What you need to know about real estate liquidity

Liquidity could be described as how long it takes you to convert an asset to cash (United States dollar—USD). Low score wins.

Generally, real estate is considered illiquid. It is a hard asset. Everything that is not denominated in dollars is a hard asset. Many people are not aware of this, but there are such things as liquid hard assets.

But how fast you can convert various types of real estate to USD varies. The worst is probably raw land. You are usually recommended to list it for six months with a Realtor® to sell it. It is hard to borrow against it. Few lenders will consider lending against land, consequently land mortgage, such as they are, are generally seller mortgages. So if you buy land, expect to take back a mortgage to sell it. Talk about lack of liquidity. You may still own a mortgage on land you bought in your twenties when you die in your eighties.

At the other end of the liquidity spectrum is the most liquid type of real estate: a medium- to low-priced owner-occupied home not in a ghetto. “Conforming” is the conventional mortgage word used to describe such homes. It means they meet FNMA/FHLMC mortgage standards. They control most mortgages in the US.

Rocket Mortgage says,

“The baseline conforming loan limit for 2021 is $548,250. The limit is higher in areas where the median house cost exceeds this number, so borrowers in high-cost areas can get conforming loans of up to $822,375, depending on the limit in their individual county.”

FHAable homes are a little bit more liquid because they can be FNMA, FHLMC and FHA mortgaged. 

Mortgages that are not “conforming” to FNMA, FHLMC, and FHA limits are called “jumbo” mortgages.

So there is a spectrum between raw land and conforming FHAable owner-occupied homes. If the home is rented to a tenant rather than owner-occupied, it is less liquid. That is, it may take longer to get a mortgage on it plus almost all the mortgage terms will be worse than owner-occupied.

As the number of units in the building increase to two and above four, the liquidity drops sharply and the mortgage terms become even less attractive: lower loan-to-value ratio, higher interest rate, shorter term, and so on. There is a sort of dead or orphan area between four units and institutional size ($5-million or $10-million minimum) because such loans are much harder to sell to Wall Street investors so many mortgage companies simply will not even consider such a mortgage. And those who will have minimum mortgage sizes that essentially say they are not going to go to all that trouble until you get to high seven figures.

Also, the liquidity varies with the loan-to-value ratio. Your equity below, say, 50% of value is more liquid than above 50%. The higher you climb in loan-to-value ratio—70%, 80%, 90%, 95%—the less liquid it becomes. Around the top 10%, it is near impossible to borrow against that equity and even if you sell, that part of the equity will be consumed by transaction costs.

Should you have all your real estate equity in the most liquid properties? No. That would only benefit you if you needed to sell everything in a hurry.

On the other hand, being “house rich and cash poor” can cost you a lot of money at times. The late Landlording author was a real estate multimillionaire. But on one occasion, he owned a mobile home park with a seller take-back mortgage that had a balloon payment.

He assumed that when the balloon payment came due he would have sold or refinanced the park. In the event, he was unable to do either. His net worth was high enough to make the balloon payment, but he did not have that much in liquid assets. The park was put into receivership by the prior owner, mortgage lender.

Leigh managed to get the property back and either renegotiated the balloon payment or found a financing source. I do not know the details. But if the seller foreclosed and took the property back, Leigh would have lost some or all of his equity, which was probably higher than the balloon payment.

So you do not want all your assets to be liquid, just enough to handle routine bills and rainy-day bills, and if you have a balloon payment or other such know upcoming obligation, enough to pay that.

He assumed that liquidity would appear without any particular action by him. Assumption is the mother of all screw-ups. It may have cost him some substantial penalty amount to get out of it. I don’t know. He could have lost much of his equity.

Liquidity is not the be-all and end-all or main thing in real estate, but it is a loose end that you must be cognizant of and tie up.