As a real estate investor, many factors can affect your portfolio. Like every market, (for example the stock market), the real estate market is constantly changing. The most critical thing is if your assets are liquid or illiquid. But what is the difference between liquid and illiquid assets, and how does it affect your bottom line?
For many real estate investors, the difference between these assets is complex. It’s also essential, as the proper asset allocation can help you achieve your financial goals.
If you’ve heard the term liquid or illiquid assets before, you likely already know what they are, but do you know how they can affect your overall net worth? We’ll be taking a deeper look at both in the paragraphs below.
Liquid VS Illiquid Assets
Most accredited investors struggle with the question of liquid versus liquid assets. It is crucial for every investor who invests in alternative investments to know the difference between liquid and illiquid assets.
These asset types have different demands, risk levels, and effects on your bottom line profits. Understanding the differences and implications of investing in liquid or illiquid assets will help you make investment choices based on your goals and risk tolerance.
A crucial piece of financial information is the asset’s liquidity or illiquidity. Most stocks are liquid assets because investors can sell them in the stock market anytime. Thus, liquid assets are taken into account by most accounting standards.
What is A Liquid Asset?
An asset you can quickly and easily turn into cash is liquid. You can use it quickly to generate cash with little to no loss of value. Since you can swiftly convert liquid assets into cash, you can still keep its market worth overall during conversion.
The simpler it converts an asset into cash, the more liquid it gets. Cash is generally considered a liquid asset.
Liquidity is necessary because holding a wealth of money can help cover basic living expenses or handle emergencies whenever they arise. However, note that liquidity comes with the costs of obtaining and managing liquid assets.
However, several variables may affect your assets’ liquidity, especially in an alternative investment. Some of these variables include:
- The length of time it took you to sell a property
- How long it takes to transfer ownership
- The current state of the market
The most common types of liquid assets include money market instruments, marketable securities, and cash. Every asset should be recorded as current assets on balance sheets when investing in liquid assets. The performance of your investment portfolio will be affected by this asset allocation.
Moreover, it would be best if you kept some assets a little liquid, so it’s easy for you to pay for expenses. Think of liquidity as a spectrum since some assets are easier to convert to cash than others.
Examples of Liquid Assets
Apart from traditional liquid assets like the ones mentioned above, there are other examples of assets with liquidity. Simply put, liquidity is being able to sell assets quickly at market rates. Most investors consider liquid assets because you can quickly sell them in brief periods with minimal risk factors.
The marketplace is essentially liquid in its initial form and has numerous buyers and sellers who drive trade volume. These markets have a characteristic termed immediate price discovery.
Top examples of liquid assets include:
- Cash in your bank account
- Funds in your checking or savings accounts
- IRAs, 401(k)s, and other types of retirement investment accounts
- Low-risk savings account with interest
- Deposit certificates
- Treasury bills, notes, or bonds
- Prepaid costs. These costs include rent, insurance, and other bills.
These options are suitable for people with low-risk tolerance and those looking for a way to invest their money without the possibility of losing most of it.
Pros and Cons of Investing in Liquid Assets
Many aspects deserve diligent attention when building a real estate investment portfolio, and one of the most important things is the type of asset you add to your investments. While liquid investment options are powerful investment tools, liquidity may not always be positive.
- Liquid assets provide greater investment security since you can sell them for cash very quickly.
- Liquid assets are more readily available to investors, irrespective of personal finance. You can invest in options like stocks and ETFs with little money in the bank.
- Liquid assets provide the most flexible investment options. You can quickly move between various liquid assets or buy and sell them without losing value.
- Since liquid assets are susceptible to inflation, they may not be great for long-term investment goals. Portfolios with liquid assets are vulnerable during market downsizing. Diversification will create a more balanced and reliable portfolio.
- Liquid assets are pretty vulnerable during times of market turbulence or instability. Irrational price fluctuations can lead to huge losses.
What is an Illiquid Asset?
An asset is illiquid if you cannot quickly sell it or convert it into cash without incurring a significant loss in value. These difficulties arise for reasons like buyers unwilling to buy or a presence of high sales-related costs.
However, illiquid assets can be of high worth. Illiquid assets do not automatically lack value simply because they lack liquidity. They typically have incredibly high value but are harder to sell, especially if you need money on such short notice. Most alternative investments fall under this category.
Moreover, the term ”illiquidity” is arbitrary and open to interpretation. Most people can’t determine the time frame for converting an asset to cash. However, most investors would generally view an asset as illiquid if it would take more than 24 to 72 hours to convert it into cash at a reasonable market value.
Examples of Illiquid Assets
Every investor should have a healthy combination of various assets in their portfolio. Illiquid assets are perfect for long-term investments, and they can help you grow wealth and make passive income.
