Successful investors correctly and consistently find the upside in investment opportunities and that's what makes them successful, right? We always hear about how the savviest investors like Warren Buffett got into the right opportunity at the right time, and that's why he's a billionaire. You usually see the highlight reel, because that's what's sexy. What you never really hear about are the investments that he didn't make. Because that's not important, right?
Wrong. Contrary to popular belief, the ability to understand risk is the single most important ability in investing and building wealth. Billionaire investor Warren Buffet, coined the following rules of investing:
"Rule no. 1, never lose money, Rule No. 2, Don't forget rule number 1."
It is far more important to understand the downside of an investment over the upside. For instance, consider Investment A that has a potential upside of 300%. And another Investment B that has an upside of 10%. You might be drawn to the A because of the upside. But what if I told you that A had a downside of 1000%, meaning you could lose more than your original investment and B had a downside of 5%. Every investment involves risk. You cannot make money without taking risk, so it is imperative for you to understand the risks involved with any financial investment decision before making one.
Today, we are going to cover liquidity risk, because liquidity risk is probably one of the single biggest risks involved with real estate investing. Liquidity risk is defined by Investopedia as follows:
"Liquidity is how easily an asset or security can be bought or sold in the market, and converted to cash."
In other words, if you needed cash today you wouldn't be able to convert a real estate investment into cash very quickly at all, at least not for what the property is worth. It takes several months to sell a property and convert it to cash. This is one of the principal reasons why financial advisors shy their clients away from holding real estate assets. At the very most if you ask you advisor about owning some investment real estate, they will sell you shares in a real estate investment trust (REIT). That way, if you need cash today, you can sell those shares today. Yes, owning shares in a REIT gets you exposure to real estate... kind of. But it lacks a lot of the benefits of having direct ownership of real estate: control, tax benefits, higher cash flow (REITs on average produce 3.7% dividend yield according to Commercial Property Executive.), the list goes on an on, but I digress.
Now, let's run this scenario. Call your financial advisor today and let them know you want to sell all of your stocks because you need the money. I will bet you they are going to ask "why" and will most likely put up a fight with you. They might say something like this: "These stocks are a long term investment. You don't want to sell them right now. This is a 10+ year hold." 10 year hold, eh? Weren't they just telling you to avoid real estate because of the liquidity risk? Which begs the question. If stocks (like real estate) are meant to be held for a long time, why aren't you being compensated for this liquidity risk?
I am fine holding my investments for a long time. I just expect to be compensated for carrying that long term commitment and so should you! This is one of the primary reasons why I like this type of risk in real estate: because it's a manageable risk. If you allocate your assets properly and have plenty of cash and other marketable securities like stocks, you shouldn't ever have to sell your real estate in panic to meet short term obligations, aaaaaand you get paid for it. Bonus! Or at least should be paid for it. Make sure that when you invest in real estate, that you expect to earn more than average stock market returns.
The second reason I actually like the illiquidity of real estate is that it forces you to be disciplined in long term holding and to best be positioned to capture the maximum upside.
A brief story: I used to manage my own portfolio of individual stocks. I would research individual companies and buy ones that had strong fundamentals. I started buying Apple stock back in 2008 for $3.20 a share. I accumulated and added to that position for several years because I believed in the long term fundamentals of the company. I had conviction. However, the stock started skyrocketing during 2010 (it hit $13.60 a share), so I sold a little of my position. It would go up another 20% and I'd sell some. I kept doing this until 2015, until I was completely out of Apple. It was $27.63 a share. To my horror, I watched over the years, absolutely hating myself. Every time I bought a new iPhone, I would check the share price. If I just held on, or even forgot about my investment in the company, my $5,000 investment would have been worth $213,000! Mind you, this is not the only stock investment I have done this with. I just do not think I would ever have the discipline to hold onto a liquid asset like a stock and watch it go up 1000% and not be inclined to sell it.
So What does this story have to do with real estate?
The point of the story is, if I would have had less liquidity, or if it was harder to sell my position in Apple or any other companies that I've owned, I would probably be a million dollars richer right now. With real estate, it takes a long time to even come to the decision to consider selling. Appreciation in Rochester, NY is pretty damn steady and nothing crazy happens with wild fluctuations in value. At the very most, if one of my properties has appreciated a bunch, I don't sell it; I refinance it, pull cash out and buy another investment property or two!
Bottom Line: don't fear liquidity risk, embrace it and make it work for you!