What is net absorption?

Net absorption is a very useful measure in identifying and assessing trends in demand for rental property in real estate markets considered for investment purposes. Net absorption is a measure of change in total rental demand for a particular property type in a market or submarket. It can, therefore, help the investor assess whether rental demand for residential of commercial properties is rising or falling.

Net Absorption and Property Investing

How investors can use net absorption in assessing/selecting rental property markets for investments in income-producing properties, such as apartments, offices, shops, warehouses, etc.? Should an investor enter a market with negative absorption and, therefore, falling demand for rental property? Should investors invest always in markets with positive net absorption and, therefore, rising demand for rental property?

Entering a market with an established trend of negative absorption and falling demand for rental property is definitely risky unless there are underway solid developments in that market that leave little or no doubt to the investor that this trend will be reversed and demand for rental property will very soon start rising. In addition, the market-wide vacancy rate for the property type under consideration has to be quite low.

Markets with positive net absorption and rising demand for rental property should be also assessed carefully before a decision to enter a market is taken. In particular, it is very important to understand why demand for the particular rental property type is rising. Keep in mind that positive net absorption and increasing demand for rental space may have been triggered by falling rents. If that is the case, this is not a healthy market and there are increased risks when acquiring properties in such markets. Furthermore, even if there is increasing demand in the face of rising rents, the investor needs to get a good estimate of the magnitude of new supply expected to come in the market in the next two years and assess the risk of the market becoming oversupplied in the short-medium term.

How to Calculate Net Absorption

Net Absorption (NA) is measured as the change in the occupied rental stock of a market or submarket from one period to the next.  So for example, if we denote the occupied stock of this period as OSt and the occupied stock of the previous period as OSt-1 then Net Absorption in this period (period t), NAt, can be calculated as follows:

NAt = OSt – OSt-1

For example, the Net Absorption for the year 2017 can be calculated with the following formula where OS2017 represents the total occupied rental stock in 2017 and OS2016 the total occupied rental stock in 2016 :

Net Absorption2017 = OS2017 – OS2016

Given the above formula, it can be easily understood that net absorption will be a negative number if the occupied stock in a property market decreases.  Similarly, net absorption will be positive, if the occupied stock of a property market increases. Note that the total occupied stock at a given point in time represents the total demand for rental property in the market under consideration.

The occupied stock is usually calculated using data on the total rental stock of that market and the prevailing vacancy rate. For example, OS2017 and OS2016 in the previous formula can be calculated as follows:

OS2017 = Total Rental Stock in 2017 * (1-Vacancy Rate in 2017)
OS2016 = Total Rental Stock in 2016 * (1-Vacancy Rate in 2016)

Note that the occupied stock in each period is considered as the stock that is physically occupied and/or is under a valid lease contract.  A grey area in the measurement of occupied stock is sublease space, which is actually space under contract but is being placed in the market as vacant for sub-leasing. Typically, this space is counted as occupied, but in severe downturns when firms are downsizing and there is a significant amount of space in the market for sublease, it is often counted when trying to determine the market vacancy rate.

Net absorption should not be confused with Gross Absorption. This term simply refers to the cumulative amount of space covered by all the lease contracts that were signed over a particular period. Analysts and investors should use great caution when examining and interpreting gross absorption numbers for a particular property market or submarket. The big problem of this measure in assessing changes in total demand for rental space in a property market is that it does not account at all for the space that was vacated during the period under consideration. So consider how misleading this measure can be in terms of highlighting what is happening on the demand side of a rental property market if the total space vacated is greater than the total space leased through new contracts. In that case, although the gross absorption number, may indicate a considerable leasing activity from a contract-signing point of view, in reality, the market would be registering a negative net absorption and falling demand for rental space.  For this reason, using simply the term absorption without clarifying whether it refers to net or gross can be quite misleading.

Example of Calculating Net Absorption

To demonstrate how the net absorption formula is applied let’s consider two examples from the apartment market, one that results in negative net absorption and one that results in positive net absorption.

Let’s consider an apartment market with an occupied stock in this period (year, quarter, etc.), OSt equal to 200,000 units and an occupied stock of 220,000 units in the previous period, OSt-1.  Then NAt in this apartment market in this period (t) is negative and equal to:

NAt = 200,000 – 220,000 = -20,000 units

Now consider that the occupied stock in this period (OSt) is equal to 200, 000 units and that the occupied apartment stock in the previous period, (OSt-1) was 185,000. In that case, NAt in this period (t) would be positive and equal to:

NAt = 200,000 – 185,000 = 15,000 units

The interpretation of the above calculation is that this period the total apartment units that were rented within the market under consideration increased by 15,000 or that the total demand for rental apartments increased by 15,000 units.

Absorption Rate

A similar term with a different interpretation that is usually used at the project level is the absorption rate which is absolutely necessary for developing the future cash flows of a development project. The term absorption rate, in this case, refers to the monthly, quarterly or yearly number of units (in the case of residential projects) or amount of space (in the case of commercial real estate) that is sold or leased per period.  This number is extremely important in assessing the financial feasibility and viability of the project because it determines the timing and magnitude of the revenues of the project. For this reason, it is important that projected absorption rates used in developing the cash flows of a development project are conservative taking into account both optimistic and pessimistic projections with respect to the conditions of the local market and the capture rate of the project. Furthermore, since most development projects of moderate or large size take many years to complete, absorption rate schedules (and resulting revenues) should not be kept constant through time but reflect the cyclical nature of property/space demand patterns.  This is important because the particular timing and magnitude of the cash flows affect directly the achievable return (internal rate of return) of the project.

 

References

Geltner, M., Miller, N. G., Clayton, J., & Eichholtz, P.  (2013). Commercial Real Estate Analysis and Investments (with CD-ROM). Oncourse Learning.

Wurtzebach C. H. and Miles M. (1994). Modern Real Estate. John Wiley & Sons, Inc: New York.

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Internal Rate of Return (IRR) and Property Investment
High-Return Property Investing
Selecting Markets and Locations for Office Property Investments
Choosing Locations for Residential Property Investment
Property Investment Analysis: The Discounted Cash Flow Model

 

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