The Real Estate Illiquidity Premium – Capturing the Upside

Some liquidity is nice to have in any portfolio, but – is that privilege too expensive? Illiquid assets may offer a different risk/return profile– something to consider in a period when many relatively liquid investment options are experiencing dismal returns. 

At RealtyShares, we’ve written before about the potential benefits of “patient capital” – less liquid, or private market, investments – which includes private real estate investments. 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. In a key study 25 years ago, Michael Jensen of Harvard 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. 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. 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 20-30% of their portfolio in “alternative” investments. The famous Yale Endowment model goes even further, currently allocating nearly 20% of its portfolio to real estate, with an additional 30% devoted to other types of private equity.

Such institutional allocations to private market alternatives are quite different, however, from the majority of individual portfolios. A recent Goldman Sachs study claimed that most individual investor allocations to private alternative investments rarely exceed 5% of their portfolio.

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.

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. 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 November 30, 2015, the FTSE NAREIT All Equity REIT Index was yielding only 3.77%.  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.

Crowdfunding can help investors realize the real estate illiquidity premium

Real estate crowdfunding sites like RealtyShares (the company that I founded and am CEO of) can help smooth the way for investors to participate in private investments that can help them realize the real estate illiquidity premium.

The most important factor, of course, is that these sites enable such participations, which used to be limited to institutions and very 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 (and sometimes only $1,000) through these crowdfunding sites.

The fees are also much lower than many private investment alternatives -- most of RealtyShares’ listings involve only a 1% 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, the better crowdfunding sites structure their 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.

Private commercial real estate investing is an illiquid type of investment, but as noted above many observers believe liquidity to be over-rated – and overpriced. Crowdfunding sites like RealtyShares offer investors access to these cash flow-oriented investments that often act as a hedge against inflation. The tax benefits often involved with equity investments using direct participation vehicles can also be attractive. No investment is guaranteed, of course, but commercial real estate has unique characteristics that argue for its inclusion in an investment portfolio, and crowdfunding has made those investments much more accessible than in the past.