A lack of liquidity is inherent in real estate investing. This surprises new investors, but I have a workaround to increase the liquidity of real estate investments. I’ve been investing in real estate for over 15 years and have a residential real estate portfolio with more than 70 houses.
How do you increase the liquidity of a real estate investment?
Liquidity is the ability to turn real estate into cash. As individual investors acquire equity, they should open lines of credit on the properties. This allows them to quickly tap the equity in a property, simulating liquidity. After that, the investor can sell the property in a realistic timeframe and pay off the credit line.
Using a line of credit is a simple way to tap a property’s equity. However, there is more to liquidity than just pulling out equity. I’ll show you everything you need to know about real estate liquidity in this article.
What is Real Estate Liquidity?
Liquidity refers to the ease with which an asset can be converted to cash without affecting its market value. High-liquidity assets are easier to turn into cash. Investments with low liquidity take more time and costs to transform into cash.
Cash and Cash Equivalents
Simply put, liquidity refers to how easily an asset can be bought or sold at a price that reflects its actual value. Of course, cash is the most liquid asset because it’s already cash and could be quickly converted into other assets. Highly liquid, low-risk investments with a short maturity are nearly as liquid as cash. Examples of these cash equivalents are money market accounts, treasury bills, and bank certificates of deposit.
Less Liquid Investments
Tangible assets, such as real estate, fine art, partial ownership in a business, and wine collections, are less liquid.
In most cases, a stock market investment portfolio can be quickly converted to cash with minimal cost. The investor sells the stock on the open market for the published price while paying a minimal transaction fee. However, this is not considered a cash equivalent due to its volatile nature.
Potential investors should know that real estate is one of the most illiquid assets. Unlike traditional investments, converting real estate to cash or cash equivalents is slow and process.
Why are Residential Properties Illiquid?
Residential real estate is one of the most illiquid investments. While it’s more liquid than commercial properties, fine art, or private company ownership, it is costly to transform into cash.
Real Estate to Cash Conversion Time
To sell a residential property investment for market value, the owner must expose the asset to the housing market for a sufficient period. Unless the property is in high demand, it will often need to be on the market for several months to attract a pool of potential buyers willing to pay market value.
The property owners could sell faster, but that almost always comes at a discount to market value.
High Cost to Convert Resal Estate to Cash
The transaction costs for converting real estate into cash are considerable. Closing fees typically run 3%-5% of property values. Converting real estate into cash is not cheap.
Real Estate Investments: Liquidity and the Housing Market
On top of the time and expense, market conditions are also an important factor in selling residential real estate. The market price of these particular assets changes on the whim of the market. The value of a real estate portfolio can easily change based on conditions outside of your control.
The Importance of Liquidity in Real Estate
Liquidity risk is the risk that an asset cannot be easily converted into cash. This can be a problem for real estate investors, as it can be challenging to sell a property quickly, especially in a down market. Below of some factors that increase the liquidity risks associated with real estate investments.
Environment Factors
Changes in demographics or other external environmental factors. For example, a building that was once in a desirable location may become less desirable if the demographics of the area change.
Supply and Demand
Changes in supply and demand. If more properties are on the market than buyers, selling a property will be more difficult.
Lending Environment
A tighter lending environment. If lenders are unwilling to provide capital, it will be more difficult for investors to purchase properties.
Failure to Meet Obligations
Property owners who are unable to meet obligations. The property may be foreclosed on if its owner cannot make the mortgage payments. This can make it challenging to sell the property and may even damage the value of surrounding properties.
Liquidity risk is an essential consideration for real estate investors. It is important to be aware of the factors contributing to the liquidity risks of real estate investments and to take steps to mitigate them.
The Equity in Rental Properties
Holding rental properties is a long-term investment strategy. Over time, properties tend to appreciate, and mortgage balances are paid down. As a result, real estate investors end up with a significant amount of equity in their properties.
The equity in these rental properties is not easily converted to cash. However, these investment properties often provide the owner with tax benefits and steady returns. The passive income resulting from positive cash flow helps to offset the lack of liquidity but does little to tap the actual value of these properties.
How to Increase Liquidity
Investors with significant real estate holdings will find most of their wealth bottled up in property values. This gives the investor a high net worth, but the lack of liquidity may make it difficult to meet financial obligations.
One of the best ways to achieve greater liquidity is for property owners to obtain an equity line of credit backed by the real estate portfolio.
Equity Line of Credit
An equity line of credit is a revolving line of credit secured by your real estate holdings. With a line of credit, an investor can borrow money against the equity in their investment portfolio and repay the loan as needed.
How is an Equity Line Different than a Cash-Out Refinance?
A line of credit, as opposed to an equity loan or cash-out refinance, is a revolving loan which means the borrower can access the funds as needed and repay them as they wish. A borrower may pull money from the credit line and pay it back, pull it again, and repay the loan repeatedly. Interest is only charged on the outstanding balance of the credit line; when the balance is zero, the interest is zero.
Liquidity and a Line of Credit
With this approach, real estate investors have access to the equity in their properties, which simulates liquidity. An investor can borrow money from the equity line and, to fully mimic liquidy, sell the houses to pay off the credit line.
This approach allows the investment holder to use the funds immediately, as though the investment was liquid, and sell the homes over a reasonable period preserving their value.
Bonus: Accelerated Wealth Accumulation
An investor can borrow funds from the credit line, mimicking liquidity benefits, and keep the properties. This approach, similar to a BRRRR, allows the owner to continue participating in appreciation. In addition, if the properties have a primary mortgage, the owner is purchasing equity as the loan balances are paid down.,
How to Get an Equity Line of Credit
A local community bank is the best source of an equity line of credit on a real estate portfolio. These banks often make flexible loans backed up by more than one property. Most community banks are used to making these types of loans, and it’s common for them to bundle several properties as collateral, giving the borrower a larger available credit line.
Here is an article that teaches you everything you need to know about borrowing against you real estate investments.
Drawbacks of an Equity Line of Credit
An equity line of credit has a few drawbacks. Unlike a sale of properties, an equity line has associated costs.
Interest
The borrower must pay interest on the outstanding balance of the credit line. If they liquidate the property, there would be no interest due.
Closing Costs
Establishing the equity line will incur closing costs, such as a title search and an appraisal. Some of the costs may apply when selling the house.
Difficult to Fully realize all Equity
The total amount of a line of credit is often restricted to a portion of the equity. Usually, the line of credit will be limited to 75%-80% of the property value. As a result, a part of the equity is not realized with a line of credit,
Conclusion
A real estate investment is an illiquid asset that can be challenging to convert quickly to cash. Several factors contribute to the illiquidity of real estate, including the time and expense involved in selling a property, the market conditions, and the fact that real estate is not easily divisible (you can’t easily sell half of a house).
Liquidity risk is a concern for real estate investors as it can be challenging to sell a property quickly and at a fair price, especially in a down market. Factors contributing to the liquidity risks of real estate investments include changes in demographics or external factors, supply and demand imbalances, a less liquid lending environment, and failure to meet obligations. Investors need to be aware of these risks and take steps to mitigate them.
A great way to increase the liquidity of real estate is to obtain an equity line of credit. An equity line of credit is a revolving line of credit secured by real estate. This allows investors to borrow money against the equity in their properties and repay the loan as needed.
Equity lines of credit can be a valuable tool for real estate investors who need access to cash quickly. However, it is essential to note that equity lines of credit come with interest charges, so it is essential to use them wisely.
