A Quick Note on Liquidity: Cap Rates, Part II

My last piece on cap rates covered some important ground about this important metric in real estate. This article discusses another key factor impacting cap rates, liquidity. (Or lack thereof). In general, investors are willing to pay a high premium (and thus accept a lower return) to hold liquid assets. This raises required returns for illiquid assets like real estate. Within the asset class, more liquid regional real estate markets, ceteris paribus, have lower cap rates because investors are willing to accept a lower return in exchange for more liquidity. In general, low liquidity in the real estate space substantially raises the cost of capital in the industry and remains an under-discussed barrier to housing production.

Liquidity

Liquidity is just the ease at which something can be bought and sold. Highly liquid assets like stocks or bonds of large companies can be freely traded with minimal costs. Less liquid bonds, such as bonds of smaller issuers, are significantly less liquid. These securities have much higher bid/ask spreads and trade less frequently.

Real estate is even more illiquid than these kinds of securities. Real estate does not trade on a public market and has very high trading costs and taxes. However, just like with securities, within real estate, there is a spectrum of liquidity across different assets. Big/superstar cities tend to have more liquid real estate markets than rural areas. Indeed, real estate in small towns can sit on the market for years without selling. So in addition to low expected rent growth pushing up cap rates in less urban areas, lack of liquidity also plays a huge role.

Real Estate Illiquidity and Housing Production

Low liquidity in real estate relative to other assets raises the required returns investors demand to hold real estate. Investors lose the optionality to trade out of the asset class, and must pay high trading costs when they realize any accrued gains. Investors are willing to pay to avoid these costs by holding other assets which are more liquid but have lower expected returns. The illiquidity in the real estate market drives up required returns and therefore also drives up the industry’s cost of capital, or the rate of return that real estate firms must promise to attract investors. This means that only projects which can reasonably be expected to provide very high returns ever get built. The capital markets themselves represent a huge constraint on housing production because very few potential projects actually clear hurdle rates.

Conclusion

Liquidity plays a huge role in the real estate market and asset markets generally. In exchange for holding illiquid assets, investors typically demand a higher rate of return. In real estate, this is expressed as a higher cap rate, which in turn explains why cap rates tend to be higher in less liquid regional real estate markets. More broadly, illiquidity in the real estate market raises the required rate of return for real estate as an asset class, which raises the industry’s cost of capital. This factor is a little discussed but important constraint on housing production.