When you hear “absorption rate,” you may automatically think of the accounting term, not real estate.
However, the absorption rate in accounting and real estate are drastically different from one another.
In accounting, the absorption rate refers to how overhead costs are factored into a business.
In real estate, the absorption rate provides an important metric for how quickly/slowly properties are selling, which can impact a variety of factors.
In this blog, we’ll cover the top things you need to know about absorption rate as it pertains to real estate.
Let’s get started.
1. What is the absorption rate in real estate?
The absorption rate is a metric used to determine the rate at which available properties or homes are sold in a particular area over a set time period.
2. How is the absorption rate used?
If you are a seller, you can use this rate to determine how to price a property for sale.
If it’s currently a seller’s market (see #6), then properties won’t stay on the market for long.
As a result, you will likely want to increase the price to match the elevated level of competition.
As a buyer, the absorption rate can help you determine whether now is a good time to get a great price on a home or lot.
In addition, appraisers will factor in absorption rates when evaluating a property’s value.
This can impact the size of your mortgage since appraisers utilize the market absorption rate as a backup for the property’s selling price.
For example, if you put in an above-market offer on an in-demand lot, the bank’s appraisal will likely determine that the property’s value is lower than the agreed-upon price.
This can be bad news for you since the bank will typically size your mortgage based on the appraised value (not the sales price).
However, the appraiser may be able to use the absorption rate to justify a higher mortgage based on the market conditions, allowing you to move forward with your competitive bid.
All this said, keep in mind that the absorption rate is just one factor to consider.
To make a smart investment decision in any market, use other real estate market analysis metrics as well.
3. How do you calculate the absorption rate in real estate?
To find the absorption rate in real estate, you need to know three pieces of information.
The specific time frame
The number of sold properties during the time frame
The number of properties currently listed
Take the total number of sold properties in the market and divide it by the total number of available properties for sale.
The result will be the rate of absorption.
The rate of absorption is the rate at which all of the current properties on the market are being sold.
Here’s an example:
A real estate market has 30 active listings and 10 of those properties are sold during the month.
So, you take 10/30 = 33%.
This is your absorption rate.
If you flip the formula and divide 30 active listings by the properties sold during the month (10), then you’ll find the number of months it takes for the complete supply of active listings to be sold.
In this example, it would be 30/10 = 3, so 3 months.
4. What is an example?
Need another example of absorption rate to solidify your understanding?
We’ve got you covered.
A city has 1,000 homes currently listed on the market.
Buyers snap up 100 of these homes per month.
As a result the absorption rate is 10% (100/1,000 = 10%).
The supply of homes for sale will be exhausted in 10 months (1,000/10 = 10 months).
In this scenario, it is a buyer’s market because the absorption rate is below 15% (see #6 for more information!).
5. What is a good absorption rate?
A good absorption rate ultimately depends on your position (buyer or seller).
Learning the rate of absorption will give you an idea of where you stand in the real estate market.
What is a seller’s market?
When it’s a “seller’s” market, it indicates that current conditions benefit the seller.
Often, buyer demand is higher than the supply of active listings.
As a result, properties tend to sell very quickly.
If the absorption rate is anything above 20 percent, it typically means that it’s a seller’s market.
What is a buyer’s market?
A “buyer’s” market indicates the opposite.
The current conditions will benefit the buyer.
Often, this means that there is a copious supply of active listings and the number of those listings being sold is low.
Buyer demand isn’t as high, and they may be likely to get better deals.
Low absorption rates (below 15 percent) signal a buyer’s market where properties take a bit longer to sell.
6. What should sellers look for?
If you have the option, you’ll ultimately want to wait for a seller’s market before you list your property.
The absorption rate is a metric that is primarily used by sellers or real estate agents to figure out the state of a real estate market to price the property accordingly.
Anytime the number of months to sell ranges from 0 to 5 months, it is indicative of a seller’s market.
The National Association defines a balanced market as 5 months’ worth of inventory (others say anywhere between 5 to 7 months).
