Markets are quiet, but just how quiet?
- Financial market liquidity broadly reflects the ease at which investors can convert assets into cash. The concept is not well understood however, probably because there is no universal definition, or indeed, consistency across markets. For example, in a liquid market, large orders should not unduly impact the underlying price. However, during periods of high volatility, liquidity is instead associated with rapid price discovery.
- Furthermore, liquid assets do not always imply liquid markets. Bank deposits are probably the most liquid financial asset. However, if everyone tried to withdraw cash from their bank accounts at the same time (a bank run), this could lead to withdrawal limits, frozen accounts, and even bank failure and financial losses.?
- Nevertheless, the IMF identifies five key characteristics of a liquid market; low transaction costs, immediacy in execution, depth of potential buyers and sellers, breadth of size and volume of bids, and resiliency.
- By these metrics (or any benchmark), real estate assets, and direct real estate markets, are illiquid. This is why the risk premium is often referred to as an ‘illiquidity premium.’ Investors do not look to private markets for liquidity (sometimes the opposite is true, as a lack of liquidity can mean a lack of price discovery, lower volatility, and so better risk-adjusted returns). But liquidity is relative, and it is still valid to look at the state of liquidity in real estate markets.
- There are a number of indicators of liquidity in financial markets. Transaction, or volume-based measures are based on the simple principle that large, active markets are generally more liquid. Price-based measures put the spotlight of the efficiency of the pricing mechanism – whether frictions exist that distort the ability for prices to clear markets – and the ability of investors to transact without unduly distorting the price. Market-based measures meanwhile look at other inefficiencies that impact the ease of transacting.
- Transaction-based measures are most popular because they are easier to quantify, especially in opaque markets such as real estate. We present a few in the chart below, comparing 2023 with the pre-pandemic average, to provide an approximation for ‘normal’ conditions. On nearly every metric, Europe has experienced the sharpest fall in liquidity, followed by the US. The Asia Pacific region stands out for its relative resilience, especially when looking at deal volumes
- A better transaction-based measure is the turnover ratio, i.e., the ratio of investment to the aggregate size of the market. This accounts for changes in the size of the investment universe, important in the context of the commercial real estate market, which in aggregate has grown by around 50% in the last decade, according to MSCI.
- This provides a more accurate reflection of the global downturn; in Asia Pacific, for example, the turnover ratio last year was around half the pre-pandemic average, showing a similar decline to the US market. Again, Europe compares poorly, although the gap narrows with the other regions.
- It is also notable that liquidity in all regions was lower in 2023 than it was through the Covid-19 pandemic, although higher than during the global financial crisis, where the global average turnover ratio dropped below 4%, compared with an average of around 5% for last year.
- Price-based measures of liquidity are a little more difficult to quantify in real estate. We know anecdotally that in many markets, large discrepancies exist between the price expectations of buyers and sellers. MSCI have attempted to quantify this with their price expectations gap analysis – an indication of the required change in prices needed to bring liquidity back to long term averages – illustrated in the following chart. Again, it is notable that liquidity is lowest in Europe, particularly in Germany, where valuations are more reliant on transactional evidence.
- Another price-based measure of liquidity is to compare current pricing with some assessment of fair value. This is done for European prime offices below, with the calculated yield providing an approximation of fundamentals, based on historical risk premiums, and future expectations for rental growth and depreciation. This analysis would suggest that we are closer to the pricing nadir compared with the MSCI price expectations gap (albeit that this looks at prime only).
- Finally, what of market-based measures? Again – data on indicators such as the average time to complete a deal are sparse in real estate, beyond anecdotes. But what we do know is that it is more difficult to execute in the current market environment, as evidenced by an increase in the number of terminated or pulled deals over the last 12-18 months.
