Sponsored by Resource Real Estate
By Alan Feldman
To whom would you rather lend $100: A trustworthy friend who promises to repay you $150 whenever you ask, or one who promises to repay you $200 in ten years?
Most would prefer the former, even if the latter option offers a better return. That is because we value liquidity—we want to be able to access our money when we need it.
In investment terms, liquidity is a measure of how quickly an asset can be sold without impacting the price. A U.S. Treasury Bill is a liquid asset—T-bills can be sold almost instantly, and that sale won’t affect Treasury market prices. A private home, on the other hand, is an illiquid asset. It would take several months to sell and the price obtained may be different from that anticipated.
Investors value liquidity and will typically pay more for more-liquid assets and less for less-liquid assets. For example, real estate assets housed in a traded fund would be priced higher than an identical set of assets housed in a non-traded fund. The rental income would be the same in either case, but investors would pay more for the stake purchased through a traded fund. In other words, investors typically pay less for a given cash flow from an illiquid asset. This difference in return is known as the illiquidity premium.
Investors demand an illiquidity premium to compensate them for liquidity risk, or the risk that they might not be able to liquidate their assets when markets turn bad. The illiquidity premium can be highly attractive. A Journal of Finance study found that buyout private equity funds outperformed the S&P 500 by more than 3 percent annually. Thus, including illiquid assets in a portfolio may help drive higher returns.
Illiquid assets may also benefit investors in other ways. Credit Suisse notes that during market downturns, closed-end funds, which have limited liquidity, may perform better than open-end funds, which allow redemptions on demand. When markets fall, investors in open-end funds frequently sell their positions, forcing the fund to liquidate assets to cover redemptions. The remaining investors are left with a smaller portfolio.
In a closed-end fund, investors cannot easily exit during a market decline. This enables the fund to stay the course strategically and retain the bulk of its portfolio. When the market recovers, closed-end funds may recover more rapidly and more completely than open-end funds.
In short, while liquidity is necessary, a diversified portfolio can benefit from the inclusion of illiquid assets. Such assets may help boost returns through the illiquidity premium, and may help smooth portfolio performance during market downturns.
Alan Feldman is Chief Executive Officer of Resource, a leading real estate and credit investment management company.
Learn more at www.resourcerei.com.