The Era of Real Estate Illiquidity
by A. Yoni Miller
The silver lining of the economic recession is that it has fostered a generation who has witnessed firsthand, the repercussions of owning an illiquid asset in financial turmoil. This has spurred a psychological imprint that will shape their investment standards for years to come. The financial meltdown has removed the false hope from the hearts of commercial real estate investors seeking endless growth, and has forced the world to acknowledge the risks associated with owning illiquid assets.
Illiquid assets are assets that cannot be easily sold or converted into cash. One of the riskiest types of illiquid assets is real estate partnership interest. Real estate partnership interests are created when two or more investors pool their funds together and create a partnership to acquire a real estate investment. In a partnership, one investor becomes the general partner who deals with the daily operations of the partnership and who is ultimately the decision maker. The other members in the partnership are called limited partners. A limited partner is a partnership interest owner that is not involved in the management of the partnership. Due to limited partners having little to no say in the management of the real estate investment, their partnership interests are considered non-controlling assets. This adds an additional layer of risk as the authority to manage, and ultimately sell, the real estate investment is left up to the general partner’s discretion.
Real estate partnerships are like marriages. While the couple is walking down the aisle, they are deeply in love. But over time, diversion of interests can occur and the marriage can turn sour, leaving one or both individuals wishing to end the marriage. Real estate partnerships are not immune from diversions of interests between investors. Unlike marriages though, limited partners will have a difficult time divorcing their illiquid assets.
The selling of partnership interest is limited to the laws laid out in the partnership agreement, which can vary greatly. In some partnerships, not only is the consent to sell your partnership interest required from the general partner and other limited partners, but from the mortgage holder as well. Even when the sale of partnership interest is allowed, there is a limited amount of buyers on the secondary market due to the asset being both illiquid and non-controlling. The shortage of buyers can adversely affect fair market value of partnership interest on the secondary market, causing limited partners to sell their positions at discounted to book value. Mark Cuban (March 4, 2015) said, “The only thing worse than a market with collapsing valuations is a market with no valuations and no liquidity.”
With the risks associated with real estate partnerships come advantages as well. One enticing advantage of being a limited partner is the lack of required time and knowledge. Those unfamiliar with commercial real estate, or those with full time jobs, can still reap in the financial benefits of owning commercial real estate without some of the hassles. Another appetizing advantage is that a limited partner’s liability is legally limited to the extent of their original investment, which removes their personal liability. Even though in many partnerships the general partners take the financial responsibility of signing for the mortgage, both the limited partners and the general partner receive a pro-rata share of profits and losses in the partnership. This means that all profits or losses are divided equally among the members of the real estate partnership according to their partnership interest.
Commercial real estate investments are illiquid and long-term by nature. Investors should be fully aware of the associated risks and prepared to deal with the drawbacks involved with selling an illiquid asset. While real estate investors normally receive annual cash-distributions from the profits of the partnership, the general partner has the authority to halt cash-distributions, leaving the limited partners owning an illiquid, non-controlling, and non-distributing asset. Instead of distributing, general partners will often use the partnership profit to pay down the debt, build up cash reserves, or even purchase additional real estate investments. Even though many of these actions by the general partner may strengthen the partnership as a whole, it limits the limited partners’ cash flow. Limited partners can hedge their risk of illiquidity by not relying on their partnership interests’ cash distributions and anticipating that the real estate investment will be held indefinitely.
When life presents unpredictable situations and liquidity is needed, limited partners can turn to the secondary market for potential buyers.
— A. Yoni Miller is Chief Marketing Officer of QuickLiquidity.