If you want to keep your real estate portfolio balanced and profitable, you’ll need to consider a wide array of different factors. Obviously, you’ll need to take precautions to ensure your real estate portfolio makes more money than it spends. You’ll also need to diversify your real estate portfolio to balance out risks and ensure more consistency of revenue generation.
But you’ll also need to consider some less obvious factors, including liquidity.
What exactly is liquidity? How does it impact your real estate investment strategy? And what strategies can you use to keep liquidity issues in check when investing in real estate?
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An Investor’s Guide to Liquidity
In the investing world, liquidity is a measure of how easily or efficiently you can convert an asset into cash. Cash itself is extremely liquid. Securities associated with big, well-known companies are also quite liquid, as you can sell these securities quickly and reliably. In most cases, you can convert shares of stock into cash immediately during trading hours.
However, some assets are considerably less liquid. Shares of stock associated with lesser known and smaller companies sometimes pose liquidity issues, as trading volume isn’t sufficient for you to have a reliable buyer every time you want to sell.
Real estate is famously known as a relatively illiquid asset. This means it’s not easily, quickly, or consistently convertible to cash. Chances are, you already understand why; selling a real property is typically a much bigger and more complicated transaction than selling shares of stock. If you’ve ever sold a house before, you know it could be weeks or even months before you find the right buyer. On top of that, transfer of funds can be delayed or complicated.
Liquidity is an important consideration because it allows you a greater degree of financial flexibility and freedom. The more liquid your portfolio is, the quicker you can convert it to cash at any time. Not only does this allow you to make faster decisions and align yourself with the market more precisely, but it also gives you access to a greater proportion of your total net worth on a moment-to-moment basis.
Liquidity becomes especially important in the face of risk. If economic conditions are beginning to decline, you need to be able to rebalance your portfolio at a moment’s notice. If you carry significant debt as part of your financial leverage strategy, you’ll need to be able to convert your assets to cash quickly to avoid potential consequences of over-leveraging.
Every portfolio should be balanced with liquidity in mind. Obviously, you don’t need all your assets to be highly liquid. However, you should have a balance of liquid assets proportional to your risk tolerance.
Your real estate portfolio will largely consist of illiquid assets, by definition. Even if your real estate holdings are only a portion of your total holdings, it’s important to keep the potential issues of liquidity in mind.
When Does Liquidity Become an Issue?
When exactly does liquidity become an issue?
This is a question that each individual investor will need to explore for themselves. What functions as sufficiently liquid for one investor might be excessively prone to risk in the eyes of another.
Still, we can broadly say that liquidity becomes an issue for real estate investors when it mitigates your financial agility in a way that complicates your investment strategy. For example, during times of economic uncertainty, most investors feel more comfortable having more liquid assets and cash on hand, both to provide a kind of emergency safety net and to enable maneuvering in this potentially exploitable economic landscape.
The ultimate consequence you’re trying to avoid is being stuck unable to convert your assets to cash without suffering massive losses. All your liquidity management strategies should be focused on minimizing the possibility and impact of this outcome.
How to Manage Liquidity Issues in a Real Estate Portfolio
So how exactly do you manage liquidity issues in your real estate portfolio?
- Diversify. Portfolio diversification is the golden rule and the one that can help you mitigate the potential impact of any liquidity issue. Within the context of your real estate portfolio exclusively, it’s a good idea to balance out different types of real estate assets. That means investing in both residential and commercial properties, investing in both single family and multifamily properties, and investing in properties in different areas of the country. This way, if a single market or a single location starts introducing selling difficulties, you can still tap into your other assets elsewhere. Outside of your real estate portfolio, it’s a good idea to keep at least some of your assets in more liquid vehicles. Publicly traded stocks are a great way to balance out the illiquidity of real estate, and you can also just keep more cash on hand.
- Create an exit strategy. You should also have an exit strategy in place for your existing real estate assets. There’s nothing wrong with the long-term “buy and hold” approach; in fact, this strategy is very likely to work in your favor if you follow it consistently, with the right initial holdings. But most of the properties in your portfolio will be sold eventually, so under what conditions should they be sold? When do you plan on selling them? What market conditions could force you to sell them? And more broadly speaking, if you’re forced to sell a property, which should you sell and why? You should have both individual exit strategies for each property in your portfolio as well as broader exit strategy guidance for managing your portfolio at a high level.