Top examples of Illiquid assets include:
- A hedge fund
- Some over-the-counter market stocks
- A few unconventional investments
- Ownership stake in private businesses
- Dollar stock
- Certain debt instruments
- Collectibles, antiques, cars, and art pieces
Furthermore, real estate is a popular form of an illiquid asset. Real estate such as land or investment property may have high value, but they aren’t easy to sell immediately. If an actual property owner tries to sell it off quickly, they will most likely run at a loss.
Another typical example of an illiquid asset is a mutual fund. While you can sell your shares in a mutual fund whenever you want, your ability may get constrained by corporate rules.
Pros and Cons of Investing in Illiquid Assets
- It’s a brilliant idea to balance liquid and illiquid assets. Illiquid assets are a good vehicle for achieving long-term financial objectives while offering many opportunities for diversification.
- Illiquid assets are more likely to maintain their value and stay steady over an extended length of time. Investors frequently see a higher return on their illiquid investments.
- If you invest in illiquid assets, you can reduce or avoid significant losses in a down market.
- Investing in illiquid assets requires a higher risk tolerance. Unlike liquid assets, you can’t quickly pull your money out when you believe an investment might fail.
- An illiquid investment frequently requires a time commitment of five to 10 years or more. The ROI may be high, but it will take an extended period. Additionally, illiquidity creates a longer lock-up period during which you cannot redeem your investments.
What You Should Know about Alternative Investments
An alternative investment is any investment asset that does not fall into any of three conventional categories — cash, stocks, or bonds. However, the different alternative investment options have the same essential characteristics. They’re more complex, less protected, and less liquid than traditional assets.
An alternative investment is often illiquid because it is complicated, unique, and challenging to value. Furthermore, there are two major categories of alternative investments:
- Private assets. This category includes infrastructure, private credit, equity, and real estate.
- Hedge funds. This category operates on the open market and uses strategies like leverage and short-selling.
Additionally, alternative investments can consist of liquid or illiquid assets. However, as mentioned earlier on in the article, alternative investments are primarily illiquid. Intelligent and savvy investors know the importance of creating a balanced and diversified portfolio with as many investment options as possible.
What is A Liquid Alternative Investment?
A liquid alternative investment is a subset of alternative investments that offer investors access to ETFs or mutual funds. Unlike many other alternative assets, liquid alternatives can be traded daily on the stock market and offer a unique opportunity for flexibility and risk protection.
This feature differentiates them from other alternative investments that typically offer at best monthly, weekly or annual liquidity.
What is An Illiquid Alternative Investment?
An illiquid alternative investment, such as real estate, cannot be bought and sold regularly. Compared to conventional assets, illiquid alternative assets provide larger yields. They also provide the ideal opportunity to build passive income. However, make sure you do thorough research before investing in them.
Illiquid alternative investment options typically fall into three types:
- Alternative credit — you can give private loans to individuals with limited access to loans from traditional institutions like banks and credit unions. These loans are for investors who are interested in alternative investment options.
- Private credit — you can provide loans to new businesses not listed on the stock exchange or to existing distressed companies. You benefit by owning a stake in the company and can make passive income as the company grows.
- Tangible assets — you can buy and own illiquid assets like real estate. This investment type is typically profitable in the long term.
Pros and Cons of Alternative Investments
- Investors can utilize alternative investments to increase portfolio diversification and reduce volatility because they often don’t operate on the stock market.
- Some may also help you reduce tax liability in ways conventional investments can’t.
- Alternative investments may offer a better rate of return than conventional ones, though this is not guaranteed.
- The complexity of alternative investments exceeds that of conventional investments. This complexity means alternative investments require more attention and care and may attract higher fees.
- The potential for a more significant return carries a higher risk. Investors with low-risk tolerance may not do well with alternative investments.
- Some alternative investments may bring possible tax concerns. For instance, when you invest in real estate, you receive a Form K-1 annually. This fact means extra tax returns in every region where you own real property.
Everyone is familiar with traditional options like stocks and bonds when it comes to investing. These conventional options are primarily liquid and provide a safety net for most investors.
However, you should pay attention to liquid and illiquid assets and alternatives. Each option can provide short-term rewards, high-yield securities, and many other investment benefits. One of the critical things to note in investment is how easily an asset can convert to cash. But both assets are vital to a balanced investment portfolio.
The Next Step
Before incorporating liquid, illiquid, or alternative assets into your investment plan, talk to a financial advisor. Regardless of your investment strategy, ensure you talk to a financial planner or tax advisor.
However, a financial expert becomes indispensable when you plan on dealing with broad ideas that involve incorporating multiple investment options into your portfolio.
You can take the next step with your new knowledge about the difference between liquid and illiquid assets. Real estate investing is a known way to grow wealth and make passive income from alternative assets.
People’s Capital Group can help you make intelligent investment choices. If you aren’t sure of the best way to start investing, we will give you the best professional guidance to transform your investments into great profit.