The Good and Bad of Financial Liquidity For Real Estate Investors (2024)

Investors love to talk about financial liquidity. And if you peruse the various online financial discussion boards, you’ll discover a theme.

High liquidity is excellent, and low liquidity is terrible.

But is this true? At the very least, it’s a gross oversimplification. And at worst, it’s propaganda designed to keep you heavily invested in high-commissioned paper assets.

What is Financial Liquidity?

Liquidity refers to the ease with which one can buy or sell assets at their current market value. Lack of liquidity refers to assets that can’t readily be sold for cash.

Cash is universally accepted as the most liquid asset class. However, other highly liquid assets, such as stocks, mutual funds, and money market funds, exist.

Illiquid assets are things like:

  • Real estate property
  • Private company ownership
  • Antiquities
  • Art
  • Collectibles
  • Cars

What you should know about Financial Liquidity

The advantages of liquidity are apparent. Being able to sell an investment quickly and access its cash value has benefits. Some stock investors utilize that liquidity to periodically rebalance their portfolio or to harvest tax losses.

However, if you sell off your assets for immediate cash needs, you may not have a large enough emergency fund or adequate insurance.

As evident as the benefits of liquidity are, the downside of financial liquidity may not be as obvious.

Financial Liquidity has a downside

Liquid assets are essential when constructing a portfolio. However, it may not be wise to be 100% liquid. There are downsides to liquidity.

Liquidity can undermine a disciplined investment plan. For example, it can exacerbate emotional investing, both out of fear and out of greed. Financial liquidity can also lead to lower returns as investors miss out on potential liquidity premiums that can come with illiquid assets. Let’s explore this further.

The DALBAR Effect

DALBAR is a market research firm that has studied investor behavior for years. In 1994, they produced their inaugural Quantitative Analysis of Investor Behavior (QAIB). In their words, “QAIB has measured the effects of investor decisions to buy, sell, and switch into and out of mutual funds over short and long-term timeframes.”

They’ve found every year since their inception that investor behavior leads to market underperformance in comparison to the index. In other words, the financial liquidity of the market allows investors to execute bad decisions. They tend to buy toward the top of a market out of irrational exuberance and sell toward the bottom out of fear of losing it all.

The volatility of the market cycle produces a whole range of emotions that lead to underperformance within the market, largely due to its liquidity. The research firm DALBAR documents this underperformance annually.

Their research clearly shows that emotional decisions coupled with market liquidity lead to an overall underperformance (5.96% return vs. 7.43% return from the index).

The Good and Bad of Financial Liquidity For Real Estate Investors (2)

Investors Chasing Return

Just as DALBAR has shown time and time again, financial liquidity enables investors to make bad decisions. One category of bad choices is chasing a return. How often have you heard someone say they sold off a percentage of their stocks or mutual funds to buy something else?

Often, that something else wasn’t part of their long-term plan. Typically, it’s the flavor of the month. Maybe it’s a hot stock pick, or perhaps it’s a new promising asset class positioned to take off. Perhaps it’s art or cryptocurrency or something else.

Illiquidity protects people from making irrational decisions like chasing returns or becoming enamored with shiny object syndrome.

Liquidity Highlights Investor Ignorance

As mentioned earlier, cash is the most liquid asset class. And you’d think that coming into a substantial financial windfall of money would create a lifetime of financial freedom. However, research shows that whether it’s lottery winners or NFL players, the financial liquidity of cash only magnifies one’s financial woes. Kiplinger reports that 78% of NFL players are in severe financial distress or have gone bankrupt within two years of retirement. They report that 60% of NBA players experience financial ruin within five years of retirement.

These individuals could benefit from a disciplined approach to investing that included some percentage of illiquid assets.

Financial Liquidity and the Lessons of Allen Iverson

While having a portfolio that contains liquid assets is essential, it’s clear that millions of people have fallen victim to the downsides of that liquidity. The poster child for this is probably Allen Iverson.

For those who don’t know, Allen Iverson was one of the best point guards in the National Basketball Association. Over a fourteen-year career, he was paid handsomely for his talents. He retired from basketball in 2010, having made $200 million. By 2012, he was broke.