- Prioritize consistent cash flow. The need for liquidity becomes less extreme when you have consistent revenue coming in. If your properties are consistently generating $20,000 of net profit every month, your inability to sell some of those properties quickly and efficiently is of trivial concern. Accordingly, make sure you structure your real estate investments and portfolio management in a way that prioritizes consistent cash flow. Even if you’re not making immense profits every month, the consistency of your income will be predictable, allowing you to make better calculations related to your risks and potential upsides.
- Consider REITs. It’s also a good idea to consider real estate investment trusts (REITs). These assets allow you to invest in companies that, in turn, invest in and manage real estate. You can buy and sell shares of REITs much like stocks, so as you might imagine, they tend to be more liquid than real properties. At the same time, they allow you to increase your portfolio exposure to the real estate market and allow you to tap into markets you otherwise wouldn’t be able to invest in. REITs aren’t a perfect fit for every portfolio, and they still have some disadvantages when compared to investing in real property directly. However, they’re often a valuable tool for increasing liquidity without necessarily decreasing your proportional holdings of real estate.
- Maintain adequate reserves. Every real estate investor should have plenty of adequate reserves to handle ongoing expenses, deal with emergencies and catastrophes, and pounce on good deals when they present themselves. An easy way to compensate for a relatively illiquid portfolio is to keep a higher proportion of your assets in reserves. Remember that cash is the ultimate liquid asset, so the more of it you have, the more liquid your total portfolio will be.
- Invest in good insurance. Selling a property isn’t the only way to lose one – and it’s far preferable to some of the alternatives. If you want to remain more liquid and hedge some of the risks of real estate ownership, invest in good insurance policies for all your properties. This way, if and when something goes wrong, you can get a significant cash payout that you can use to repair and rebalance your portfolio as necessary. Be sure to read your insurance policy carefully so you thoroughly understand what it covers and what it doesn’t; insurance coverage isn’t always as straightforward as we would like it to be.
- Avoid overleveraging. There are many creative strategies you can use to finance new properties. Most of them are inherently beneficial, allowing you to invest with far more capital than you currently have. However, there’s also a risk to increasing the amount of debt you hold; in extreme circumstances, you can overleverage yourself. Essentially, this means holding more debt than your portfolio and long-term financial strategy can tolerate; under these conditions, even a minor disruption to your cash flow or holdings could cause a domino effect that compromises the integrity of your investment strategy. If you’re interested in mitigating the potential consequences of illiquidity, it’s very important to tread carefully when managing financial leverage.
- Keep your properties in good shape. Work hard to keep your properties in better shape. Properties that are in good condition are going to be much more attractive to prospective buyers, inviting more offers faster and increasing the total value of those offers. Similarly, if your properties are already in good condition, you’ll need to spend less time, money, and effort fixing them up when you’re ready to sell. These twin benefits incentivize real estate investors managing liquidity to prioritize the structural condition of each property and their holdings.
- Utilize HELOCs and similar financial tools. If you find yourself in problematic liquidity constraints, consider tapping into alternative options to raise the funds you need. If you need money to cover unanticipated expenses, for example, you could look for an alternative to selling your existing properties. One such alternative is a home equity line of credit (HELOC), which is a unique financial tool that allows property owners to tap into the equity of their property to borrow money. The terms of HELOCs are typically quite favorable, but always do your due diligence before utilizing any of these tools for your own financial benefit.
- Be ready to sell at a realistic price. Similarly, if you’re in a liquidity crunch and you need to sell, be ready to sell at a realistic price. Illiquid assets aren’t necessarily difficult to sell; they’re just difficult to sell at maximum hypothetical value. If you’re willing to take even a slight loss, you can typically sell your properties quickly and raise the cash you need to take care of your new expenses.
- Consider seller financing. Another option available to you is to offer seller financing. In this arrangement, you’ll offer to finance the purchase of one of your properties. You’ll relinquish ownership immediately, but you’ll likely only receive a portion of the total sell price of the property immediately. From there, the buyer will continue making payments to you as if you were their mortgage lender (as, in a sense, that’s what you are). This maneuver can help you sell the property in an otherwise stagnant market and broaden your reach to prospective buyers who may not be able to qualify for a conventional loan on their own. However, be warned that seller financing is a risk to you and it isn’t exactly straightforward to put together.
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