Illiquidity Exploitation In REITs

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Includes: NXRT, RAS, SOHO
by: Dane Bowler

Summary

Liquidity is a broadly misunderstood concept.

This article shows how to identify the various types of illiquidity.

And how to be on the winning side of the trade.

Liquidity is a widely misunderstood concept, particularly as it pertains to small cap REITs. It is often thought of and described as a single aspect of a stock that is measured by trading volume. However, there are multiple types of illiquidity, each with drastically different implications for the trading trajectory of stocks.

Types of illiquidity

We look at and categorize the various types of liquidity and illiquidity by their fundamental economic etiologies. It is insufficient to simply say a low volume stock is illiquid without fully understanding why it is low volume.

Following is a quadrant chart showing the 4 types of liquidity. We will attempt to clarify these categories with case studies that can serve as a template for identifying illiquidity in other REITs.

Click to enlarge

The top left quadrant, is where the low volume is created by a low supply of shares and high demand for shares, making it quite easy to sell and difficult to buy. The best REIT example of this at the moment is NexPoint Residential Trust (NYSE:NXRT).

Ownership has gotten concentrated, with the top 10 institutional holders owning 77% and insiders owning another 16%.

Data from SNL Financial

As long as these holders keep their shares, the supply of shares available to buy is minimal. Demand for shares, however, remains normal for the size of the company. Thus, we have normal demand competing for a tiny percentage of float which has caused a price spike that could continue until either fundamental valuation is reached or a large holder egresses. In the last month, NXRT returned 15%.

While the move was fully supported by fundamentals, we think the speed of it was largely caused by the particular type of illiquidity with which NXRT trades. Hard to buy illiquidity is the most desirable kind.

The neutral kind of illiquidity, we have dubbed disinterested illiquidity (the lower left quadrant) and it is characterized by both low supply of shares and low demand for shares. The RAIT Financial (NYSE:RAS) preferreds epitomize disinterested illiquidity. The screenshot from my screener below was taken at 11:42 Central time on 4/8/16. Halfway through the trading day, RAS-C had only traded 16 shares with the others also showing small volume.

Click to enlarge

Other key aspects of this type of illiquidity are the enormous bid-ask spreads ranging from $0.20 to $0.60 on the RAS preferreds. What causes this?

We believe disinterested illiquidity is rooted in a lack of impetus. Those who hold these preferreds are comfortable with them and generally content to just sit and collect the dividends. They see no reason to sell unless given a great price. Buyers are equally unmotivated due to a combination of not even being aware of RAS-C's existence and a lack of near-term catalysts. There seems to be no particular reason to buy now instead of next month.

The 3rd and worst kind of illiquidity is the hard to sell kind (lower right quadrant) characterized by high supply of shares and low demand for shares.

Sotherly Hotels (NASDAQ:SOHO), unfortunately manufactured this situation for itself. It has always been a small market cap stock with low trading volume, but the demand and supply of shares was in balance allowing its strong fundamental performance to carry it. The stock performed nicely until SOHO decided to dump 3.4mm shares on the market in June of 2015 through a secondary offering.

Management was of the impression that the issuance would improve SOHO's liquidity situation because issuing equity raises the market cap which should raise trading volume. This is an example of the standard definition of liquidity in which one only looks at trading volume. There is much more to liquidity than trading volume and failure to account for it can have devastating effects.

Instead of improving SOHO's liquidity situation, the issuance sent SOHO into a downward spiral. If we analyze the actual effect of issuing shares, it is fairly obvious that it directly increases supply of shares. This is always true in every situation. The change in demand for shares upon an issuance is more variable. Share demand can go up if there is a great story behind raising the equity (think Tesla issuing shares to build a giga-factory), or it can go down if the issuance does not seem justified.

I think SOHO was somewhere in the middle. Acquiring the rest of the Hollywood hotel was a decent acquisition, but the cost of capital was quite expensive. Thus, I think the impact on demand was neutral.

So to review, demand and supply of SOHO shares were balanced, then equity was issued which dramatically increased supply and did not increase demand. Share supply began to massively outpace demand causing the stock to drop nearly 40%.

How does one get out of hard to sell illiquidity?

Once SOHO drops far enough, demand will go up from sheer fundamental valuation. At just over 4X P/2016 estimated FFO, the value is deep enough to pique the interest of some investors who were not interested before. In this way, the market naturally corrects trading imbalances, but it is not a pleasant fix. There is a cleaner and more efficient way to fix hard to sell illiquidity; a share buyback.

Buying back shares immediately and substantially reduces supply of shares and in the case of an undervalued company like SOHO immediately and substantially increases demand for shares. SOHO would still be illiquid, but it would be the good kind, the hard to buy kind.

Exploiting illiquidity

The title of this article mentions exploitation of illiquidity and so far, we have only defined it and described how to identify it. We can now use this framework to discuss exploiting it for financial gain.

Illiquidity is typically thought of as a negative thing. Liquid stocks trade at premiums to their illiquid counterparts because liquidity is valued as a positive trait. I would contend that this is not true. Liquidity and illiquidity have potent implications, but these are not necessarily positive or negative.

At the transaction level, trading is a zero sum gain in which one party benefits to an equal degree that the other loses. For example, if I were to buy a stock at $10.50 instead of buying it at $10.60, my 10 cents per share benefit is equal to the loss of the counterparty who sold at $10.50 instead of $10.60.

Liquid securities have very small benefits and losses of trading because the bid-ask spread is usually small. If a stock has a bid of $150.32 and an ask of $150.33, the clever trader who buys at the bid through making the seller come to him rather than coming to the seller at the ask only receives a marginal benefit. Among illiquid securities, the spread is much larger and the potential gains to clever trading are much greater.

Thus, illiquidity is not a bad thing. Instead, it is an opportunity to take advantage of counterparties who are disadvantaged with time sensitivity or the emotional influence of panic or greed.

At 2nd Market Capital, we have become intimately familiar with illiquid REITs as our value REIT trading universe tends to consist of mostly small caps. Following are some behaviors that we consider best trading practices for each type of security.

Hard to buy illiquidity: In accumulating a stock with demand that exceeds supply, recognize that it may take a while. Any attempt to buy a substantial quantity will be met with a material increase in the stock price. We find it best to just nibble whenever the price gets opportune.

Disinterested illiquidity: As shown with the RAS preferreds, bid-ask spreads can be particularly large here. Patience is the key. Keep low-ball bids in place that will occasionally get hit as a holder needs to sell and puts shares out with an "at the market" order. Look for spikes in supply of shares around certain events like tax loss selling or ex-dividend dates.

Hard to sell illiquidity: It is easy to get locked into these securities, and a forced sale can be disastrous, so the key here is to make sure you have a long investment horizon. Pick a price where you feel comfortable that the long run fundamental value will provide a decent return.

Illiquid securities are not something that should be avoided. It can be a fun and profitable type of security, just be on the right side of trades, the exploiter not the exploited.

Disclosure: This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. 2nd Market Capital and its affiliated accounts are long RAS, RAS-A, RAS-B RAS-C, SOHO and NXRT. I am personally long SOHO and NXRT.

Disclosure: I am/we are long SOHO, NXRT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.