How Much Do You Value Liquidity?

Question

I'm interested in hearing people's opinions on the value of liquidity. For example, if you could choose between an investment that pays 8% annualized and can be liquidated in 48 hours with no penalty vs an investment that pays 12% annualized where liquidation is slow and has considerable cost (such as selling a property), which do you prefer?

Of course this is somewhat circumstantial, but if you're actively investing, you must have criteria, right?

Perhaps you have a threshold below which you won't commit your capital to an illiquid investment. Or perhaps the degree of illiquidity (6 month vs 5 year commitment) impacts that too?

When I use the BP calculators, I value my own money at 10%. I don't pretend that it's "interest free" if I can use my own cash for an acquisition, because it's not. It has opportunity cost! I also value cash return over equity gain, but not infinitely. I am investing for the long-term, so I don't need cash to spend, but I do prefer it for liquidity.

I'm interesting in hearing how other people balance these considerations.

James Free · Answer

@Joseph Cacciapaglia I have the same opinion on retirement accounts.

I am not thinking about quick access to capital as an emergency fund here. I am thinking about maximizing returns. Locking money up means that if a deal requiring a quick close lands on my plate, I might not have the capital for it.

I suppose we could have a follow-up conversation about the merits of borrowing from HML vs using your own capital (say, by selling equities). You're probably better off using your own money if you have it, on paper, but if that costs you the ability to finance the next deal, then maybe not!

Joseph Cacciapaglia · Answer

Once I reached a level of personal liquidity that I felt comfortable with, I stopped giving much weight to the liquidity of my remaining investments. At one point not too long ago, I was sick and out of work for 3+ years. I had plenty of time to sell properties and rearrange my finances to get through that. I also relied on credit, at certain points. It's hard to imagine a scenario where I needed to access a substantial portion of my investment capital all at once.

I think your statement about preferring cash flow over equity gain because of liquidity considerations is backwards. Having equity in your property gives you the ability to sell or refinance, if you're in need of getting your capital back. I'll take that over some additional cash flow any day. I suppose it's a matter of degrees though. If I had 5 times as many rental units when things went south, I probably wouldn't have had to liquidate at all. As it is, the only property that I kept (and didn't get much help from) was one that had no real equity but cash flowed well.

All that being said, I guess I do have some liquidity preference. I'm not a big believer in retirement accounts, because I don't want to wait another 20 years before I can touch that money.

Joe Villeneuve · Answer

Liquid means it can be moved again.  If you could move that 8% return more than once while waiting for the 12% return, which do you think would be the most valuable?

This is why I never use percentages to measure success.  They lie.

Example:  Returns in cash after 12 months based on starting with 100k

A - 12% over one year = $112k

B  - 8% every 6 months = $116k+

C - 8% every 4 months = $126k

Daniel McNulty · Answer

@James Free

You could certainly model it out, but practically speaking, I prefer to use the spread between what I can get in public markets vs what I can reasonably achieve on a similar instrument in the private market. Its not perfect as there are many additional risks besides just liquidity, but its benchmark...

Anecdotally, I find the spread on debt is normally a couple percent (3-4). Today the spread is much wider closer to 5-6, both a reflection of today's economic circumstances and peoples desire for liquidity.

The more difficult part is always finding the data to track down a spread. I frequently use the high yield bond market and private debt market yields to pencil it in myself, primarily because I have the data and it is comparable from an underlying company perspective. The same could technically be said for equities. LT averages on equity are 7-8 annually and decent PE should be mid to high teens. Its a larger spread naturally reflecting the different level of risk in the capital stack.

The shorter the lock-up, the less premium I would demand. By the time you are talking about a 4-5 year lockup I would demand the full liquidity premium.

To your point, if you value your money at 10%, I would tack on upwards of a half dozen points for debt instruments with a extended lockup and approaching a full dozen on equity of any kind (RE included) with a full lockup. Notably, your 10% interest is a high starting point, so the liquidity premium results in a higher overall return standard than most.