Wednesday, July 15, 2009

Illiquidity = Risk, Commercial Real Estate is Illiquid, Therefore Commercial Real Estate is Risky

Illiquid investments are risky. From the Knowledge at Wharton Post “Why Economists Failed to Predict the Financial Crisis”:

"When there's a default in one kind of bond, it causes reassessment of all the risks," says Wharton economics professor Richard Marston. "I don't think we have really fully learned from the LTCM crisis, or from other crises, the extent to which things are illiquid." These crises have shown that market participants can rely too heavily on the belief they can quickly unload securities that decline in price, he says. In fact, the downward spiral can be so rapid that it leaves investors with losses far larger than they had thought possible.

In the current crisis, he says, economists "should get blamed for the overall unwillingness to take into account liquidity risk. And I think it's going to force us to reassess that."

The dotcom bust and accompanying recession had little effect on commercial real estate market, in part because problems were concentrated in high tech markets, and mostly because falling interest rates freed up cash flow and boosted leveraged returns. You need to go all the way back to the early 1990’s to recreate the current sensation of free falling commercial real estate values. Almost twenty years was plenty of time for investors who had no idea how illiquid CRE can be to enter the market (see my post Waves of Stupid Money for a discussion of how investors who don’t understand the risks can skew a market).