What is absorption rate?
(Article originally published November 18, 2016)
Absorption Rate is a parameter I like to use when I talk about the market. Why? Because it makes me sound more intelligent? Absolutely. But also, because it's the best answer for the question I get all the time - "How's the real estate market doing?"
Every month I put out a simple market update (subscribe to my monthly newsletter in the bar at the top of the page to recieve my market update) with median sales price, average days on market, how many homes sold, and other information that most people are familiar with, but one of the key pieces of information is one that few people truly understand: Absorption Rate.
Simply put, absorption rate is a measure of how fast homes are selling. It can be expressed as a percentage, but I prefer to express the absorption rate in months of inventory. The most recent market update indicated that we had 3.72 months of inventory. What that means is that at the current rate homes are selling, it would take 3.72 months to completely sell out of all of the homes that are actively on the market, if no new homes were added.
So, it's neat that we know how many months of inventory we have, but what does that tell us about the market? Well, I'm glad I asked. A balanced market has about 6 months of inventory - at 3.72 months, we're low on inventory. This tells me that demand is outpacing supply, or in more practical terms, there are more buyers than there are homes for sale. Conversely, if we had a 12 month supply of homes, this would indicate that supply is very high, but there's not a whole lot of demand. So in times like now, when demand is high and supply is low, prices tend to move up. We remember this concept called "the Law of Supply and Demand" from high school economics, but in the real world, why does low supply/high demand result in price increases? Two words: Bidding War. Right now, it's not unusual for a home to receive multiple offers on the first day it's listed. When there are multiple offers, the listing agent will notify the buyers' agents that there are multiple offers and to bring their "highest and best" offer. This often results in the house selling at full price, or, in some instances, above the list price.
How is Absorption Rate calculated?
The calculation for absorption rate is fairly simple. We need three pieces of information.
- Time Period
- How many homes sold during that time period
- How many homes are available for sale at the end of the time period
So for October of 2015, we know there are 31 days in the month, we know that 520 homes sold in those 31 days, and that at the end of the month, 1871 homes were available for sale. Now, we simply plug in the numbers:
31 days / 520 homes = 0.05962 (one home sold every .05962 days)
Now, we apply the rate of 0.05962 to the number of homes available
0.05962 x 1871 = 111.54 (how long it would take to sell all 1871 homes expressed in days)
111.54 / 30 days = 3.72 months
How do we use the Absorption Rate?
Real estate agents (the good ones), appraisers, and builders all use absorption rate. Real estate agents and appraisers use absorption rate to price homes. If the absorption rate is telling us that there is great demand and minimal supply, then real estate agents know they can afford to price homes a little higher. Likewise, when appraisers are assigning value to a home, they must consider the market conditions, so they factor absorption rate into their valuation.
Builders need to be aware of absorption rate as well. If the absorption rate indicates demand is outpacing supply, then they know that it's time to ramp up their production and "make hay while the sun's shining". If supply is high and demand is low, they know that building a whole bunch of spec homes could be a very costly mistake.
Absorption rate is an incredibly useful metric, and if your current real estate agent gives you a blank stare when you ask about it, go ahead and give me a call.