Liquidity in Investing (Part 2)

In the previous post, we discussed liquidity (the ease at which you can convert an asset into cash without affecting the asset's market price) and its importance for investors. In this post, we examine the importance of liquidity among lenders and sponsors in any transaction. 

Lender 

There will always be some amount of risk accompanying any loan, but lenders prefer borrowers to evidence enough liquidity to be able to cover some potential expenses and/or losses that exceed the initial down payment of an investment. Thus, typically lenders will require a certain amount of ratio of liquidity among borrowers. 

When investing in real estate, the required down payment will likely be anywhere between 20-25% of the total transaction value. The lender may likewise want the borrower to have approximately 20-25% of the property value in liquidity. If the property comes with operational costs, the lender may require liquidity in the amount of 6-12 months of the property's operational costs. All requirements are situation dependent, but lenders will likely require liquidity above the mere down payment on the property. 

Sponsor

An investment sponsor is a person or entity that provides the right amount of funds for a specific venture. For instance, it is possible for an angel investor to sponsor a startup. In other scenarios, well-capitalized firms invest in established companies or properties. In real estate partnerships, a sponsor is an entity charged with identifying, acquiring, and managing properties on behalf of the entire partnership. Any real estate investment opportunity that involves multiple investors may have a sponsor. 

When a sponsor takes part in a real estate investment, they may assume a substantial amount of risk, and they are required to be the most active participant in the investment. Along with ensuring the subject property is inherently a good investment opportunity, sponsors must also review tenants and maintain and manage the property. 

A sponsor needs a certain amount of liquidity from other investors because of the needs that come with such management demands. No matter how much diligence a sponsor performs, investments could prove weaker than anticipated for various reasons. In this situation, the deal could become illiquid. 

If transaction are not properly inspected or pro formas are not accurately calculated, investments may become illiquid due to unforeseen circumstances or unrealistic expectations. For a sponsor to be successful, they must be able to purchase properties that put them in the best position to exit the deal when desired and to handle any liquidity constraints during the hold period. This requires proper liquidity to overcome any challenges that arise.

Conclusion  

Having a certain amount of liquidity is one of the keys to success for any investor, lender, or sponsor. As an investor, liquidity allows you to make an investment and manage unexpected issues that could arise. Likewise, lenders and sponsors will also require a certain amount of liquidity from borrowers and investors in order to confidently fund investments—whether real property or otherwise. 

While liquidity is certainly not the only factor to consider in investing, it is important review your portfolio liquidity any time you consider a potential investment opportunity.