volatility and even crash at times. The same applies to real estate, where changes in market conditions have a large impact on the value of properties and their liquidity, or value at market price. Over the last two years, liquidity has become indispensable in determining the true value of real estate assets for portfolio managers.

How does this impact Portfolio owners?

Most recently, in a post pandemic era, commercial real estate markets have been shaken-up around the world as remote work models and other pandemic related circumstances have driven tenants away. Companies are opting for remote and hybrid work models, and that has drastically reduced occupancy rates leaving portfolio owners and employers alike on sinking sand. Tenants are more demanding now, and the buildings that once held ’trophy’ property status have been turned upside down in many cases.

As cities adjust to varying market conditions and uncertain ‘back to the office’ initiatives, more and more buildings have the potential to become increasingly illiquid. The fundamental purpose of the office has changed, where properties are no longer attractive to potential tenants, investors, creditors, or even private debt brokerage firms that sometimes come in as the fall-guy to provide capital when all else fails. Portfolio managers are scrambling, and have difficult decisions that lie ahead amid great uncertainty. Recent geopolitical tensions have only served to obscure matters further as the energy crisis threatens each country across the European continent and global economy.

Otherwise, even without pandemic or other treacherous conditions, real estate investments are considered illiquid, where property assets come with varying levels of liquidity risk. Assessing liquidity is fundamental to ensure that outcomes for property investment portfolios and ownership income are maximized.

Frequent Market Changes Result in Uncertainty – Liquidity Risk Exists Across a Spectrum

Because liquidity is subject to numerous factors, liquidity risks exist across a spectrum. In real estate, for example, a building that was appraised at a high value to market price and able to attract long term tenants based on location may lose status if the demographics or other external environmental factors change. For example, a large skyscraper located close to public transport with a history of housing some of the most prestigious businesses in a region may be re-zoned where the location becomes undesirable over time as a business hub. This building would then become more illiquid, and potential investors should be aware of the changing intrinsic value and liquidity status.

As a matter of supply and demand, the building and surrounding properties may also face less demand, becoming more illiquid and almost certainly sell more slowly and for less than market price at that point in time. Problems can be exaggerated as well in a more illiquid lending environment as creditors react to central banking policy changes and are less willing to provide the capital needed. It’s also the case that property owners who are no longer able to meet obligations in worse case scenarios may introduce NPLs onto the balance sheet and the property then becomes even riskier as an investment for those unwilling to assume the debt if the building increases as a liquidity risk.

Understanding Liquidity Risk is Paramount to Building a Profitable Real Estate Portfolio

In reality, successful real estate investing is highly diversified, encompassing a wide range of investment options. Real estate investors and property owners then must be able to deeply assess and understand their liquidity risk across a wide range of assets. For example, if a seller wants to dispose of a property quickly, the investor may have to sell it for a much lower price than anticipated. That’s liquidity risk. Without a credible data source, investors lack the transparency needed to make informed decisions that facilitate diversification. Diverse in the sense that the portfolio includes properties that are liquid enough to generate cash upon sale, meet obligations, and retain capital for deployment into other assets.

Overall, understanding the risk involved with illiquid assets such as real estate can help investors to shape their portfolios. For example, an investor who might need cash in three years’ time will likely have enough liquid assets in the portfolio to cover that short-term obligation. Knowing this ahead of time can help ensure sufficient allocation of assets ready to monetise.

What are the challenges to understanding liquidity and achieving a diverse portfolio?

As previously mentioned, one of the main challenges today in real estate investing is a lack of transparent data. Traditionally, property listing websites are the most widely accessed source of information but contain missing information where the prices are not reflected accurately.  The property’s asking price and the actual price can be affected by non-recorded issues and negotiations that have not been reported from previous property transactions. Private markets are especially susceptible to off-record activity and neglected records as those involved in transactions often rely on in-house legacy methods for decision making and are not necessarily keeping the public record up to date.

Ultimately, though, in spite of limited data and missing information in publicly available real estate records, estimating liquidity can offer better price guidance by increasing the accuracy of property value estimates. It’s also true that higher liquidity leads to a higher volume of transactions as similar property prices become more well known, resulting in easier price discovery for properties with specific and desirable risk profiles. By the same token, liquidity provides investors with the knowledge that certain properties will not be monetised quickly, and that the capital needed may have to be raised through other sources.

Real Estate Illiquid, but Long Term Value Appreciation Can Create a Strong Liquidity Position for Those That Understand the Market

In conclusion, real estate investors buy properties for two primary reasons, the first being the ability to generate cash flow and income, and the second includes the investor’s potential to make money from the sale of a purchase. While real estate is generally considered illiquid, liquid real estate properties are easier to buy and sell at the current market rate without trading at a discount.

Today, market fluctuations and varying asset types all combine to create a wide spectrum of liquidity risk for investors. In today’s perfect storm, investors that ascertain their risk most accurately with credible data will be at an advantage. More than ever, in a post pandemic and volatile economy, portfolio managers need a strategy that includes access to accurate and timely data to enable the creation of diverse portfolios that are able to provide continuous investable cash for the expansion of future portfolio assets. Prior legacy systems and public records are no substitute for vetted data technologies that supply the proper analysis needed to determine liquidity risk in modern markets.

About Recognyte

Recognyte creates software solutions that help companies maximise their investment returns from real estate and lending. Recognyte has combined years of real estate knowledge alongside cutting-edge artificial intelligence, machine learning, and large-scale data collection, to reshape the landscape of property portfolio management with its suite of SaaS products.