Liquidity can be defined as the ease and certainty with which an asset class can be converted into cash at, or close to, its market value. Unlike gilts and equities, which can be bought and sold quickly and efficiently in centralised markets, real estate has no such market which, inter alia, causes it to be illiquid. Furthermore, the price of a property is not certain until contracts have been exchanged. Even in a normal market, this may be several months after the original decision to sell (Lusht [1988]).

Although real estate is considered to be an illiquid form of investment, Fraser [1985b] claimed that its disadvantages are overstated and that the problem of illiquidity has been overestimated. Although unit transaction costs for real estate are higher than for gilts, he argued that institutional investors trade very actively in gilts, with sales and purchases of 60% to 80% of their total holdings, while real estate sales amount to only 2%. Provided that real estate is traded infrequently, therefore, its high unit transaction costs are more than offset by the lower number of transactions. However, this argument has been much reduced by the reduction in institutional commission rates negotiated after 1st May, 1975 in the US, and `Big Bang' in the UK engendered by the Financial Services Act, 1986.24

Fraser's point was based on the argument that for institutional investors, the time penalty attached to real estate transactions is unimportant, as they receive sufficiently large and regular inflows of funds. The rebalancing of any portfolio can thus be achieved by adjusting the use of these inflows, and any extra liquidity can be fully satisfied by other investments.25

Another point of relevance is that there have been several failed attempts to introduce financial instruments specifically aimed at injecting liquidity into the real estate market. A discussion of these and the merits of indirect real estate investment is contained in Appendix B.

The significance of real estate illiquidity tends to be reduced when its performance as an investment is based on valuations alone. This leads to a consequent underestimation of risk and/or an overestimation of return, providing two possible outcomes. Either illiquidity increases uncertainty as to the final price obtainable on the sale of a property, thus raising risk. This strengthens the arguments contained in section 2.4.1 on the effect of a lack of information. Or, it requires a sale at a discount to valuation estimates, thus lowering returns. As discussed, Rydin, Rodney & Orr [1991] have highlighted, institutions point to the lack of liquidity in real estate as the most important negative factor.


24The provisions of the Financial Services Act did not formally come into effect until 1st April, 1988.

25Debenham, Tewson & Chinnocks [1988] found that of a random sample of institutional fund managers, 58% traded real estate assets 'frequently' in order to rebalance their portfolios. Note, however, that their figures indicate a very small number of properties were involved in this 'frequent' trading.