Liquidity is overrated. How often are you really drawing down funds to pay for an emergency? Every single one of my biggest investment wins have occurred because I waited 10 years or longer before selling. There was only one stock that I made an enormous return on in 2000 in just six months, but that was basically dotcom bubble luck.
Granted, some liquidity is nice to have in a portfolio, but what are you paying for that privilege? Illiquid assets may offer a different risk/return profile–something to consider in a period when many observers believe that relatively liquid investment options may be “topping out.”
The Potential Benefits of “Patient Capital”
Patient capital = less liquid, or private market, investments – which includes private real estate investments.
One study focusing on hedge funds shows that funds with longer “lockups” tend to earn higher returns than those without.
Liquidity often seems advantageous; if a disaster breaks out, many people want the agility – liquidity – to adapt to the increased uncertainty. Yet there is a fair amount of evidence that liquidity involves a very real price in the form of lower return rates – and that people generally seem to over-value its benefits.
Some of this can be attributed to the very nature of private companies (investments in which are generally illiquid) vs. public enterprises. Just think about how many times you were tempted to sell stocks at the bottom or buy at the top? Without liquidity, you save yourself from yourself.
In a key study 25 years ago, Michael Jensen of Harvard University argued that the tradable nature of any public corporation generates an inherent discount because of the fundamental conflict between those who bear the risk (shareholders) and those who manage the risk (executives) over the payout of free cash flow.
Jensen noted that public corporations tend to hold twice the amount of cash as private companies, which by contrast exhibit higher equity ownership by managers and more leveraged corporate structures that help limit the waste of free cash flow.
Private companies were thus seen as better aligning the interests of owners and managers, and in fact appeared to Mr. Jensen to achieve “remarkable gains in operating efficiency, employee productivity, and shareholder value.”
What is Illiquidity Worth?
Gauging the value of liquidity (the premium) with any precision is difficult, as it’s hard to untangle it from other market forces. (article continues below)
One study focusing on hedge funds shows that funds with longer “lockups” (which enable managers to invest in less liquid holdings) tend to earn higher returns than those without.
The data there indicated that fund returns actually rise as their lock-up period increases, from a median of 4.5% for funds with lock-ups of less than a fiscal quarter up to a median return of almost 13% for funds with a two- to three-year lock-up.
Another study by researchers from the universities of Chicago, Virginia and Oxford showed that while venture capital results varied, U.S. buyout funds generally outperformed publicly traded equities by as much as 3% annually.
To capture some of the illiquidity premium, institutions and endowments typically hold a significant portion of their portfolio in alternative” investments.
This may even be an underestimation; other research claims that the differential may approach nearly 7%. Yet another analysis argues that the combination of a successful private equity investment and a diversified portfolio can create a synergy that increases time-weighted returns and may provide a substantial increase to value-weighted returns.
That report also advises that the commitment to private equity be significant – between 15-20% of the total investment portfolio.
Are individual investors missing out on the illiquidity premium? Institutional investors seem to understand this.
To capture some of the illiquidity premium (as well as for purposes of diversification), institutions and endowments typically hold a significant portion of their portfolio in “alternative” investments.
The famous Yale Endowment model goes even further, currently allocating approximately 13% of its portfolio to real estate, with an additional 30% devoted to other types of private equity.
The concern over high fees was cited by a majority of both institutions and financial advisors in a recent survey, higher even than the concern about the liquidity itself.
Such institutional allocations to private market alternatives are quite different, however, from the majority of individual portfolios. Historically, individual investors’ portfolios have had little, if any, direct exposure to private equity; individual investors may have faced market access obstacles here that online marketplaces are now addressing.
Some of this reluctance to invest in illiquid investments seems to be driven by the high fees that are sometimes demanded by private investment vehicles, in addition to liquidity fears. The concern over high fees was cited by a majority of both institutions and financial advisors in a recent survey, reported Goldman, higher even than the concern about the liquidity itself.
Yale source: https://news.yale.edu/2018/10/01/investment-return-123-brings-yale-endowment-value-294-billion
The Real Estate Illiquidity Premium
In real estate, publicly-traded REITs offer a way to invest in the sector in a way that maintains some degree of liquidity – but detractors say those vehicles have shortcomings.
Recent surveys estimate that institutional investors continue to place between 80% to 95% of their real estate allocations into private real estate investments, rather than publicly traded REITs.
The value of publicly-traded REIT shares can fluctuate constantly along with the broader market, so that true asset class diversification may not really be obtained. REITs also arguably incur increased refinancing risk because of their requirement to distribute nearly all of their income.
Then, of course, there is the usual argument that private equity real estate is better managed and investor-aligned because sponsors are highly invested, and so better focused on achieving high returns.
There seems to be some truth to this. Recent surveys estimate that institutional investors continue to place between 80% to 95% of their real estate allocations into private real estate investments, rather than publicly traded REITs.
At recent trading levels, the overall listed-REIT sector seems somewhat unattractive; as of September 2018, the FTSE NAREIT All Equity REIT Index was yielding only 3.95%.
Since recent unlevered capitalization rates on real estate transactions in the private sector are expected to remain in the 5-8% range in 2016, a substantial portion of the price of listed REITs may be attributable to the liquidity factor.
Online Marketplaces and the Illiquidity Premium
Real estate finance marketplaces can help smooth the way for investors to participate in private investments that can potentially help them realize the real estate illiquidity premium.
The most important factor, of course, is that these marketplaces enable such participations, which used to be limited to institutions and high-net-worth individuals. Private commercial real estate syndications that used to require minimum investments of $100,000 or more can now be accessed for as little as $5,000.
Private commercial real estate syndications that used to require minimum investments of $100,000 or more can now be accessed for as little as $5,000. In other words, the common man can now invest in commercial real estate to potentially earn higher returns that were once reserved for institutions or the ultra wealthy.
The fees are also much lower than many private investment alternatives — most of RealtyMogul’s listings involve only a 1.2% administrative (or servicing) fee. Compare this to many hedge funds and private equity firms where, in addition to a (usually higher) administrative fee, typically as much as 20% of the potential upside is demanded from investors.
Finally, RealtyMogul structures its equity investments by using pass-through vehicles like limited liability companies (LLCs), which not only avoid double taxation but also allow investors to obtain the full benefit of depreciation and interest expense deductions. These benefits add further to the real estate illiquidity premium previously enjoyed largely by institutional investors.
Invest With The Largest Platforms
With real estate crowdfunding, you don’t need to risk $100,000 or more to invest in CRE. Instead, you can invest for much lower amounts such as $5,000.
The best real estate crowdfunding platforms today are:
1) CrowdStreet, founded in 2041 and primarily for accredited investors. CrowdStreet focuses on 18-hour cities, those secondary cities with higher growth rates and lower valuations. I think this is very smart because coastal cities like San Francisco and NYC are reaching affordability limits. There is also a demographic shift towards secondary cities thanks to technology and lower prices.
2) Fundrise, founded in 2012 and available for accredited investors and non-accredited investors. I’ve worked with Fundrise since 2016, and they’ve consistently impressed me with their innovation. They are pioneers of the eREIT product. Most recently, they were the first ones to launch an Opportunity Fund in the real estate crowdfunding space to take advantage of new tax laws.
Both of these platforms are the oldest and largest real estate crowdfunding platforms today. They have the best marketplaces and the strongest underwriting of deals.
About the Author: Sam began investing his own money ever since he opened an online brokerage account in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at two of the leading financial service firms in the world. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $220,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies and writing online to help others achieve financial freedom.