RCA Insights

How Much Do Investors Pay for Liquidity?

By on March 2nd, 2018

RCA’s Capital Liquidity Scores confirmed most everyone’s hunch that Manhattan is the most liquid market in the U.S. But the liquidity scores reveal much more than that: they impart the value that investors put on liquidity.

The relationship between a market’s observed cap rate and its Capital Liquidity Score, an RCA measure which aims to gauge liquidity in disparate markets, is significant. The higher a market’s liquidity score, the lower its observed cap rate. Long-term average cap rates are plotted against long-term average liquidity scores for key U.S. markets in the chart below.

1803 liquidity cap rates scatterplot

Looking at the relationship between cap rates and liquidity scores reveals much about how investors value liquidity. For every point increase in liquidity score, a market’s cap rate is expected to compress by almost 3 basis points. Cap rates inferred by this relationship are within 30 basis points of the market’s actual observed cap rate for the majority of U.S. markets.

With the relationship between cap rate and liquidity score established, one can use today’s liquidity scores to infer a current liquidity-adjusted cap rate for each market. However, some of the markets’ inferred cap rates are very different to their currently observed cap rates. For these cases, the question becomes this: has liquidity become too dearly priced?

1803 cap rate markets-01

The five markets in the top section of the above chart have a lower current cap rate than their liquidity scores would imply, and markets in the bottom section of the chart clock in with higher cap rates than their similarly-liquid peers. Though one may jump to the conclusion that investors are therefore overpaying for liquidity in Manhattan and underpaying for it in Chicago, growth expectations for rent are also a pricing factor to consider.

Growth expectations for rental income may be driving cap rates down in markets such as Manhattan and San Francisco at the time of acquisition. The liquidity-inferred cap rate can then be thought of as an appropriate exit cap rate for these markets.

Growth expectations may similarly play into differences for markets in the lower section of the chart. Atlanta and Dallas are financial markets, and expectations for growth from this tenant base may be smaller than the growth expectations for tech-centric markets such as San Jose.

While the liquidity score can’t explain everything about a market’s cap rate, they tell us much about how investors value liquidity and can be used as a standalone measure to infer relatively accurate market prices.

If you are an RCA client you can access the RCA Capital Liquidity Scores launch report, data file, and methodology document on the RCA website. To get more information about becoming a client, contact us