Absorption Rate: What it is, and Why you Should Know it

by Rich Schiffer, Weichert, Realtors 

Before I began my career in Real Estate, I had often heard the terms "sellers market" and "buyers market" but I had never stopped to think at all about what these terms really meant.

Now that I am engaged in this career, and am being looked to as an expert by my clients, I thought I should boil this down in a way that would make it easy to explain to the consumer.  In addition, a recent conversation with Jeff Bellonger tipped me to the fact that this simple concept may be misunderstood by other professionals in the industry also, so this article goes out to everyone who ever wanted to know, and to those who never realized they didn't know about this fundamental measure of market conditions.

ABSORPTION RATE is the mathematical representation of the relationship between supply and demand.  The total amount of available product is divided by the total amount of product sold in the previous month.  The resulting number represents the number of months it would take, at that same pace, to sell the entire inventory of product.

"Normal Market" conditions exist when the Absorption Rate is between 5 and 6 months.

"Sellers Market" conditions exist when the Absorption Rate is lower.  (1-4 months)

"Buyers Market" conditions exist when the Absorption Rate is higher.  (7+ months)

Here is a (fictitious) example:

• Anytown, USA has 252 homes currently on the market.
• In the past month, 78 homes sold
• 252 / 78 = 3.23
• This would be a Sellers Market, but is approaching "normal" conditions.

CAUTION SHOULD BE TAKEN however.  Don't think that Absorption Rate is all you need to look at to determine the condition of the market.  In fact, many people misuse or misunderstand the application of this important ratio, and overlook several important factors:

1. To have real meaning to you in your practice, or in understanding the market you are buying or selling homes in, you need to look at not the overall conditions, but the local, price-range specific conditions.
2. The ratio reflects a general condition.  That is, it is not specific.  Specific property features, condition, and price will do more to determine how fast it will actually sell than any mathematical formula will.

I recommend calculating the Absorption Rates in your specific areas, but broken down into several geographic areas and price-range specific categories.

• Calculate based on County-wide figures,
• Calculate based on School District figures, and 
• Calculate based on Municipality figures.

This will help you identify such things as which School Districts are "sought after" and which Municipalities are "highly desired."  (I often see those terms used in MLS descriptions, and I wonder what objective criteria if any were used, or if the listing agent just liked the sound of them.)  If districts or municipalities have lower Absorption Rates than the County-wide rate, then that is an objective measure that those areas are in higher demand than others.

You should analyze the absorption rates in several price ranges: (for example:)

1. Under 300K  (total number of homes actively listed under 300K divided by the under 300K sales in the previous month)
2. 300K to 500K
3. 500K to 800K
4. 800K to 1M
5. 1M+

Use ranges that are significant in your market, or significant to your client.

Failure to look at the local data, can result in an unclear picture of the market.  You may inadvertently render poor advice to a client, because your information is too broad in scope, and not specific to their situation.  Telling a buyer that they are in a strong Buyers Market, with an Absorption Rate of 10.6 will ill prepare them for the reality of negotiating the purchase of a 200K home in Anytown, USA, if the Absorption Rate in that price range is actually 1.5.

HOW IS KNOWING ABSORPTION RATES VALUABLE?

1. FOR SELLERS
   Knowing the market conditions can help you determine the appropriate asking price for your home, based on your need for a timely sale.  If the Absorption Rate in the 300K to 500K is 4.2, while 500K to 800K is 17.4, and you were considering pricing around 510K, you might want to reconsider and price at 499K instead if you need a faster sale.  If you can afford to have your home on the market for a year or more, then pricing it at the 510K would be fine.
2. FOR BUYERS
   Knowing the market conditions in the specific areas you are looking to buy in will prepare you for negotiating.  It the Absorption rate in Springfield is 3.1, while in Shelbyville it is 15.2, and you want to negotiate a lower than asking price, you can see that in Shelbyville that may be more likely than in Springfield.
3. FOR AGENTS
   Knowing your market conditions will help serve your clients as you evaluate pricing, negotiate offers, etc.
   If your client is looking for that negotiating edge, you will be able to show them where to find it.   By demonstrating your knowledge of the market with prospective clients, you will also be able to attract more business.  It is very valuable when dealing with unrepresented sellers (FSBOs) since they often lack the access to the very data that is used to calculate the information, they may tend to overprice their property, and simply hope for the best.  Show them your expertise, and you can win their business, too.

This article can be found at http://activerain.com/blogsview/86836/Absorption-Rate-What-it

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In a separate post, I will discuss the correlation between Market Absorption Rate, and Market Value.  Stay Tuned.