What is Liquidity Risk?

What is Liquidity Risk?

Posted by Jacob Adams on May 3, 2021


Real estate investors know that if they buy a property then turn right around and sell it, they’re likely to take a fairly large loss on the property. In addition to market conditions, liquidity plays a big role in the buy-and-hold nature of real estate investing.

But what exactly is liquidity, and what risk does it present for investors? We’re going to demonstrate what liquidity risk is by using stocks as an example. We’ll then show how liquidity risk can impact real estate investors, making it an essential risk for real estate investors to consider.

Stock Market Liquidity

Buying and selling a stock is a fairly simple transaction — put in an order, name a price, and wait for the order to fill. Of course, there is a lot more going on behind the scenes. 

Let’s say an investor wants to buy 100 shares of a stock trading at 75. The 75 represents the last trade price. That doesn’t mean the trader can buy the stock for 75. The bid x ask (pronounced bid-ask) is 74.75 x 75.25, which means the trader will have to buy the stock at the ask, 75.25. 

The difference between 74.75 and 75.25 is the bid x ask spread. Every stock, ETF, option, and futures contract has one.

The wider the bid x ask spread, the less liquid the stock is. How does that impact the trader? If liquidity dries up (i.e., decreases), the spread may increase from 74.50 to 75.50. Now the trader must buy the stock for 75.50, a 0.25 increase. Because liquidity and the spread are inversely related, as liquidity drops, the spread widens.

A trader may buy the above stock at a time when liquidity is high. The spread may only be 74.95 x 75.05. But if there is a market shock or even some negative news hits the stock, sellers may rush in. 

A one-sided transaction, such as the dominance of sellers due to people trying to get out of the stock in a hurry, can also dry up liquidity. Sellers may push the price from 75, 74.50, 73.75, 72, 70 very quickly. These large gaps in price occur because there aren’t enough buyers on the other side of the transaction. While there is plenty of liquidity on the sell side, there is very little on the buy side. For the spread to close, liquidity needs to have a balance of buyers and sellers.

That is how liquidity risk in the stock market surfaces. Fewer traders mean fewer transactions, which can create a large bid x ask spread. An imbalance of traders can also create illiquidity. What does liquidity risk look like for real estate investors?

Liquidity Risk in Real Estate Investing

Real estate transactions already suffer from inefficient price discovery. Unlike a stock market, where prices and the number of traders are broadcast in real-time, there is no similar system for real estate. The best an investor can do is ask around, check the MLS or real estate websites for the latest prices.

Even after checking the limited resources to find property prices, the actual price can vary significantly. This is due to negotiations and potential issues found through inspection. Here, we are talking more about price discovery than liquidity. However, the two are related. High liquidity leads to better price discovery as more similar homes sell and prices become better known.

The liquidity risk for real estate investors is the potential inability to sell a property quickly. An investor who needs to raise money now will be at a disadvantage when selling their property. That isn't to say an investor can't sell the property. The problem is that to get rid of it immediately, the investor will likely have to sell it for a lot less than anticipated. That's liquidity risk. 

Of course, a hot real estate market can change that scenario. But if the market is not hot, liquidity risk is ever-present.

Investing in real estate means tying up money for long periods of time. Real estate is not a liquid asset — those investors who understand this use only money that isn’t needed in the near future.

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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