What is the Absorption Rate?
The Absorption Rate is a measure of supply and demand in the commercial real estate market, most often segmented on a per-sector basis.
In short, the absorption rate is the difference between the total square footage (sq. ft.) of vacated space and the newly leased space by tenants within a set time frame, relative to the initial total amount of space marketed as available for lease.
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How the Absorption Rate Works in Commercial Real Estate
In commercial real estate (CRE), the absorption rate is an indicator of market demand that is closely tracked by practitioners, namely to forecast future trends of a specific sector or on a macro level.
Based on the current absorption rate of a real estate market (or submarket) – such as the commercial office, retail, and industrial sectors – CRE investors can derive useful insights pertaining to the current level of liquidity and supply-and-demand dynamics.
Therefore, the absorption rate is a closely tracked indicator that serves as a proxy for the market conditions in the real estate sector at a given point in time.
From the perspective of real estate investors, the current supply-and-demand dynamics and liquidity in a specific real estate market are instrumental factors in determining whether they will meet their targeted return (“hurdle rate”) on a given property investment.
This reasoning is tied to the inherent cyclicality of the commercial real estate (CRE) market, which causes the timing of the date of purchase and sale to be two of the core drivers of returns.
That said, real estate investors are incentivized to purchase when asking prices are compressed and sell (i.e. “exit”) at peak valuations – albeit, timing the market is easier said than done.
Buyer’s Market vs. Seller’s Market: What is the Difference?
A real estate market can be designated as either a buyer’s market, seller’s market, or balanced market:
- Buyer’s Market → The supply outpaces demand in a buyer’s market, which is favorable to buyers since the asking prices of properties available for sale are most often compressed.
- Seller’s Market → The demand exceeds supply in a seller’s market, meaning that the number of buyers in the market actively looking to purchase properties exceeds the quantity of properties listed for sale.
- Balanced Market → The market is in a state of equilibrium concerning supply and demand, favoring neither the buyers nor sellers.
Therefore, the absorption rate is higher from the expansion in demand in a seller’s market, and vice versa in a buyer’s market.
The factors that influence absorption rates are frequently specific to the location, sector, and property type.
But the prevailing economic conditions and interest rate environment can also impact absorption rates.
For instance, the interest rate hikes by the Fed to fend off inflation post-COVID caused net absorptions to decline across all sectors, with the effects persisting into 2024.
The commercial sector remained most stable, with the office space sector struggling to recover from the shift toward work-from-home (WFM) and hybrid models.
Absorptions Data – Real Estate Market Insights (Source: Aprio Insights)
Positive vs. Negative Absorption Rate: What is the Difference?
In practice, the absorption rate is described as either positive or negative.
- Positive Absorption Rate → A positive absorption rate implies an increase in the occupancy rates, or that more square footage of space is occupied relative to the amount of space vacated and that is now available to be leased in a set time period.
- Negative Absorption Rate → In contrast, a negative absorption rate is indicative of a decline in occupancy rates, in which more square footage is vacated by tenants compared to the amount occupied by new tenants.
The periods with high positive net absorption rates tend to correspond to a widespread increase in property prices, often attracting more real estate investors like property developers to enter the market (i.e. outsized tenant demand, increased rental rates).
However, the decision to invest based solely on these types of trends by themselves is not a viable investment strategy, especially for property development, as the trend could be short-term (and the market direction can easily pivot).