I remember reading an article written in the 1990s by an academic finance researcher, one well-received in the academic community, arguing that real estate was the king of all investment vehicles in the post WW II period. How so? Real estate, the author asserted, had not only a higher rate of return than stocks, bonds or cash, but it was also less volatile in price.

The flaw in this argument, which would be obvious to anyone who has ever owned a house, is that the author calculated volatility using only actual transactions. This is the most obvious and straightforward way to proceed. But in the real world, there can be long periods of time–in recession or when interest rates are high–where there are virtually no transactions done. For example:

today’s office market

The current market in the US for big urban office buildings is a striking example of the lack of liquidity phenomenon. Especially in the case of older buildings, they may be half empty, losing tenants, and rents not covering operating expenses + mortgage payments. If a potential buyer were simply to assume the existing mortgage, leaving the owner with nothing, I think there would already be transactions between deep value buyers and current owners. But it looks to me that we’re not yet at the point where owners and their banks are both ready to agree on a formula to share losses.

bank net asset values

same thing

residential real estate

A more straightforward example: my wife and I bought a house in early 1981, when mortgage rates were at 17%. It was three years–and a drop in the fed funds rate from 19% to 5%–before there was another transaction in our neighborhood. This wasn’t because no one wanted to sell. It was because any offers taken, at maybe 60% of what we’d paid, would have made the sellers worse off.

junk bonds

…municipal bonds, too. …and to a lesser extent off-the-run government bonds.

These are all what are called “original issue” securities, meaning they trade a lot around the time of the public offering and then trading volume dries up to the point where they trade “by appointment only.”

I don’t know enough about munis to comment.

During the late 1980s junk bond blowup, investors found that their junk bond funds were being priced, by industry custom, at “last trade,” which might have been many months in the past. So any redemptions created substantial downward pressure on fund NAVs.

In 1998, Long Term Capital Management, whose board was led by Nobel Prize-winning academics, imploded, in large part because of its huge holding in illiquid “off the run” Treasuries (meaning Treasury issues not used in the creation of financial derivatives). It needed a gigantic, government-orchestrated bailout–and two years–to help it unwind this illiquid position.

more tomorrow