Illiquid assets

GLOBAL INVESTOR 1.15 — 45
Hints for investors
1 / Adopt a long investment
horizon. Transaction costs
are best absorbed by having a
long investment horizon.
2 / Mind the leverage. Sufficient
own funds help to avoid
fire sales as price and liquidity
cycles can be long.
3 / Know your product.
Legis lation is very different for
distinct types of real estate
funds and country-dependent.
Some setups are more
exposed to liquidity problems.
4 / Take your time. Avoid
making your decision to buy
or sell too quickly. This could
turn out to be very costly.
5 / Add real estate to your
port folio. Do not be frightened
of illiquidity. Real estate is
a good diversifier in portfolios.
01_Allocation to property in
UHNWI investment portfolios
While residential property (main residence and
any second homes) makes up almost 30% of
the total net worth of UHNWIs, real estate also
plays an important role when it comes to making
investments. On average, property accounts
for 24% of UHNWI investment portfolios.
In over 40% of all cases, this share has even
increased in recent years.
Source: Knight Frank, The Wealth Report 2014
in percent
35
30
25
20
15
10
5
0
Australasia
Asia
Russia/CIS
Africa
Global
Europe
Middle East
North America
Latin America
When talking about illiquid assets,
real estate is at the forefront as
it belongs to the most prominent
of illiquid assets. In developed
markets, real estate is the most important
wealth contributor in household portfolios and
adds up to enormous amounts of wealth. It is
not surprising that regulators and central
banks pay a lot of attention to real estate
markets. Residential real estate accounts
for almost 30% of net worth in portfolios of
ultrahigh-net-worth individuals (UHNWIs) (see
Figure 1), and pension funds also have a substantial
share of their allocation in real estate
(see Figure 2).
Causes of illiquidity of real estate assets
The illiquidity feature of real estate results
from a combination of several characteristics.
To begin with, real estate assets are always
tied to a certain location. The combination of
a particular location and a specific object
quality creates a unique tangible asset. Consequently,
every building requires a one-off
analysis and, on a microlevel, prices can even
differ heavily on the basis of, for example,
exposure to noise or view. All this is reflected
in the valuation of a property: there is no true
02_Asset allocation of
Swiss pension funds as
of September 2014
Swiss pension funds traditionally have a substantial
allocation to real estate. As of September
2014, almost 20% of their funds were invested
in real estate. This number typically decreases to
some degree when equity markets are doing
particularly well and therefore make up a larger
part of the asset allocation.
Source: Credit Suisse Swiss Pension Fund Index, Q3 2014
2.1%
19.7%
4.9%
31.3%
Liquidity Bonds Equities
Alternative investments Real estate
Mortgages Rest
1.2%
7.0%
33.7%
or objective price. Target prices depend on the
type of valuation model used and on investorspecific
preferences. Finding a price becomes
even more difficult when there is only limited
data available on similar transactions and if
assets have rare characteristics. This often
makes price negotiations time-consuming, and
adds to illiquidity. Determining a fair price is
especially important when one considers the
large size of the transaction.
Several other real estate characteristics
contribute to illiquidity, mostly from a cost
perspective. For example, the design and, to
some degree, the location of a building predetermine
its suitability for certain activities.
The conversion of a big department store
into many small retail units is relatively costly,
and regulation must also be taken into account.
Changing the use of a property from
a legal point of view, such as the conversion
of apartments into shops and vice versa, may
be difficult or even impossible. Investors must
bear this in mind and should therefore have a
clear strategy when investing in real estate.
Other costs include legal expenses and taxes
at the transaction stage. In total, there are
five steps in the acquisition of a commercial
building (see Figure 3). At each step, different
types of costs occur. Purchasing a commercial
real estate building typically needs a
negotiation time of about three months, plus
several months to conclude the transaction.
One last reason for the illiquidity of real estate
is simply the state of the market, which can
dry up quickly in periods of excess demand
(when nobody wants to sell a property) or,
more seriously, in a situation of weak demand.
Investors are facing difficult decisions
The main question for investors is whether it
is worth accepting this disadvantage from
a risk-return perspective. This depends on
the time horizon. As high transaction costs
associated with illiquidity are fixed costs,
it makes sense to hold such an asset for a
longer period. Therefore, pension funds and
other institutional or private investors with
a long time horizon are typical real estate investors.
In addition, these investors need to
accept that their real estate positions may not
be 100% liquid at any time. For wealthy investors,
these constraints are easier to cope with
(a fact that is reflected in the higher real estate
allocations of UHNWIs, see Figure 1). For
these investors, it makes sense to accept the
illiquidity and be compensated for it. For example,
the historical average premium to the
intrinsic net asset value (NAV) for listed >