What is Illiquidity in Commercial Real Estate?
Liquidity and illiquidity are commonly used terms in the investing world. If an asset is liquid, its owner quickly can convert it into cash with little time, effort or trouble. Highly liquid assets include cash in a money market fund and shares of widely traded stocks, index funds and exchange-traded funds. One feature of liquid assets is a valuation that’s transparent – participants in the stock market and in cryptocurrency markets know the value of every equity or asset at all moments in the trading day.
If an asset is illiquid, on the other hand, owners can extract their cash only after devoting time and effort to the marketing and sale of the property in question. Examples of illiquid assets include shares of privately held companies, partnership shares, investments in hedge funds, art, collectibles and, of course, real estate. Pricing of illiquid assets is opaque, and a potential buyer can feel comfortable making a bid only after a period of inspections and appraisals. This due diligence period slows the selling process and reduces liquidity.
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What is the Difference Between Illiquidity and Liquidity in Commercial Real Estate?
Every piece of commercial real estate is unique, a quirk that makes real estate inherently illiquid. If you want to sell real estate, you’ll inevitably face a lengthy period of time before you can extract your investment and any profits. Commercial real estate transactions usually unfold in months and sometimes years -- but never in minutes or hours. The owner must prepare a building for sale, advertise the property, work with a listing broker, conduct tours, accept bids, negotiate contracts, complete due diligence and wait for financing to come through. All of these steps take time, which creates a distinct lack of liquidity. For a buyer, the timeline is equally lengthy; the to-do list includes touring and researching properties and making offers. This illiquidity isn’t necessarily bad – the commercial real estate market functions well amid liquidity constraints – but it is a defining characteristic of the sector.
Illiquidity does add some risk for sellers who are planning a sale. Usually, an owner can put a property on the market today and trust that when the sale closes in nine months, the world will be the same. But there’s a chance that something bad could happen to scotch the sale. A hurricane, flood, fire, tornado or earthquake could damage the building. A recession or the loss of a significant tenant could dry up the supply of buyers. It’s worth noting that these liquidity constraints aren’t all bad. While the value of liquid stocks can plummet, prices of commercial real estate are sheltered by their very illiquidity. Volatility and panic-driven fire sales are far less common in an illiquid market.
A workaround to real estate illiquidity emerged in the form of real estate investment trusts, or REITs. These companies exist to own commercial real estate and to issue shares to investors. In the case of publicly traded REITs, this ownership structure creates extreme liquidity. An investor can buy or sell shares at the click of a button, and a trade can be executed in seconds. A fidgety investor can buy shares of a REIT after breakfast and sell them after lunch. The REIT still faces the usual illiquidity issues when buying and selling properties, but for the investor, the liquidity problem is solved. REITs create an instrument by which an illiquid asset can be traded with ease, and investors are said to pay a ‘liquidity premium’ when they invest in REITs. This is a cost they incur above the value of the underlying asset that provides them with the benefit of liquidity for an illiquid asset.
What are Some Examples of Illiquid Commercial Real Estate?
By default, all commercial real estate is illiquid. However, some pieces of property are more liquid than others. A grocery-anchored shopping center that’s well-maintained and filled with tenants, a newly built distribution center that’s 100% leased – both properties likely will sell quickly. The biggest questions will be how many buyers submit bids, and how low will they drive the cap rate? At the opposite end of the scale, troubled properties can require much more due diligence, and therefore are much more illiquid. Consider a retail property that has lost several major merchants. Department stores and big boxes aren’t lining up to fill the vacancies. Perhaps the wisest use is a repurposing of the property to residential or distribution space. However, doing that means an investment of time and effort. Local authorities must sign off on changes in zoning or land use. Neighbors probably will object. Lenders will wonder how to value a new use for an old space. All of those variables ramp up the marketing time and increase the illiquidity.
