Making sense of market indicators, part 5: absorption.

In this, the last article in my series on real estate market indicators (unless I discover more indicators) we’ll look at what I think is, by far, the most powerful indicator, the statistic that tells you more of what you need to know, more quickly, more concisely, than any other.

At least most of the time.

Whenever I start working in an area where I haven’t been active for a while, one of the first things I’ll do is crank out its recent absorption statistics. Because nothing tells me better whether the market in that area favors buyers or sellers, and to what degree. Nothing tells me better what I’m up against, either as a buyer’s agent or as a seller’s agent.

The absorption rate is simple to calculate. Just divide the number of sales for the period under consideration, typically but not necessarily a month, by the amount of inventory for that period. For example, if ten homes out of the hundred available in an area sold in the month of June, you have a monthly absorption rate of 10 percent or .10. You also have what’s most likely a market on its knees gasping for breath, an extreme buyer’s market, at least in this area, at least in most price ranges in this area.

I should mention that “absorption rate” is simply the reverse of another indicator you may have heard mentioned, “months of inventory”. Instead of telling us what percentage of homes on the market sold in a month, as absorption does, months of inventory tells us how many months it would take to sell the current inventory, at the current pace of sales, with no new inventory introduced to the market. So instead of dividing sales by inventory to find absorption, you divide inventory by sales to find months of inventory. Absorption seems more commonly used in the commercial real estate market, months of inventory in the residential market, although absorption works well in residential as well. More than six months of inventory traditionally signals a buyer’s market, less than six months a seller’s market, although again, our faster-paced market has its own parameters.

Which brings me to a critical point: neither months of inventory nor the number we’ll be using here, absorption, exist in a vacuum. As we’ll see, an absorption rate has a context, and it’s a bad idea to try to make sense of it outside that context. For example, I suspect that in many parts of the country agents would spontaneously break out in song if ten percent of the homes on the market sold in any given month. Even here, where a .10 absorption rate most often means a market on life support, we’ll see that for years it’s been the baseline for one local sub-market that does well enough despite that.

So nothing gives you a better feel for a marketplace than its absorption rate,  if you have an historical rate to compare it to. You’ll need to know what “normal” is before you can know what “low” or “high” is and put that information to good use, and “normal” varies by area and sub-market.

That’s powerful stuff all by itself, but let’s also see if absorption can be used to predict changes in today’s sales prices before those sales prices are known. It’s a tantalizing possibility, because on August 1 I can calculate July’s absorption rate but I can’t know the sales prices of the vast majority of July sales. Why not? On August 1 most July sales, except for a small minority with quick closes, will still be in escrow, and their sales prices will still be a closely guarded secret to all but the participants in each transaction. But a fast-moving market—and this area doesn’t seem to have any other kind—won’t wait for agents, buyers and sellers to catch up with the latest sales prices. That offer you’re writing tonight with your agent? The closed comps you’ll use are typically at least a month old and often older. But that was then and this is now, and did prices conveniently stay the same over the past month, or did they suddenly drop 5 percent, or did they suddenly jump 5 percent? Who wants to pay 5 percent too much, or make an offer on their dream house that’s rejected because it’s 5 percent too low?

So the advantage of knowing the latest absorption rate is that it tells you where the market is, right now. But like any market indicator, it may not give you the clearest indication and, for that matter, it may give you no indication at all.

To try to unlock whatever secrets absorption offers, let’s first look at the absorption rate of one of the hottest sub-markets in the country, the communities surrounding Stanford University: Palo Alto, Menlo Park west of 101, Los Altos and Mountain View. I’ll call this sub-market “midrange” because for years it’s where many of Silicon Valley’s go-getting upper-middle class have wanted to live. And let’s see how the absorption rate for this sub-market has varied from 2000 to present, veering from boom to bust to boom to bust to boom to whatever we’re in now—maybe the chart will help us decide.

abs1

What does the chart tell you? Let’s start at the beginning. Note that in early 2000 over 60 percent of the homes for sale in this sub-market sold each month. What does that mean? Not much, unless you know that a 60 percent absorption rate is unheard of. A good—a darn good—market might boast a 40 percent absorption rate. 40 percent is an extreme seller’s market, with buyers bitterly complaining about multiple offers and escalating prices. A 30 percent absorption rate is still good and still favors sellers, just not as much. So 60 percent is off the chart, at least figuratively.

