An ‘illiquid project’ – a term that only an economist would think of using – refers to an investment that may not allow you to cash out at the time of your choosing. Alternately, if you demand your money back, you may receive less than market value. An example is an investment with an early surrender charge, because they force you to give up money in order to cash out of the deal. Direct ownership of real estate is also an illiquid project.
IT IS RISKY TO OWN INVESTMENT REAL ESTATE WHEN YOU MIGHT NEED TO SELL ALL, OR A PORTION, PRIOR TO THE COMPLETION OF YOUR PROJECT – I.E., PRIOR TO THE TIME OF YOUR CHOOSING.
Suppose that you are 55 years old and that you discover a real estate opportunity that should produce significant profits. The project is a condominium development. Financial projections suggest that if the condominiums can be built within the anticipated time and cost, investors will make a 100% return on investment over the next three years – assuming they can sell all units within six months of their becoming available. Condo units are currently in very high demand.
Unfortunately, the project runs into a host of difficulties. Construction hits impenetrable rock, which causes significant cost overruns and time delays in building the foundation; a slowdown in the real estate market creates financing difficulties for buyers which, in turn, means that the project cannot sell all available units as soon as anticipated. The project takes five years; and, investors hope for a near term pickup in the market so that they can break even.
Once funds are committed to an illiquid project, the investor becomes financially vulnerable. A sudden need for cash during a period when money is tied up can result in financial catastrophe and great personal turmoil. A reduction in earned income, a sudden medical expense, a tuition increase might ordinarily have been survivable. This changes, however, when money is unavailable. You can’t sell one half of a bedroom in a rental property to raise cash.
If an illiquid project prevents you from accessing you money, how much extra return is required to compensate you for the added risk? A recent study by Columbia Business School Professor Andrew Ang estimates that an investor should require an additional 0.7% for illiquidity lasting a year, 4.3% for five years, and 6.0% for ten. These numbers do not include the extra compensation required if the project is leveraged – e.g., needs to carry a mortgage loan obligation. Leverage requires you to borrow money to finance the project; and so, on top of everything else, you have to worry about making the interest and principal payments on the loan.
Bottom Line: Illiquid projects can generate spectacular returns. However, these projects are often likely to be highly leveraged; and, truth be told, often generate spectacular losses. As a general rule, unless you have a very high tolerance for risk, it is unwise to engage in an illiquid project without having (1) sufficient financial reserves, and (2) project management expertise. The free seminar that will show you how to make a fortune in real estate won’t.