An extreme example of illiquid commercial real estate is presented by the tallest building in Memphis, Tennessee. The 37-story office tower is the most prominent structure in the downtown skyline. And yet it has sat empty since 2014, in part because of soft demand in the local office market. Thieves harvested the copper wiring. Vandals knocked books from the shelves of dusty law libraries left behind by attorneys who once rented office space there. To stop the decay of a highly visible landmark, the Downtown Memphis Commission in 2021 deployed a creative – and risky – strategy. It paid $10.75 million for the entire block that’s home to 100 North Main Street. The commission in turn marketed the empty building to developers – and the building’s disrepair meant potential buyers touring the building had to climb 37 flights of stairs. The elevators didn’t work. In early 2022, the Downtown Memphis Commission named a developer to take over the property. However, this liquidity event occurred only after years of underuse and the involvement of the public sector to rescue and market the property.
What Causes Illiquidity in Commercial Real Estate?
The mantra of commercial real estate is “location, location, location,” and no location is exactly the same. Even two seemingly identical retail properties on the same corner can have differences that affect their values. Perhaps one spot is more visible or accessible to passing motorists. Maybe one lot is slightly bigger or smaller, or one structure is in need of repair and the other has been recently updated. The very nature of commercial real estate lends itself to illiquidity. Because no property is exactly like another, a prospective buyer will want to perform an inspection, hire an appraiser and complete a title check. Local zoning and building authorities have a say in how the property is used, so savvy buyers research municipal codes and ordinances to avoid any nasty surprises. All of that is much different from selling a share of stock – one share really is indistinguishable from another.
Where does Crowdfunding Fit on the Liquidity Scale?
Real estate crowdfunding is a form of direct ownership of commercial real estate. Investors typically are locked into an investment for a predetermined period of time, perhaps three to five years. Most sponsors impose penalties or fees for early exits. Unlike the liquidity premium in REITs that costs the investor more, the illiquidity premium for real estate crowdfunding reflects the additional benefits investors receive from tying up their capital in an illiquid investment. By committing to a longer term investment than via a REIT that can be traded at the click of a button, investing in crowdfunded real estate provides investors the potential for substantial returns that no REIT can offer.
The flip side to the illiquidity premium is, of course, that investors must accept that once they invest in a project, their money will likely be tied up for months or years before they can access it again. Most crowdfunding deals require investors to make a capital commitment of at least a year or more. Some require investors to commit to a three, five or even 10-year time horizon. This makes real estate crowdfunding inherently less liquid than investing in a REIT. That said, there are usually provisions to allow investors to exit crowdfunded deals early, even if doing so results in a penalty or fee.
What is the Difference Between Illiquidity and Insolvency in Commercial Real Estate?
These concepts might sound similar, but they’re quite distinct. All commercial real estate is illiquid for all the reasons we’ve discussed. But very few pieces of commercial real estate are insolvent. Insolvency refers to a state of financial distress in which a property owner is unable to meet its debt obligations. During the coronavirus pandemic, some commercial properties faced solvency issues because of a sudden shift in demand – hotels experienced a sharp decline in guests, retail centers suffered a loss of shoppers, office properties lost tenants amid the work-from-home trend. An insolvent property owner might try to negotiate with lenders to establish new terms of debt repayment. If those negotiations fail, the lender can file for foreclosure, the legal process to take the collateral underlying the loan. And the borrower can seek bankruptcy protection, a legal process that allows for the restructuring or forgiveness of debts. But those are the hallmarks of insolvency, and they have little to do with illiquidity.
Liquidity and illiquidity are important concepts for investors in commercial real estate to understand. Commercial real estate investors realize that illiquidity isn’t necessarily good or bad – it’s just the reality that characterizes the asset class. This reality explains why commercial real estate crowdfunding platforms typically require minimum hold times. Allowing investors to sell shares at will would create a mismatch with the marketing times of months or years that are required to create liquidity events in the commercial real estate sector.
Chris Rising manages the day-to-day business activities of Rising, while also serving on its Investment Committee.
He received his J.D. Law, Real Estate from Loyola Law School and his B.A. in History and Political Science from Duke University.