Welcome to the dot-com boom.

And welcome to the dot-bust. That first sharp drop in absorption is a nasty little debacle on Wall Street known as Black Friday, April 14, 2000, when the Nasdaq capped off a rocky month by dropping like a stone. For a month or so after that, Silicon Valley real estate was so quiet you could hear a pin drop. But note the healthy upsurge in absorption by early summer 2000. Also note that nose dive late in 2000, as Silicon Valley’s start-ups started dropping like flies. There’s nothing like a local economic bust to take the sparkle and zip right out of a real estate market. Note also the prolonged agony of 2001, as the local, national and international scene went from bad to worse.

I won’t review the entire recent history of this sub-market here, but perhaps you can see how absorption charts its ups and downs with something close to uncanny precision. The more astute among you will have noticed that absorption varies quite a bit over the short as well as the long term—it has what might be called “micro-movements” as well as “macro-movements”. That’s because absorption tracks not only the overall tenor of a real estate market, but also its seasonal nuances. Absorption typically rises in the spring, as buyers pouring into the market outnumber sellers. It flattens and even declines a bit over the summer, as rising inventory begins to catch up with declining demand, especially in August. September usually sees absorption jump, as buyers return from vacation to the market. Absorption typically tapers off gradually toward Halloween, then falls precipitously near Thanksgiving and stays low until after Super Bowl Sunday. Any variation in this pattern indicates either an unusually good year—for example, high absorption in January—or an unusually bad year—for example, no September recovery.

One final note on this chart: you’ll see that absorption in this sub-market has recently fallen sharply from spectacular highs. In fact, several months of late 2007 were hotter—more of a seller’s market—than any month of the supposed peak of the market, 2005. June 2008’s .29 rate is slightly under this sub-market’s eight-year average of .34, but there aren’t too many markets, either in this area or throughout the country, that can say their absorption is off just 15 percent from its recent historical norm.

Speaking of other, less-fortunate markets, let’s see if we can find one nearby that gives us some context. How about a local sub-market right next door, the entry-level neighborhoods of southern San Mateo County? East Palo Alto, the Belle Haven area of Menlo Park, Redwood City east of El Camino and San Mateo east of 101 are the most affordable neighborhoods of the mid-Peninsula. Let’s put their collective absorption rate up against the more expensive mid-range and see if we can spot any differences.

abs2

Wowsers! I guess so! Which reminds me: the next time you run across an economist who snaps “the idea that all real estate is local is a crock”, that it’s all just a plot by the real estate industry and its running dog economists, you might want to ask him—nicely, of course, because he’s an expert—if he knows what he’s talking about. Because those two trend lines sure look different to me. Yet the two sub-markets that produced them are no more than a few miles apart.

For instance, see how much more revved midrange was during dot-com, how much more it tanked during dot-bust, how much better it recovered in early 2002 and how much more it dropped back to earth during the build-up to Iraq. Also see how mid-range flat-lined through most of 2005 as entry-level peaked—there’s that shot in the arm sub-prime gave entry-level but not midrange neighborhoods, which explains why the two markets are faring so differently these days—how much better midrange held up during the late-2005 Katrina market, the wide gap in performance through 2006 and then midrange’s spectacular ascent in 2007 as entry-level went down for the count.

Good stuff, huh? All secrets revealed.

Let’s see, we’ve already contrasted and compared absorption for Silicon Valley’s midrange and entry level sub-markets. Let’s wrap up this part by throwing the local top end into the mix.

abs3

Yikes! The top end—homes listed for $1M or more in Atherton, Portola Valley and Woodside—has had an even slower pulse than the low end for most of the past eight years. In fact, the top end has pretty much just bumped along, except for that atypical flurry early on. (Charting top-end absorption is incredibly boring because nothing ever happens.) How can this be? You’ve always heard that “there’s lots of money in this area”.