Higher than 5 months indicates a buyer’s market and lower than 5 months indicates a seller’s market.
Ultimately, this means that all active listings will sell in a relatively short period of time.
Spring season normally marks the time when the absorption rate is above 20 percent and below 5 months.
Demand is high, and supply can’t keep up.
Arming yourself with this knowledge will help you market your property at the right time.
If you’re able to wait and list your property when the market is hot, then you’ll have a better chance of selling and getting a great price.
7. What should buyers look for?
Just like sellers, buyers can use the absorption rate in real estate to determine if they’ll get a deal or if it’s a good time to invest.
A buyer’s market is anything below 15 percent or longer than 6 months to sell.
This means that properties are on the market for longer, and buyers do not need to worry about extreme competition as there are plenty of active listings to go around.
If you’re dealing with a competitive market (absorption rate is above 20 percent), then you’ll be racing against other buyers.
To give yourself the best advantage, study the real estate market, keep track of listings, get pre-approved for a mortgage, and have a clear strategy so you’ll be ready to take action when you find something you love!
8. How do you find the right price using the absorption rate?
First, you need to calculate the current absorption rate in your market.
To do this, you’ll need to determine the number of properties closed in your market over a specific period (say 12 months).
Next, divide the number of properties by the number of months in the period.
In this case, it’s 12.
This calculation gives you the number of properties sold per month.
Finally, divide the number of current listings by the number of properties sold per month to yield the months’ supply of property.
Remember 5-7 months is considered a balanced market.
For ease, we’ll say a 6 months’ supply is balanced.
This is when the number of listings roughly equals the number of buyers.
Numbers above 6 will represent a buyer’s market and numbers below 6 will represent a seller’s market
Even in a hot market, it is rare for more than 50 percent of properties to sell.
If it is a seller’s market, you can be a bit more aggressive with the price.
However, if it’s a buyer’s market, you will need to lower your price if you want to sell quickly.
Once you’ve evaluated the absorption rate at large, you can also focus on the absorption rate in particular neighborhoods or price ranges and evaluate how that impacts your pricing.
You want your pricing to be competitive within your market – otherwise, you’re not setting yourself up for success!
10. How does the absorption rate influence investors?
The absorption rate influences the real estate market through buyer and seller activity.
When the absorption rate is low, properties aren’t selling as quickly.
As a result, sellers who want to get their property sold will likely need to lower their price (or take their home off the market until it favors them again).
When the absorption rate is high, properties will sell quickly.
When this occurs, sellers tend to raise their prices.
As a result, it’s typically not the best time for an investor to buy.
Real estate investors will often do the opposite of what buyers are doing.
They will buy when the market slows, and others aren’t buying.
If the market is slow for long enough, then sellers often get desperate and lower their prices even further.
This is where investors hope to strike gold!
11. How does the absorption rate differ when it comes to commercial properties?
While similar, the absorption rate does differ in a couple of ways when it comes to commercial properties.
One big difference is the unit of measurement in commercial spaces.
Rather than using individual homes or properties, commercial properties use square footage.
To find the absorption rate, you must subtract the square feet that became vacant from the occupied square feet.
Another difference is the length of vacancy.
Because a lease is signed months in advance for commercial spaces, the absorption rate can be calculated either at the time of lease signing or at move-in.
Thinking about absorption literally (as in to “take in” or occupy a new space) often makes people more inclined to use the actual move-in date.
The absorption rate in real estate is a really powerful tool that can be used to get a quick read on the market.
Is it hold or cold?
Is it a buyer’s market or a seller’s market?
What’s the best way to go about selling your land or buying a new property?
Although you can’t fully rely on absorption rate to tell you everything, it’s a crucial part of your due diligence as you do a full market analysis.
Do you still have questions?
Let us know in the comments.
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Disclaimer: we are not lawyers, accountants or financial advisors and the information in this article is for informational purposes only. This article is based on our own research and experience and we do our best to keep it accurate and up-to-date, but it may contain errors. Please be sure to consult a legal or financial professional before making any investment decisions.