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Absorption Rate

Updated on March 26, 2024
Article byRutan Bhattacharyya
Edited byRutan Bhattacharyya
Reviewed byDheeraj Vaidya, CFA, FRM

Absorption Rate Definition

Absorption rate refers to the rate at which the sale of properties available in a certain real estate market takes place during a specific timeframe. This metric helps sellers determine when they should list their property. Moreover, it allows developers and investors to evaluate real estate projects’ timing and feasibility.

Absorption Rate

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The rate sheds light on the balance between supply and demand in the market. Real estate professionals utilize this key metric to price properties. Generally, when this rate is over 20%, it is a seller’s market. On the other hand, typically, a rate under 15% signifies a buyer’s market. Key factors impacting such rates are inventory levels and economic conditions.

Key Takeaways

  • Absorption rate refers to a metric that people use in the real estate sector to find out how fast homes are selling in the market. It lets investors know when to allocate funds to the real estate asset class.
  • There are multiple absorption rate factors. Three examples of the elements influencing this rate are market demand, pricing trends, and inventory levels.
  • Contrary to the formula of absorption rate in accounting, the metric used in the formula for the metric used real estate sector does include overhead costs.
  • This metric helps formulate pricing strategies.

Absorption Rate In Real Estate Explained

Absorption rate refers to a useful metric used in the real estate space by individuals or organizations to determine the rate at which the sale of homes is taking place in a particular area or market. This figure helps sellers determine when it might be the right time to list a property. The metric does not consider the extra homes entering the market at different times. While the projection of absorption rate computation is possible, usually, its usage is based on actual inventory and current available data.

If the metric is high, it may be a sign that the available homes’ supply will decrease quickly. Typically, homeowners can sell their homes quicker during high absorption periods. That said, one must note that the duration linked with the computation of absorption rate is essential to consider.

As noted above, one can calculate the absorption rate to know if it is a seller’s or a buyer’s market. In the case of the former, the demand exceeds supply, which means it is an ideal time for homeowners to sell their property. On the other hand, in a buyer’s market, supply exceeds demand. This means it is the ideal time to purchase a new property.

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Factors

Let us look at the vital absorption rate factors.

  • Inventory Levels: The total property inventory left has a huge impact on the metric. Usually, a high level of inventory means a high rate, thus indicating a buyer’s market. That said, less inventory usually indicates a seller’s market or lower absorption rate.
  • Market Demand: A key driving factor of this metric is market demand. Various elements, for example, population growth and demographic shifts, can influence this factor. High demand in the market can increase the metric, thus giving the indication of a seller’s market.
  • Pricing Trends: In a specific real estate market, pricing trends can influence the rate of home sales. When prices increase, demand may fall, resulting in an increased rate.
  • Economic Conditions: Both national and local economic conditions have a great influence on this metric. Note that factors like income levels, economic growth, and employment rates can affect both demand and supply for real estate, impacting the metric.

Formula

One can use the formula below to calculate the absorption rate:

Absorption Rate = Average Number of Home Sales Each Month/ Total Number of Properties Available In The Market or Area

Examples

Let us look at a few absorption rate examples to understand the concept better.

Example #1 

Suppose David listed his home for sale in the Los Angeles real estate market. He attached a competitive price tag to his house as compared to most properties in the same market to ensure that it sells fast. David wanted to know approximately how much time would be needed to complete the sale. For this, he approached a real estate agent in Los Angeles, California.

The real estate agent looked at the overall available houses in the last year. Moreover, the person considered the monthly house sales during the same period.

Over the past year, 20,000 houses were up for sale and the sale of 5,000 houses was taking place every month.

The real estate agent computed the absorption rate using the above data:

Absorption Rate = 5,000/20,000 x 100, i.e., 25%

Considering this high absorption rate, the agent informed David that it is a seller’s market it would be an ideal time to sell the property. He also told David that he would need to wait roughly 4 months (20000/5000) to sell his property.

After hearing this, David became confident that he would be able to sell his property at a good price.

Example #2

Per a report published by a real estate consultancy named Anarock, Gurugram, India, topped the list in both absorption rate and housing supply among every city in the National Capital Region. In 2022, the sale of 63,710 units in total was recorded, and out of that, Gurugram accounted for 51%. According to the city-based developers, the prices were steady, and the trend would not cease to exist in 2023. Despite the surge in home loan interest rates, homebuyers were keen on purchasing property.

Importance

One can look at the following factors to understand the importance of absorption rate.

  • It can indicate how long properties will be on the market.
  • This metric assists sellers and brokers in setting the price of the property. 
  • Appraisers can utilize this metric to demonstrate market demand.
  • Contractors can use this rate to determine if there is property demand in their area.
  • Real estate investors can consider this rate to determine the right time to sell or buy.

Absorption Rate In Real Estate vs Absorption Rate In Accounting

One must note that the concept of absorption rate is there in accounting too. That said, the meaning and purpose of the term for accountants is completely different. Knowing the key differences between the two is necessary to avoid confusion, especially for people new to the finance world. So, let us find out how they differ.

Absorption Rate in Real EstateAbsorption Rate in Accounting
It is a term denoting the rate of property sales in a certain area or market.This metric refers to the rate at which organizations compute and allocate overhead expenses.
Elements of the formula do not include different business expenses, like variable production or manufacturing overhead costs and fixed manufacturing overheads.  The formula includes various business expenses.

Frequently Asked Questions (FAQs)

1. What absorption rate is considered a market in equilibrium?

Conventionally, a percentage of 15% to 20% is a sign of a neutral real estate market. If the rate is more than 20%, it indicates higher demand, which means the price of homes may rise.

2. What are the disadvantages of absorption rate?

One must remember the key limitations of this metric. Let us find out what they are.
– This metric is less accurate for making forecasts with regard to future trends.
– External factors, such as government housing policies and mortgage interest rates, can quickly influence the metric.
– This metric alone cannot capture the real estate market’s full complexity.

3. How to improve the absorption rate?

One can take these steps to improve this metric:
– Implement effective marketing strategies.
– Invest in home improvement to increase the appeal to potential buyers.
– Price the property on the basis of current market conditions.

This article has been a guide to Absorption Rate and its definition. We explain its formula, factors, importance, and compare it in accounting & real estate context. You may also take a look at the useful articles below –

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