Let's start with a dry definition of absorption rate in real estate and then we'll make it a bit more interesting. Absorption rate is the number of months it would take to sell the currently listed homes in the market. That sounds simple, and the math is for the most part. However, it's an important concept, and it's used by a great many real estate related businesses to attempt to predict home prices and sales activity going forward.
Most of those who use absorption rate use six months of home sales as their baseline. Let's use a fictional example to illustrate how absorption rate is calculated:
1. In a large urban area, the previous six months report of home sales showed 38,235 homes sold.
2. So, 38,235 homes divided by 6 months yields 6373 homes sold per month.
3. There are currently 28,145 homes listed for sale in this market. We divide this number by 6373, and we find that there is currently a 4.42 month supply of homes for sale in this market. At the current rate, with none withdrawn and none added, it would take 4.42 months to sell them all.
That wasn't hard, but being easy doesn't make it less important. One comparison that is made to help in anticipating market activity and home price action is looking back at historic absorption rate numbers for the market.
Let's say that this particular market has seen several 6 month periods in the recent past with inventories running between 5 and 6 months of homes for sale, a slower rate of absorption. This speeding up of sales, which gives us a faster 4.42 month absorption rate, could mean that prices are climbing or will shortly. It's a supply and demand thing. Let's see how this information is used.
Real Estate Professionals
The real estate broker or agent is interested in absorption rate because they're tasked on a regular basis to value properties to be listed for sale. When they're sitting in front of a listing client, they want to make them happy and tell them that the home is worth every dollar the owner wants to get. In many cases that isn't the case, and it's hard to tell them that they must list it for a lower price and be prepared to bargain on that.
One of the tools they use is the absorption rate. They can show the homeowner that the current absorption rate has slowed, and use that information to justify lowering the listing price. On the other side, if the rate has increased, they may be able to list for more than they anticipated, as there is good demand and a smaller supply. Of course, this changes almost daily, but we must use some measure to help in decision-making.
The real estate and mortgage crash caused a lot of hardship for many. We seem to be climbing out of that, but a lot of government regulation followed with the intention of avoiding another crash caused by the same factors. Some of those regulations attempt to put more accuracy into the appraisal process. Appraisers have new requirements, and one of them is to consider absorption rate, which they may or may not have done in the past.
New rules that went into effect in 2009 require appraisers for home loans secured by Fannie Mae or Freddie Mac to consider absorption rate in their valuations. They must look at absorption rate trends in the market and compare historic numbers with the current market. If they see a longer absorption period in the current market, they may need to lower the valuation to adjust for the slower sales.
Now you can impress your realtor, mortgage broker, or banker the next time you're talking about home values by asking them about the current absorption rate and how it compares to past rates.