By Andy Friedman
When most people evaluate a real estate investment, there is a small set of initial questions that they look to get answered:
- What is the cap rate?
- What is the vacancy rate?
- How are rents or lease rates trending in that area?
- What is the condition of the building?
Further diligence will involve deeper sets of questions, but I seldom hear anyone refer to liquidity.
Liquidity refers to the degree to which an asset can be purchased or sold in a marketplace without adversely affecting its price. I’ll use the stock market as an example.
As I write this, the stock of Apple is quoted at $185.20 x 2,900 on the bid, and $185.22 x 1,500 at the offer. This means I can sell 2,900 shares of Apple at $185.20 without it moving, or could buy 1,500 shares of Apple at $185.22 without it moving- it can soak up $537,080 on the bid, and $277,830 on the offer. It is almost the end of the trading day, and 18 million shares of Apple have traded, representing a notional amount of $3.3 billion.
On the other end of the spectrum is Hexcel Corporation. Currently quoted at $66.05 x 700 on the bid, and $66.08 x 800 at the offer. I can only sell $42,235 worth of stock on the bid or buy $52,864 worth on the offer before the price will move. 277,000 shares have traded today, representing a notional amount of $18 million.
The takeaway from this is that you can transact a much larger dollar amount in Apple compared to Hexcel before moving price. This fact is extremely important to fund managers as well as traders, and figures into their decisions before making investments. An Apple position is safer than a Hexcel position with respect to the exit. How much will you get hurt if you want to get rid of it?
Real estate is not traded on an exchange, and you can’t repeatedly buy the same building as you can with stock, but the effects are similar.
Take a hypothetical 6-flat in a so-so neighborhood that has been on the market for months and can be picked up on the cheap with a high cap rate. Will the situation be any different when you go to sell?
Now take a hypothetical 36-unit courtyard building in Lincoln Park- it won’t stay on the market for long, and it will trade at a low cap rate. This can be extremely frustrating for buyers, who can’t understand why something would sell for such a low yield.
An important factor for the difference in these situations is liquidity. There are tons of buyers for courtyard buildings in core Chicago markets, and those buyers tend to be very deep-pocketed. There are only so many people that want to speculate on a small building in an up-and-coming neighborhood, and those buyers are often not well funded. There are of course other factors involved in real estate valuations, but liquidity has a meaningful effect, just as it does in financial markets.
The intent here is not to say that any one product type is better than the other, but to point out that they differ greatly in liquidity which in turn affects the cap rate on both entry and exit. Lack of liquidity leads to not only higher cap rates but to longer sales times, and high liquidity leads to lower cap rates and quicker sales. Those that are willing to carry a less liquid investment are rewarded with higher yield. Those that require high liquidity in a real estate investment must accept lower yields. Make sure that you understand the liquidity levels of the area and product type that you are investing in, and how they may or may not change over time.