Liquidity Risk

Definition of "Liquidity risk"

Written by

Sandy Wickware

Fathom Realty

To understand what liquidity risk entails, first, we must investigate what liquidity means. On the one hand, it refers to an individual or company’s capacity to meet debts without sustaining financial losses in the meantime. On the other hand, it means how easily one can buy or sell an asset in the market and convert it to cash.

If an individual succeeds in paying off their debts without going bankrupt in the process, we say they have liquidity.

Liquidity risk has an absence of an investment’s marketability at its core. A firm or person can’t sell or buy this particular investment soon enough to avert or lessen a financial loss.  

Liquidity risk in real estate

The event of liquidity risk signals that an individual may have to sell assets at low prices to raise funds. In real estate, renting an apartment or owning a house usually involves various expenses that tenants and proprietors must meet. See rentals, mortgages, insurance policies, warranty contracts, etc. 

Liquidity risk occurs when homeowners cannot afford to make mortgage payments. Generally, they no longer have sufficient funds to cover rent or deposit the fees for debts because, for instance, they have recently lost their job. Thus, they must sell their property at a small price. 

Enjoying liquidity is a primary reason why specialists don’t recommend buying a house with cash. To avoid your home’s exposure to liquidity risk, we recommend you carefully manage your finances at home. 

Local market trends define liquidity risks

Another considerable liquidity risk emerges for real estate investors when they can’t sell their property at market value. One of the reasons could be that the housing market lacks buyers. Are we talking about a seller’s market or a buyer’s market? Do properties increase or drop in value in the neighborhood? Market analytics compile statistics on liquidity risks based on a region’s housing trends.

Let’s take, for example, a $700,000-worth house. The house will probably not sell fast when the real estate market is down. Once the market booms again, the given property could sell above the list price. If the owner needs money desperately, they must sell the house below the median house price. Therefore, they could lose profit and a significant part of their investment.

Investors in real estate must study whether they can turn their short-term debts into financial obligations before investing in a property they can’t sell fast. The objective is to dodge the liquidity risk bullet.

You might want to contact a local real estate agent for updates on real estate market trends in your neighborhood.

Liquidity risk in a business

A business enterprise can also face dire straits by having inadequate cash flow and working capital. As a result, they can no longer cover ongoing expenses, pay creditors and lenders. Additionally, they will not maintain capital facilities in proper working order. In short, a financial institution endures liquidity risks when it can’t pay its short-term debts.

A commercial property’s owner, for example, can’t upkeep the general building maintenance, meaning electrical, structural, and plumbing systems. Consequently, tenants will leave the building sooner or later. At the same time, the owner might have to sell the property below market price.