What is an Illiquid Investment in Todays Market?
This article is part of our passive investors guide on real estate syndications, available here.
Illiquid investments are assets that cannot quickly convert into cash at fair market value. These assets are not designed to meet short-term cash needs. Having a well-diversified portfolio should consist of liquid and illiquid assets. Passive cash flow investments are assets with the goal being long-term growth.
This article will discuss illiquid investments and how they are applied in the marketplace that is currently extant.
So What is an Illiquid Investment?
An illiquid investment is an investment that does not convert to cash as quickly as bonds, stocks, cash, mutual funds, cryptocurrency, and bitcoin. Physical cash itself is one example of a liquid asset.
Examples of illiquid investments are classic cars, rare art collections, old first edition books, or original manuscripts, especially if the manuscript has historical importance and private equity real estate. Real estate has historically generated 5% higher returns over periods of 10 to 25 years. Any investment strategy should include a healthy mix of liquid and illiquid assets.
What are Examples of Illiquid Assets?
Examples of illiquid assets include:
- Ownership interest in private companies
- Hedge Funds
- Commercial Real Esate
- Alternative Investments
- Penny Stocks
- Collectibles include cars, antiques, and rare art
Most investors know that a healthy, diversified mix of liquid and illiquid assets is needed so their financial health in both the long term and short term is solid and steady. If an investor has too much of one or the other and there is an immediate need for cash, the process could take longer than he might desire.
In economic times like we are experiencing now, liquid assets are more vulnerable to market downturns. That is where illiquid assets can come to the fore and provide the safety net investors should have in their portfolios. The most popular type of illiquid asset is land and real property like commercial properties. Although most stocks and bonds are considered liquid assets, they are not completely liquid because they are subject to market fluctuations and conditions.
Anywhere business is transacted qualifies as commercial property. The advantage of owning a commercial property is that it is illiquid and would take a long time for a downturn in the other markets to impact the business’s balance sheet. Because businesses provide a community service, an investor’s chances of actual harm are small. The downside for real estate investors is that owning a commercial property requires taxes and the insurance needed to protect the property.
In this context, a multi-family dwelling also fits the criterion of commercial properties when it contains five or more units and if these properties produce income, even if the owner lives in one of the units. On that basis, the owner has created a private company.
Private Company Interests
A private company is one where the owners are not subject to the filing requirements of the Securities and Exchange Commission—because of this, tracking inflows and outflows of most illiquid investments every quarter is a lot more complicated. Sales gains, losses, and gross profits and margins are virtually impossible to track.
The only person or persons that are answerable to the owners are the owners. There is no oversight from a governmental agency. The most illiquid investments are rare collectibles and real estate.
Which Investment Option is the Most Illiquid?
Commercial real estate is the most illiquid of all real estate investments. This is because many steps need to be taken to cash out of these properties or sell them outright. It is nothing like getting cash out of your home.
If there are multiple owners of this store, ready and willing investors would have to agree to the cash-out process, including the amount and the repayment schedule. One of the key takeaways with investments of this type is the risk of substantial loss of investment capital and the inherent risk of lack of access to the capital invested.
Related Read: Liquid vs. Illiquid Assets: Which is Better to Invest In?
Why is Private Equity Illiquid?
Private equity is an illiquid class. This means that investors cannot simply sell their funds whenever they want. To do so would expose them to high losses. These privately held assets generate liquidity on a per-annum basis, usually in the form of distributions and when the underlying investments are sold.
As part of investing in private equities, the investor needs to be compensated for losing access to their capital. This is referred to as the illiquidity premium.
The Illiquidity Premium
The illiquidity premium is compensation paid to investors for losing access to the capital they have invested. The longer the access is lost, the higher the premium paid to him becomes. The relationship between time and return is crucial and central when investing in private real estate.
Frequently Asked Questions About What is an Illiquid Investment
The asset that has the highest liquidity is cash. Cash could be held at banks in forming checking and savings accounts, CDs, money market accounts, and municipal bonds.
Private companies are illiquid. This is because there are frequently partners with an ownership interest in them.
The lack of interest or activity of stock causes illiquidity to occur. These positions are challenging to get out of, and the return on investment is very low when the issue is finally sold.
Illiquid Investment - Conclusion
The purpose of having a healthy mix of liquid and illiquid investments and assets is pretty straightforward. It is about balance. The best metaphor is about one’s diet. If you ate only carbohydrates, the health effects would be disastrous. The same holds for investments and assets. Too many liquid assets and investments could be unhealthy because a lot of the principal would be lost due to market fluctuations.
Too much on the other side of the scale means that should an investor need cash quickly, it won’t be there as soon as he may need it, and they could face losses of principal and capital.
- CapitalDynamics, “Is Private Equity Really Illiquid?“
- SmartAsset, “What Types of Assets Are Liquid?“
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