The Pros and Cons of Liquidity

By Alexander Bermudez

Now that we have discovered the miracle of compounding property values, it may be a good time to discuss the inherent shortfalls of real estate. Remember all investments harbor risk, in the case of real estate; the lack of liquidity is its Achilles Heel. Liquidity is a term that refers to an asset's ability to be sold (liquidated), in a short period of time and with minimum loss of value.

Although one of the best asset classes available to individuals with long term investment horizons, real estate can take months, if not years to sell. In a slow market, pricing may be unpredictable and adding insult to injury the transaction costs are high. In a poor market leverage only exacerbates the problem, by increasing the volatility of the asset. Needles to say, you don't want to be forced to sell an illiquid asset under adverse conditions. Thankfully there are steps we can take to reduce the risk, without significantly diluting return expectations, thus engineering a more efficient investment.

Short-term reserves of cash or cash equivalence, while unlikely to rival the investment performance of leveraged real estate, provides a hedge against the inherent lack of liquidity. The amount of accessible cash will largely depend on your fixed liabilities and your risk tolerance, but three to six months of expenses, set aside for unforeseen costs, would substantially reduce the likelihood of default or distressed sale. However a word of caution, while cash reserves are highly recommended, excessive cash positions do present a substantial opportunity cost.

In addition to short-term reserves, insurance, hedges against the possibility of catastrophic events. Banks will always insist you insure any real estate, they hold mortgages on. However in this litigious climate we all live in, additional liability insurance is highly recommended. Statistically speaking, landlords are amongst the most commonly sued. Not only will insurance companies bear the financial burden of any legitimate claim against you, but also they will likely use their vast legal resources, in an effort to preserve their own capital, to defend you against any frivolous lawsuits. A good insurance broker should be able to show you a host of different insurance products, specific to your real estate needs..

Property Management, regardless if you delegate the job or not, is of paramount importance to the long-term performance of real estate. Attractive well-kept buildings not only command premium rent, but also attract good long-term tenants, substantially reducing vacancies. As a landlord, empty apartments are amongst the largest of expenses, due to lost rent and all the costs associated with re-leasing the unit. Avoiding vacancies through good management will preserve the cash flow of the investment.

As with all investments, low levels of uncertainty tend to have lower yields, conversely high levels of uncertainty tend to have higher yields. However, tremendous long-term returns can be achieved with real estate, through good management and successful hedging, with minimal downside risk to the investor. The key is to remember, that in real estate you will only get a good price, if you do not need the money.