The absorption rate metric in real estate measures supply and demand. Real estate absorption rate is one standard real estate investors can use to time the market, determining when it's a good time to buy or sell.
Absorption rate explained
The absorption rate in real estate tells investors how long it's taking houses to sell in a particular market. The answer can indicate whether it's a buyer's or a seller's market. Investors typically buy during a buyer's market because that's when real estate prices drop.
How absorption rate influences the real estate market
During a low absorption rate period, houses aren't selling quickly. Sellers who want to move their product will probably need to drop their price -- either that or take their property off the market with the hope that the market will favor sellers again soon.
During a high absorption rate, houses are selling quickly. Seeing this, sellers tend to raise their prices. This is probably not the best time for an investor to buy, unless they catch this change in absorption rate early and buy before prices become too high.
Real estate investors tend to do the opposite of what most buyers are doing. They often wait until the market slows, when people are rarely buying, before they buy.
Some investors wait even longer than the early stages of a buyer's market, hoping to see whether the market is slow for long enough that sellers start becoming desperate and lower their prices even further. Or in the case of sellers who took their homes off the market to wait for a better selling time, investors might wait for those sellers, many of whom can wait no longer, to put their homes back on the market.
Absorption rate example
Say there are 2,000 homes for sale in your geographic area of interest in the month of June, and then say 400 homes sold in June. The absorption rate would be 20%. And 20% happens to be the dividing line many investors use to distinguish between a low and high absorption rate period.
Anything 20% and above is typically considered a high absorption-rate period, with the higher the percentage, the higher the absorption rate and the stronger the seller's market, meaning probable high prices.
Anything below 15% is generally considered a low absorption-rate period, meaning a buyer's market and probable lower prices. The lower the percentage, the stronger the buyer's market.
How to calculate absorption rate
To figure the absorption rate of homes in your area, you first need to pick a time frame. Let's say one month for this example. So you're trying to find out what percentage of homes have sold in a month.
In the example above where there were 2,000 homes for sale and 400 sold, you would take 400 and divide by 2,000 to get 20%.
You can also determine how long it would generally take to sell a home in this 20% absorption-rate climate. To figure that, you would take the 2,000 homes for sale and divide it by the 400 sold homes to come up with five months.
This means if the current inventory of homes on the market were to stay the same, it would take five months for the other 1,600 homes to sell. But real estate rarely stays the same over time; it's constantly changing, so the real estate absorption rate metric is one that investors should recalculate regularly.
Regarding how to view whether five months of inventory is a buyer's or seller's market, it's more accurate to call it a balanced market or a neutral market. Six months is considered a perfectly balanced real estate market (not a buyer's or seller's market). But many investors consider anything between five and seven months to be a balanced market. Four months or less is generally a seller's market, and eight months or more is typically a buyer's market.
Other factors that affect demand in real estate
Absorption rate can also set the pace for homebuilding. During high absorption-rate periods, when demand is high and supply is low, builders are more likely to build more homes to satisfy demand. During a low absorption-rate period, where homes aren't moving quickly, there will probably be little or no demand for new builds.
Another factor, though, is building regulations, which can artificially create a high absorption-rate scenario that leads to such high prices that many buyers are priced out of the market they seek, as happens in San Francisco, for example.
Geography, even neighborhood, can also affect absorption rate. A popular neighborhood or region could have a high absorption rate while a less popular neighborhood or region could have a low absorption rate.
Homes could be priced the same in both areas, particularly if they're near each other and of a similar size, but if you know the absorption rate for one area is low and the other area high, you might want to buy in the low absorption-rate neighborhood and use your absorption-rate knowledge as a negotiation tool.
When figuring absorption rate, make sure you compare similarly priced homes, which can also affect the absorption rate. The starter-home market might have a high absorption rate in a particular town while luxury homes might show a lower absorption rate.
Real estate absorption can serve to balance the real estate market
Investors who study the market and know the absorption rate for their area can help balance the real estate market. As we mentioned earlier, a balanced market has about a six-month supply of inventory.
During a seller's market where homes are flying off the market and there's a one- or two-month supply, the market will likely correct. Prices should rise, which should result in fewer buyers. Builders might determine it's time to enter the market during this time and build more homes. When more homes come onto the market, prices should come down, and buyers and investors will probably get back in the game.
If the market is flooded with homes, however, there could be an 11- or 12-month inventory, which signals a buyer's market, and building will likely slow or cease altogether. Eventually a balanced market should happen again as the cycle corrects.
Absorption rate in commercial properties
In commercial real estate, the absorption rate's meaning is similar to that of investment homes, but there are a couple of differences.
One difference is that the unit of measure in commercial space is square footage rather than individual homes. To figure the absorption rate for commercial properties, you subtract the square feet that became vacant from the occupied square feet.
Let's say a company leases a commercial space that has 10,000 square feet but wants to move to a larger building of 15,000 square feet. The absorption rate here would be a positive net absorption of 5,000 square feet. If the tenant wanted to downsize from a 15,000-square-foot space to a 10,000-square-foot space, there would be a negative net absorption rate of 5,000 square feet.
Another factor is length of vacancy. In commercial space, a lease is often signed months in advance. The absorption rate calculation can occur at the time of lease signing or at move-in. If you think of absorption literally, you would probably be more likely to use the move-in date as the absorption rate figure, as absorb means to take in, so moving in would then be the more accurate real estate absorption figure.
Don't confuse real estate absorption rate with accounting absorption rate
Accountants are probably familiar with the term "absorption rate" because it's used in that industry as well as in the real estate field. The absorption rate in accounting, however, differs from the absorption rate in real estate.
Just to satisfy any curiosity (feel free to skip this section if you just want to understand real estate absorption rate): In accounting, absorption rate refers to how overhead costs are factored into a business. For example, say you run a factory, your annual overhead costs are $300,000, and the machines in your factory run for 5,000 hours a year. Your absorption rate per machine hour would be $60.
Accountants can use this $60 per machine per hour figure to determine under- or over-allocation of overhead costs. Let's say the machines were used for only 4,500 hours one year. That would be $30,000 of overhead not allocated, which would be expensed for that period.
Again, accounting absorption rate might be more than what you need to know here. The explanation is just in case you were curious about the difference between the two absorption-rate meanings.
The bottom line
It's helpful for investors to know how quickly or slowly homes are selling in their market. Figuring out the absorption rate gives investors an important metric they can use to know when to make an offer or when to wait.