Liquidity in Real Estate is all about how easily an asset can be converted into cash in the market. In simple terms, it can be defined as the ability to sell the asset or property at a fair price within a fixed period of time. Liquidity risk can be stated as the difficulty in selling the investments when desired. Normally in these cases, investments are sold at a fairly lower price and the transaction cost is high. Real estate and property investment have given high returns in the past.
Despite the major returns, it may yield, the fact that the real estate market has a low liquidity rate and that the buyers have lesser equity at the time of buying is the major challenge faced by the real estate industry. This article analyzes various aspects of liquidity such as liquidity risk in finance, calculation, means to control liquidity rate, etc.
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What is liquidity risk in finance?
The investments made in the real estate sector can bring in certain added risks other than those existing in the case of traditional assets. Uncertainty and immeasurable risk formulate liquidity risk. The five main determinants that can be used to analyze liquidity in real estate and the risk associated with real estate include tightness, depth, resilience, breadth, and immediacy. These features can be explained as:
- Tightness: it can be stated as the cost of trading the assets.
- Depth: it can be explained as the ability to trade without causing any impact or minimal impact on the price of the asset.
- Resilience: it can be stated as the increase that has occurred as the result of trading quantities and its ability to affect the speed at which the marginal price of the asset changes.
- Breadth: The fourth factor that contributes to understanding liquidity in finance is breadth. This can be stated as the total volume that is to be traded.
- Immediacy: it is the cost that is arising when there is an asset that needs to be sold quietly.
The investment in real estate is dependent on different portfolios such as returns which give higher returns than the interest rate, the global investment opportunity and to gain stable cash flow. Thus the risk in liquidity arises when the property cannot be transferred or transacted within the desired period.
How to calculate liquidity in Real Estate?
Investing in real estate can be done in different ways and each has a different level of liquidity. Liquidity is evaluated in the real estate sector under five main categories. These categories are inclusive of transaction cost measures; volume-based measures; price impact measures; time-based measures; return-based measures.
- Transaction cost measure is done by measuring the illiquidity by the cost of immediate execution.
- The volume-based measure is done by dividing the liquid market into an absolute or relative transaction that is necessary to understand the depth and breadth of the asset as it analyses the transaction volume, turnover ratio, quote size, number of bids, and the market depth.
- Transaction measure is an indirect method used to calculate or estimate the liquidity in real estate and is calculated on the basis of individual trade within a fixed or particular period of time and turnover ratio is calculated by on the basis of the outstanding volume of assets that are transacted within a specified period of time.
- The Price Impact Measure of calculating liquidity in real estate is by separating liquidity from other market conditions.
- The liquidity in real estate can also be calculated using the turnover ratio. The turnover ratio presents the number of property or assets that have been transacted within a specific time period.
Why is high liquidity in real estate bad?
- It is believed that a high liquidation rate is not good for the individual. Experts believe that liquidation processes should be carried out keeping a clear objective as to the employment of these funds.
- High liquidity in real estate implies that the investor has been off the market for a long time which may cost largely to them as real estate has proven historically to be raising over the long term and it looks like going against the upward trend of the market.
- A high market liquidity risk indicates that selling stipulated assets might be challenging, accruing to low demand for the same.
How is liquidity risk-controlled?
Real estate is often stated as a sector that contains low liquidity which is a major concern among property owners. Alleviation of liquidity risk in property investment can be achieved by minimizing the debt and other unforeseeable costs in order to maintain healthy cash flow. The liquidity risk can be controlled by:
- By forecasting and Analysing the various factors associated with your investment process. By doing so you can avoid surprises and prepare for such circumstances in a systematic manner.
- By diversifying your options. In your real estate investment diversification can be made based on the number of properties owned, types, and location of the properties. However, diversifying your option can be a challenging option due to the value of the property. If you are an individual investor, then you may include co-investors or investment trusts such as syndicates and fractional investments to diversify your portfolio.
- Limiting your risk and take insurance to cover any unfortunate circumstances that may arise in the future.
- You may also set up a reserve fund to protect your investments.
How will good liquidity in real estate impact the buyers of the property?
The question as to how the liquidity in real estate will affect the buyers of the property. It can be analyzed in their easiness to arrange funds to carry out the investment process. Real estate property has fewer liquidity rates in general. This is due to the fact that the property transaction takes time to complete. This is also because the buyers do not always have the entire cash required for the purchase of the property. The people tend to go for different types of financing and also ask for seller financing as well as discounts to speed up the process of the transaction.
The acquiring of a loan after analyzing various options can take a little while however in the present scenario of lockdown, the repo rates have been cut due to which interest payable on home loans has been reduced to all-time lower rates of 7.15% and 7.8%. Due to this, more of the buyers have been interested in investing in the homes and considers it one of the best ways of investing. High demand for the purchase of the property and the easiness to estimate the value of the property are factors that contribute towards increasing the liquidity in the real estate market.
Summing up, it is to be stated that liquidity in real estate is the ability to convert the property into a fair amount within a specified period of time. Liquidity risk arises in situations of uncertainty and immeasurable risk. There are various factors that affect the liquidity in real estate and the risk associated with it. The fact that the liquidity in the real estate market is negligible makes it a major concern to the owners of the property. In the recent past, various factors have caused some immeasurable risk which leads to liquidity risk. This makes the calculation of liquidity in real estate necessary.