Exploring The Liquid Value Of Real Estate - SF Federal Reserve Study

If you have not heard me preach in the past about the value of liquidity, and how defining that value might impact your borrowing strategy, now is a good time to listen-up.

When a millionaire buys a million dollar home, they typically don't pay cash. They use a mortgage, because they want to maintain liquidity. Would you rather have a million dollar home, and no cash, or a million dollar home, a big tax-deductible mortgage, a million in other investments, and a monthly payment?

Liquidity preserves options, and builds control and safety into the financial picture. It has a cost (the mortgage interest) and its up to each consumer to figure out where the benefit of liquidity out-weighs the cost of interest. This is what we can help you evaluate.

Real estate, in general, is illiquid. We are seeing this realized on a whole new level, as sellers are dropping prices to entice buyers, and the time required to sell a home has skyrocketed. If you need to sell a home, and you are not liquid, how long can you wait for a buyer?

The Federal Reserve Board of San Francisco recently published a brief letter discussing the relationship between falling prices, days on market, and liquidity, and the message is noteworthy. The author (John Krainer) suggests that real estate values should be adjusted for their lack of liquidity, and in doing so, we see a different picture.

Think about this. If you are selling a home, and its worth 100k, but it costs 1k per month to pay the bills, and you are facing an average time on the market of 6 months, you face a decision of carrying for 6k to sell in 6 months for 100k, and net 94k in your sales price. Why not drop the price to 94k today, and sell it right away?

If you are holding the asset, you also hold the risk of market deterioration. What if in 6 months, the present value has dropped to 90k? Now you've spent 6k and will be selling at 10k below what you could received 6 months ago. Not to mention what you could have done during the past 6 months with the cash in-hand!!! Time. Is. Money. Case in point.

In fairness, if you hold the asset, and the value increases by 10k over the 6 months, you also own that. But who wants to bet on this market getting better over 6 months? If buyers believed that were going to happen, the average time on market would not be 6 months!!!

The tricky part about markets is understanding where psychology intersects with economics. Sellers typically try to hold out for the top dollar when they are selling their former home, but there are some cases where sellers are trying to hurry. These are auctions and foreclosure sales, typically driven by builders, banks, and other business entities. They want to cut to the chase, while the homeowner doesn't want somebody to take their home on the cheap. But they have to compete against non-homeowner sales in their market, especially when there is an imbalance of buyers and sellers!

So be careful. Real estate is liquid enough at a low enough price, but when sellers outnumber buyers, that price is likely far lower than what your concept of value is in your home. And this brings us back around to why its important to maintain liquidity outside the home; if you want to sell your home, and want top dollar, you better be prepared to wait. You'll need savings to carry the cost of owning. There are a lot of reasons why this may work better in the long run, but each case is subjective.