What's liquidity premium?

Updated 2 months ago by Blocksquare

Liquidity is a complex multidimensional concept that manifests itself in a number of ways, and has no single, generally accepted definition or measure. Keynes’ description of a liquid asset “being more certainly realisable at short notice without loss” is probably the most frequently cited one. In this sense, liquidity can be viewed in terms of the transaction price and transaction time. Typically, investors who are forced to sell within a certain time limit may be able to do so at the cost of a lower effective sale price, while a higher price could be achievable if a longer marketing period had been accepted. Moreover, liquidity in private markets is associated with uncertainty regarding the time and the value of the transaction.

Most of the literature on real estate liquidity focuses only on certain aspects of the problem, namely:

  • Transaction intensity
  • Transaction cost
  • Duration of the sale process (time on market)
  • Uncertainty associated with the sale process

In simplified terms, liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price. Market liquidity refers to the extent to which a market, such as a country’s stock market or a city’s real estate market, allows assets to be bought and sold at stable prices. Cash is the most liquid asset , while real estate, fine art and collectibles are all considered relatively illiquid. Illiquid does not necessarily mean untradeable, but rather significantly costly to trade. The cost of trading illiquid assets is referred to as the ‘liquidity premium’ or correspondingly ‘illiquidity discount'.

Global real estate value was recently estimated at USD 217 trillion. Roughly 25% of that total, USD 54 trillion, is commercial. If Blocksquare were to unlock 10% of their current liquidity premium, that is over USD 5 trillion. The illiquidity discount on global commercial real estate is therefore multiple times the aggregate value of the current cryptocurrency market.

Illiquidity discount is a lower valuation applied to illiquid assets. Lack of liquidity may increase volatility of the assets price. Therefore investors will discount an illiquid Investment at a higher rate than a liquid one. This higher discounting rate will result in the illiquidity discount, or in opposite terms liquidity premium.
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