Liquidity Risk of Private Assets: Evidence from Real Estate Markets

• Published date: 01 November 2013
• Date: 01 November 2013
• Author: Ping Cheng,Zhenguo Lin,Yingchun Liu
• DOI: http://doi.org/10.1111/fire.12020

The Financial Review 48 (2013) 671–696

Liquidity Risk of Private Assets: Evidence

from Real Estate Markets

Ping Cheng

Florida Atlantic University

Zhenguo Lin∗

California State University, Fullerton

Yingchun Liu

Laval University

Abstract

Investment in thinly traded private assets involves liquidity risk. Existing literature pro-

vides limited guidance as it mainly focuses on publicly traded security assets such as stocks and

bonds. This paper develops an analytical tool for quantifying liquidity risk of private assets.

Using commercial real estate as a model asset and under reasonable assumptions, we find that

the magnitude of liquidity risk is too large to be ignored, especially in down markets when

liquidity risk is a great concern.

Keywords: illiquidity, liquidity risk, thinly traded private asset

JEL Classifications: G11, G32, R3

∗Corresponding author: Department of Finance, Mihaylo College of Business and Economics, Califor-

nia State University, Fullerton, CA 92834-6848; Phone: (657) 278-7929; Fax: (657) 278-2161; E-mail:

zlin@fullerton.edu.

C2013 The Eastern Finance Association 671

672 P.Cheng et al./ The FinancialReview 48 (2013) 671–696

1. Introduction

Asset illiquidity (or lack of liquidity) is an important source of investment risk

and a frequent subject of academic research. Interestingly, existing literature on the

subject has overwhelmingly focused on the illiquidity of securities, such as stocks and

bonds, which are commonly perceived as highly liquid assets and traded in relatively

efficient public markets.However, the “real” illiquid assets, such as real estate, private

equity, hedge funds, partnership interests, business ownership, nonstandard loans,

capital goods, and precious metals, have not attracted nearly as much attention from

financial economists, despite the fact that modern finance premises on the existence

of a market portfolio that includes both public and private assets. The current study

takes the less-traveled path and ventures into the private side of the capital markett o

investigate the liquidity risk of thinly traded private assets.

Unlike security assets, private assets are traded in decentralized markets through

a process typically characterized by sequential search and random match. Existing

literature of search-and-matching models generally assumes that investors are risk-

neutral, so they do not address the randomness of the search and matching process.

Although Duffie, Garleanu and Pedersen (2007) and Vayanos and Weill (2008) as-

sume that investors have constant absolute risk aversion, most analytical results are

based on an approximation in which investors are assumed to be risk-neutral with

regard to the risk introduced by the random matching process. Such approximation,

however, may not be appropriate if the matching process is substantially long with

great uncertainty, which introduces significant liquidity risk that cannot be disre-

garded by rational investors. For example, in the case of investing in commercial

real estate, there have been dissatisfactions among institutional investors with the

way property performance is conventionally measured. According to a recent survey

by Goetzmann and Dhar (2005), leading institutional investors and fund managers

expressed serious concerns over the reliability and accuracy of measuring real estate

return and risk based solely on observed transaction data, which ignores their number

one risk factor—liquidity risk. In this study, we attempt to fill the gap by addressing

liquidity risk of thinly traded private assets. We develop a concept called liquidity

risk factor (LRF) which provides an analytical tool for quantifying liquidity risk of

private assets. Using commercial real estate data as a testing ground, we find that,

for typical investors, liquidity risk is to such magnitude that the conventional return

volatility should be adjusted upward by as much as 97% in order to fully reflect the

liquidity risk. While such adjustment varies over market conditions and investment

horizons, suffice it to say that overall the magnitude is too large to be ignored by any

rational investors, especially in downmarkets when liquidity risk is a serious concern.

Tothe extent that liquidity risk is an intrinsic part of the overall risk of private as-

sets, the liquidity-adjusted risk (via the LRF) in this paper enables “fair” performance

comparison between private and publicly traded assets, and it can be instrumental

in constructing optimal mixed-asset portfolios that include both public and private

assets.