There is, but with the exception of the dot-com peak, when a few of the hoi polloi were briefly allowed to touch big money, there just aren’t that many people with “lots of money in this area”. How many, even here in the land of milk and honey, can afford a $3M home? Not many.

But notice how steady, albeit low, the top end’s absorption rate is. It falls in a remarkably tight range, and stays tight even through the current credit crunch. Why? Because people who buy $3M homes often pay all or mostly cash, and even when they borrow, they’re the well-heeled borrowers mortgage bankers still like.

Next, let’s see if we can find a correlation between absorption and a few other market indicators. We’ll focus on midrange to keep things simple. First let’s compare absorption with sales price.

abs4

There’s a correlation, but it’s not always close or consistent. Absorption is far more volatile, and while the two trend lines seem to follow roughly the same path, there are times, particularly in 2007, when they diverge. Why? My guess is that while a smaller percentage of homes sold then, those that did sell were the type—traditional architecture, great location, most likely remodeled—always in high demand. That’s certainly the picture I’ve seen lately, as buyers become more discriminating but are willing to pay top dollar for the right house.

So far absorption doesn’t look like a fool-proof predictor of where sales prices are or where they’re going. Let’s try it again, this time using the absorption rate and average sales price for the entry level.

abs5

Seems incredible, doesn’t it, that low-end absorption dropped so precipitously, starting in 2005, yet low-end prices held until late 2007 and the collapse of subprime lending. It’s dangerous to credit (or blame) one factor for any market event, let alone this remarkable discrepancy between entry-level absorption and sales price, but out-of-control subprime credit in 2005 and 2006 seems the likely culprit—which makes me all the more skeptical that it is. Real estate is far more nuanced than most people including, apparently, many real estate economists, realize, and I have more faith in the expert willing to say “I’m not sure” than the so-called expert who goes around exclaiming “Eureka!” or claiming “it’s simple, it’s just numbers” (but guess which one gets the press). Most likely there were several reasons why low-end prices were strong even while low-end sales declined and inventory ballooned. I keep coming back to the idea that “prices are sticky on their way down”, something we’re seeing even in markets where subprime was a non-factor. And note that the midrange chart shows absorption and prices returning to a relatively strong positive correlation after credit tightened late in 2007, yet more proof that these two price ranges march to different drummers.

By the way, see how far entry-level prices have sunk—virtually to 2000 levels—implying that every loan made over the past eight years was bad, even though invariably I see the loans of 2005 and 2006 behind today’s foreclosures. It’s a sure sign, as sure as any you’ll get, that the market has over-reacted and buying opportunities are rampant at the low end.

Next let’s compare midrange absorption with sales.

abs6

Again, the overall shapes are roughly consistent, with sales now the more volatile trend line, although I suspect this has more to do with an imbalance between supply and demand during the winter months—maybe it’s not such a bad idea to put your home on the market during the holidays, at least in this area, where buyers aren’t snowed in. Note the discrepancy between absorption and sales in late 2007, as demand stayed high but low inventory made the number of sales plunge.

Next let’s compare absorption with inventory.

abs7

If demand was consistent, you’d expect a negative correlation: as inventory went down, absorption would go up, and vice versa. And to a large extent, that’s what the chart shows, as one trend line’s peak tends to match the other’s trough. Since the commonly used indicator of demand, sales, is dependent on inventory—you can’t sell what you don’t have or, usually, what you have too much of—this seems to confirm my belief that absorption is a far better indicator of demand.

Finally, let’s look at absorption and “bid”, the average amount above or below list price that buyers offer.

abs8

A strong positive correlation, again with the exception of late 2007 as absorption shot up while bid declined. Since bid is most likely an indicator of the strength of buyer confidence, this appears to confirm that midrange buyers are less sanguine about the future of real estate than they were as recently as early 2007, yet sanguine enough to push prices to new heights. It may also be a tip-off that absorption is less an indicator of buyer confidence—or not at all—but just, as I said at the start of this article, a clear signal as to whether the market favors buyers or sellers.

copyright © John Fyten 2008

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