Performance of Thinly Traded Assets: A Case in Real Estate

• Author: Zhenguo Lin,Ping Cheng,Yingchun Liu
• DOI: http://doi.org/10.1111/fire.12013
• Published date: 01 August 2013
• Date: 01 August 2013

The Financial Review 48 (2013) 511–536

Performance of Thinly Traded Assets:

A Case in Real Estate

Ping Cheng

Florida Atlantic University

Zhenguo Lin∗

California State University, Fullerton

Yingchun Liu

Laval University

Abstract

Thinly traded private assets do not fit into the traditional financeparadigm of a liquid and

well-functioning market where trading is continuous and instantaneous. Since private assets

cannot be bought and sold easily, they bear liquidity risk. Classical finance theories cannot

properly gauge the performance of illiquid private assets because they implicitly assume such

illiquidity is trivial. This paper proposes an alternative performance metric for the illiquid

private asset, which explicitly captures liquidity risk in a formal analysis. Applying the new

performance metric, we are able to explain the decades-old “real estate risk premium puzzle.”

Keywords: liquidity risk, private assets, investment performance

JEL Classifications: G11, G12

∗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 511

512 P.Cheng et al./ The FinancialReview 48 (2013) 511–536

1. Introduction

Classical finance theory defines the market portfolio as one that includes all

assets—publically traded securities, as well as privately traded nonsecurity assets.

Advancement in the finance field, however, primarily has been concentrated on the

public side of the portfolio, namely the relatively efficient security market. Signifi-

cantly less attention has been paid to the private side that includes variousnonsecurity

assets (e.g., private business ownership, partnership interest, hedge-fund holdings,

capital goods, nonstandard loans, artwork, real estate, etc.) that are infrequently

traded in decentralized, incomplete, and inefficient markets. Due to their heterogene-

ity, indivisibility, immobility, and information opacity, among other things, private

assets typically cannot be instantly bought and sold at any time an investor desires. So

the potential loss of welfare due to such an inability to trade out of a position when

needed is a significant source of liquidity risk. Theories developed for publically

traded security assets provide limited guidance for gauging the performance of thinly

traded private assets due to the significant differencesbetween the two types of assets

and their respective markets. We propose an alternative performance measure for

private assets, by which such liquidity risk is explicitly captured in a formal analysis.

Much finance research has dealt with the illiquidity (or the lack of liquidity) of

security assets from various points of view, but relatively few studies have focused

on the illiquidity of the private market and nonsecurity assets. So it is necessary to

note that the concept of illiquidity in the private market differs from the illiquidity

of publically traded security assets. Generally speaking, the research accepts two

definitions of illiquidity. In the securities market where trading is instantaneous

among market participants, liquidity is typically measured by the price discount

(e.g., the bid-ask spread) necessary for an immediate sale (Demsetz, 1968; Amihud

and Mendelson, 1986). Alternative liquidity measures proposed by later studies such

as Brenan and Subrahmanyam (1996) and Amihud (2002) also are for the security

assets. On the other hand, in thinly traded private markets where infrequent trading

is conducted through a lengthy search process, liquidity is measured by the expected

time necessary to sell an asset near its fair market value, the so-called “time-on-

market” (TOM) (Lippman and McCall, 1986). These two measures, though somewhat

related, are fundamentally different due to their difference in underlying transaction

processes and normal trading behaviors. For example, while it is rational to accept

a discounted price for the immediate sale of stocks, the instant sale of a piece of

real estate (as in the case of imminent foreclosure) would characterize the behavior

of an extremely distressed seller. While the likely (deep) price discount reflects the

degree of distress of the seller, it does not properly reflect the illiquidity of the real

asset under normal situations. Put differently, since normal real estate sellers do not

attempt immediate sales, the price discount that would be necessary for such an

immediate sale is not an appropriate measure of the asset’s illiquidity. This leads

us to Lippman and McCall’s (1986) liquidity definition—the expected time until an

asset is successfully exchanged for cash under optimal policies. As has been widely