As good as Allen was at basketball, he didn’t have a handle on his finances. Allen frequently dealt in cash and spent it as fast as he could make it. Whether it was cars, jewelry, or clothing, Allen spent extravagantly. He didn’t spend everything on himself either. He was famous for lavishly spending on friends and family as well.

Financial liquidity led to his economic collapse. Fortunately, financial illiquidity saved him from becoming destitute. He had one asset that he couldn’t fritter away. It happened in 2001 when Iverson signed an endorsement deal with Reebok. The deal was structured to pay him $800,000 a year for life and supply a trust fund worth $32 million that he can’t access until he’s 55 in 2030.

The deal’s lack of liquidity has provided Iverson with a lifelong income stream and a second chance at real wealth in 2030. Hopefully, he has learned from his mistakes.

Loss of a Liquidity Premium

Investments that lack financial liquidity tend to pay a liquidity premium. A liquidity premium is simply extra compensation for investing in an asset that can’t easily or quickly be cashed in.

The easiest way to understand a liquidity premium is to think about bonds. Short-term bonds typically pay less than long-term bonds. The liquidity premium is the higher return gained from a longer-term illiquid investment.

It’s your opportunity to gain enhanced returns.

Financial Liquidity and Modern Portfolio Theory

Financial liquidity is neither good nor bad. Instead, it is a feature of every investment one should consider before investing. Modern portfolio theory revolves around owning a range of assets that diversify one’s portfolio while maximizing the return given one’s risk tolerance.

For that reason, many people don’t have all financially liquid assets or all financially illiquid assets. Instead, they retain a mix of the two to achieve the results they are looking for.

Liquidity has downsides, and being overweight in financially liquid paper assets can make you vulnerable to those downsides. If you find yourself in that situation, you would be wise to learn more about multifamily real estate.

Using Illiquid Real Estate Investments To Balance Your Portfolio

Liquidity is neither good nor bad. Everyone should have liquid assets in their portfolio. However, being all liquid or all illiquid can be risky. Instead, it’s better to balance assets with your investment goals and risk tolerance to include both liquid and illiquid assets.

Multifamily real estate is considered an illiquid asset class. Investing in it could help balance a portfolio that is too heavily weighted with stocks, mutual funds, and cash.

Multifamily real estate has a long history of superior returns. Apartment returns have enjoyed high (stock-like) returns and low (bond-like) risk. That’s why they’ve had a risk-adjusted return (Sharpe ratio) that has outperformed stocks and bonds over the last two decades.

If you’re not investing in apartments, perhaps it’s time to learn more. 37th Parallel Properties utilizes a fund model in which one can invest fractionally in direct real estate for diversification, cash flow, and the potential for appreciation.

Contact us today and let us know how we can help you.

To learn more about commercial multifamily real estate investing, download your free copy of Evidence Based Investingfrom 37th Parallel Properties.
Download Now
The Good and Bad of Financial Liquidity For Real Estate Investors (2024)

FAQs

The Good and Bad of Financial Liquidity For Real Estate Investors? ›

Liquidity is neither good nor bad. Everyone should have liquid assets in their portfolio. However, being all liquid or all illiquid can be risky. Instead, it's better to balance assets with your investment goals and risk tolerance to include both liquid and illiquid assets.

What are the advantages and disadvantages of liquidity? ›

Liquid funds are ideal for low-risk investors looking to park surplus cash for the short term. The biggest advantage of liquid funds is that it offers superior returns than bank deposits. But the returns on liquid funds is not guaranteed. This is the biggest disadvantage of liquid funds.

Is liquidity an advantage of investing in real estate? ›

Illiquidity: Real estate is not a liquid investment, and selling a property can take time. You may not have access to your funds quickly in case of an emergency. This lack of liquidity can be a disadvantage compared to more liquid investments like stocks or bonds.

Is liquidity good for investors? ›

When investing in the financial markets, liquidity is an important factor to take into account. Simply put, liquidity is how easily an asset can be converted into cash without having a negative impact on its price.

What does it mean if a financial investment has great liquidity? ›

Liquidity refers to the efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price. The most liquid asset of all is cash itself. Consequently, the availability of cash to make such conversions is the biggest influence on whether a market can move efficiently.

What are the negative effects of liquidity? ›

Unmanaged or poorly managed liquidity risk can lead to operational disruptions, financial losses, and reputational damage. In extreme cases, it can drive an entity towards insolvency or bankruptcy.

