The “Early Warning” Indicator

The “Early Warning” Indicator
03 Oct

The “Early Warning” Indicator

I call the absorption rate the early warning indicator because sometimes it lets you actually get out in front of a movement in real estate prices. Once you learn how this works, you’ll know something around half of real estate professionals don’t understand.

The absorption rate is the rate at which homes are selling based on a time length measured and the sales as compared to the currently listed inventory. In other words, you have 4000 homes currently listed. You want to see the absorption rate based on the previous three months, and you find that in that time 1500 homes sold.

That’s an average of 500 each month for the three-month period. Now we divide the current 4000 homes listed by that 500 number to see that it would take 8 months to sell the entire inventory if no more homes were listed and based on the rate of sales over the three months we measured. There are different opinions, but 5 to 7 months for an absorption rate is considered “normal” in many markets. This is really not a good way to look at it.

Your market is unique, and there can be valid reasons for it to historically see higher or lower absorption rates. In vacation home markets, homes typically can stay on the market lots longer, so absorption rates can be 8 months to a year or so. In hot markets, it can be one month, or even weeks.

Here’s a quote from a Denver area real estate site: “The current absorption rate in the Denver Metro area is just 2 weeks! If Denver’s active listings remained the same at, 2,732, given the speed at which homes are selling, all the listings in the Denver Metro area would be sold in just 2 weeks.”

Obviously, that’s a fast market, or more likely there is a very low inventory compared to past history. In fact, it’s low inventories that often cause these blips in really fast absorption rates.

So, why is this the “early warning” indicator? First, keep in mind that you can use a three-month quarter or any other period of time for this calculation. You can even measure absorption rate from month to month, though that may give you some swings that aren’t really showing you enough time to see a trend in the market. However, seeing a monthly rise or fall over two to three months can give you some early warning information.

But, let’s say that our example of 8 months, when compared to several past quarters was longer, meaning a lower absorption rate (home inventory not being absorbed as fast). If the change was fairly large, say from 6 months to 8 from just the previous measured quarter, we may have a clue as to near term market movement.

This longer time frame could be because there has been a flurry of new listings, which could be seasonal. Or maybe something has happened locally that has people selling to move to other areas or jobs. Whatever the reasons, this suddenly lower absorption rate could tell us that prices are about to or are already dropping. It’s just supply and demand at work.

Now, if we’ve been following the absorption rate for a while and suddenly we get a new report and it changed from 6 months to 4 months, we may have a clue of coming price increases. Homes are either selling faster or inventories have dropped. Either way, supply and demand should mean higher prices if the trend stays in place.

So, how does this help? If suddenly there is a slower absorption rate, you may want to think twice about trying to buy for a flip in that area. You could find that the price you thought you’d get on the flip won’t happen by the time you’re ready to sell it. Or, you could buy a home for a rental only to see the value drop for a while. That may not hurt your cash flow, UNLESS people are selling to move away and you find renters are leaving as well.

If it’s going the other way, and the absorption is speeding up, you may want to pull the trigger on a deal you’ve been thinking about before they do another market valuation and raise the price.

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