How to Calculate Liquidity Risk?

How to Calculate Liquidity Risk?

Posted by on May 28, 2021

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Real estate isn’t known for its liquidity. But what is liquidity, and why should real estate investors care? Liquidity is the ability to discover the current market price of an asset and immediately convert the asset to cash at that price. To discover the current market price, buyers and sellers need to be readily available at that price. Real-time price discovery allows an investor to convert their asset into cash. There are many levels to that statement. In this article, we’ll unpack them and go through why we think it is important to consider liquidity risk.

Note that we are using stock market terms when referencing liquidity. These terms include price discovery, bid x ask spread, and trade price. Our stock market liquidity references are not perfect analogies to real estate as these are two different markets.

What is Real Estate Liquidity?

Before we discuss real estate liquidity, let’s step back and look at liquidity in the stock market. 

Highly liquid stocks have real-time price discovery. This means you can pull a stock and see what it is currently trading for. However, some stocks are more liquid than others. Less liquid stocks will still display a price, but the market may have moved away from that price when someone tries to trade the stock. 

The problem here is that the current price hasn’t yet been reflected for the stock. This happens because no one has executed a trade at the current market price. The next trade will show the current price, but someone has to be willing to execute that trade.

On the other side of the spectrum are very liquid stocks. Microsoft, Facebook, and Salesforce are good examples. If Microsoft is trading at 210, you can almost be sure that you’ll get a trade price very close to 210. Some trading platforms will show market depth. This reveals the number of traders who want to buy and sell around the 210 price. Market depth is another view of liquidity.

Getting an accurate market price for real estate is difficult. For the buyer and seller, they will always end up negotiating on a price. However, all is not lost since the MLS, or a quoted price is usually within the ballpark and helps to set expectations.

Can You Calculate Liquidity Risk?

In real estate, there isn’t really a way to calculate liquidity risk. Based on market depth (i.e., the number of buyers or sellers putting in offers for a home), you can get some idea of potential liquidity. Any liquidity risk calculation needs more readily available quantifiable data.

The stock market provides such data. Each stock displays its last trade price along with a bid x ask. The bid x ask might be 75.50 x 75.75 for a stock that last traded at 75.60. The bid x ask spread in this case is 0.25. The smaller the spread, the more it tends to reflect a liquid market.

Because real estate doesn’t have an easily available bid x ask, it’s difficult to calculate any meaningful spread or liquidity risk. 

Portfolio Liquidity

Identifying illiquid assets within a portfolio reveals the percentage of the portfolio that is susceptible to liquidity risk. Consider the following portfolio:

Property 1 — $200,000

Property 2 — $450,000

DST 1 — $125,000

Stocks — $250,000

Bonds — $100,000

Total: $1,125,000

Property 1, Property 2, and DST 1 (Delaware Statutory Trust) are all illiquid real estate assets. They total $775,000 or 69% of the portfolio’s value. This portfolio has a high liquidity risk. If, for some reason, the investor needs to raise $500,000 in cash very quickly, they would start by liquidating stocks and bonds for a total of $350,000. That leaves $150,000 in illiquid assets to try and liquidate.

Those illiquid assets are not likely to be liquidated immediately without taking a loss or a fairly large cut in any gains. Those are the risks presented by illiquid assets — they are difficult to sell in a hurry and the sooner you need to sell them, the more likely you are to take a larger cut in value.

Understanding the risk involved with illiquid assets can help to shape a portfolio. For example, an investor who might need cash in three years will probably have enough liquid assets in the portfolio to cover that need. Knowing this ahead of time can help ensure a proper allocation of assets.

A portfolio that is 100% invested in real estate or other illiquid assets is similar to the house rich, cash poor homeowner. Not to say that the primary residence of the investor will need to be sold. It’s more that there isn’t really anything in the portfolio that is easily converted into cash. That portfolio is made up of 100% liquidity risk. If the investor needs cash at any point, he may take a (significant) loss on the value of his assets to convert them into cash.

Realized helps you to understand the liquidity risks inherent in real estate. That’s why we are developing a secondary DST marketplace. The marketplace is designed to help with liquidity risk, allowing investors to seek buyers on their illiquid assets. 

Working with a financial advisor is one of the best ways to ensure that a portfolio is not overly allocated to illiquid assets and is aligned with the investor’s financial goals.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.

 


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