What are the disadvantages of liquidity? ›

Cons of high liquidity in a company are:
  • Low return: Liquid assets like a bank or current debtors doesn't provide a lot of returns. ...
  • Increased risk: Lower returns can lead to increased risk. ...
  • Stuck cash: If the liquidity is due to excess cash in hand, it indicates the non-utility of cash and increases the cost of capital.

Why liquidity is a major drawback for real estate investment? ›

Lack of Liquidity

It's easy to sell stocks if you need money or just want to cash out but that's not usually the case with real estate investments. You could end up selling below market or at a loss because of the lack of liquidity if you need to unload your property quickly.

What is liquidity in real estate investment? ›

In real estate, the liquidity refers to how quickly and easily a property can be sold in the market without significantly affecting its price. High liquidity means a property can be sold quickly due to high demand, favorable market conditions, or the property's attractiveness to a wide range of buyers.

What are the advantages and disadvantages of real estate investing? ›

Investing in real estate offers potential for steady income and long-term growth. Pros include passive income, tax benefits, and portfolio diversification. However, cons involve high upfront costs, market volatility, and management challenges. Success depends on careful consideration and risk tolerance.

Why do investors prefer liquidity? ›

Liquidity Preference Theory and Investing

Holding highly liquid assets provides protection and the flexibility to shift into other investments when the market changes. When that occurs, you may take on more risk and illiquidity through investments like stocks, real estate, or high-yield bonds.

Why is liquidity important to investors? ›

Whether you're a seasoned investor or just stepping into the financial arena, understanding liquidity and its impact is essential. The ability to swiftly convert assets into cash provides you with the freedom to navigate market fluctuations, seize opportunities, and manage unexpected situations.

Is liquidity good or bad? ›

Is Market Liquidity Good or Bad? There's only upside to market liquidity. In fact, the financial markets need liquidity to ensure that traders can open and close their positions efficiently and enjoy tighter bid-ask spreads. To put it simply, market liquidity actually lowers the cost of investing.

What is a good financial liquidity ratio? ›

In short, a “good” liquidity ratio is anything higher than 1. Having said that, a liquidity ratio of 1 is unlikely to prove that your business is worthy of investment. Generally speaking, creditors and investors will look for an accounting liquidity ratio of around 2 or 3.

Do you want higher or lower liquidity? ›

A high liquidity ratio suggests that a company possesses sufficient liquid assets to handle its short-term obligations comfortably. A low liquidity ratio may signal potential liquidity issues.

What are the benefits of liquidity? ›

In addition, high liquidity can make it easier to enter or exit positions quickly, which can be an advantage in markets where prices can change rapidly. It is also essential for companies to maintain sufficient liquid assets to cover their short-term obligations, such as paying bills or meeting payroll.

What is the advantage of liquidity? ›

Liquid assets can be quickly and easily changed into currency. Healthy liquidity will help your company overcome financial challenges, secure loans and plan for your financial future.

What are the advantages of good liquidity? ›

The main advantage of strong liquidity is knowing there are enough assets to cover unexpected emergencies, changes in demand and surprise expenses. It can also improve a business's credit score which will give you a greater chance of securing funding should you need it.

What are the advantages of liquidity in finance? ›

Liquidity simplifies the selling process

It is easier to discover a buyer for a liquid asset than for a non-liquid asset. However, this does not mean that you should not have non-liquid assets at all. Instead, it would be prudent to not depend on non-liquid assets for emergencies.

References

Top Articles
Latest Posts
Recommended Articles
Article information

Author: Errol Quitzon

Last Updated:

Views: 5423

Rating: 4.9 / 5 (59 voted)

Reviews: 82% of readers found this page helpful

Author information

Name: Errol Quitzon

Birthday: 1993-04-02

Address: 70604 Haley Lane, Port Weldonside, TN 99233-0942

Phone: +9665282866296

Job: Product Retail Agent

Hobby: Computer programming, Horseback riding, Hooping, Dance, Ice skating, Backpacking, Rafting

Introduction: My name is Errol Quitzon, I am a fair, cute, fancy, clean, attractive, sparkling, kind person who loves writing and wants to share my knowledge and understanding with you.