Often, a value-add investment strategy involves a significant renovation and/or the purchase of a property with a high vacancy rate. In either case, the investor/buyer must forecast how long the renovation will take and/or how long it will take to fill the space with rent-paying tenants. This amount of time is heavily dependent upon the property’s estimated absorption rate.
In this article, FNRP explains what the absorption rate is in commercial real estate, the difference between gross absorption rate and net absorption rate, and why the absorption rate matters.
What is the Absorption Rate?
In commercial real estate, the absorption rate is a metric used to indicate the pace at which space is “absorbed” in a specific geographic area. Absorption rate is often expressed in two different contexts: lease context and sale context.
In a lease context, the absorption rate is often expressed as the square footage or amount of space leased in a specific time frame, usually monthly or quarterly. For example, if an investor has 100,000 square feet of vacant space that needs to be leased, they must estimate how many square feet they can lease in a given month or quarter. Doing this estimate helps to forecast cash flow over a long period of time.
In a sale context, the absorption rate is often expressed as the number of units in a commercial property that are purchased or sold in a given time frame. For example, if a developer is constructing a condominium building, they will need to estimate how many units are going to be sold each month to forecast their cash flow.
Varies by Market
The absorption rate can vary widely by market and is driven by demand for new space. In a market with high demand, the absorption rate can be high. Conversely, in a market with low demand, the absorption rate may be low.
Gross Absorption Rate vs. Net Absorption Rate
When talking about a market’s absorption rate, investors commonly refer to it in one of two ways: gross absorption rate or net absorption rate. For the purposes of this article, we are discussing these in a leasing context.
What is Gross Absorption Rate?
A market’s gross absorption rate is the total amount of space that a tenant physically moved into in a given time frame.
What is Net Absorption Rate?
A market’s net absorption rate is the total space that a tenant physically moved into minus the amount of space they moved out of.
Which is the Better Indicator?
Net absorption rate is the better indicator of a market’s true demand. If the market has a positive net absorption rate, it means that more space is being leased than is being moved out of. This is a good sign. Conversely, if the market has a negative net absorption rate, it means that there is more space vacated than occupied. This is a negative sign.
Why the Absorption Rate Matters, an Example
Simply, the absorption rate is a critical input into a pro forma projection of cash flows and/or a property’s business plan. To demonstrate this point, consider a very simple example.
Suppose that an investor has purchased a retail property in a Manhattan submarket. At the time of purchase, the property is 90% vacant (10% occupancy). It has a great location, but it has fallen into a state of disrepair and is desperately in need of renovation. One of the reasons the investor purchased the property is that they know the market has strong leasing activity, which gave them confidence that they could lease the available space once renovated.
As part of the property’s business plan, the investor has obtained a short-term construction loan, the proceeds of which will be used to finance the renovations. The loan has a term of 24 months and is due in full upon expiration. The investor has permanent financing lined up, but it is contingent upon the property reaching 85% occupancy by the end of the construction term.
The above example is fairly common in commercial real estate investment. And, it serves as a good example to underscore the importance of the absorption rate in the construction of a pro forma. In this case, the investor would have to carefully estimate how long it will take to complete construction and then use the market’s absorption rate to help determine if they can meet the occupancy requirement prior to the expiration of the construction term.
Assume that the investor will have to lease 50,000 square feet of commercial space and the market’s net absorption rate is 20,000 square feet per month. The investor knows that they won’t get all of that, but they have reason to believe that they can lease 5,000 SF per month at a rental rate of $10 per square foot. These estimates have two important implications:
- At 5,000 SF per month, it will take 10 months to lease the total square footage of the property. This means that the investor has to be reasonably confident that they can complete both the renovations and lease-up within the 24 month construction loan term.
- At 5,000 SF per month and a $10 per square foot rental rate, the investor can model an additional $50,000 per month in gross income during the lease-up period. These funds will provide the capital needed to pay the property’s operating expense and the debt service on the permanent loan.
This information allows the investor to make a more precise financial model and a more informed buying decision.
Where Does the Information From the Absorption Rate Come From?
Most information on real estate transactions is private, so it can be difficult to get the information needed to calculate the absorption rate. Instead, many investors subscribe to proprietary data services like Metrostudy or CoStar. With such subscriptions, these firms do the hard work of compiling the sale and lease transaction information and deliver it, for a fee, to subscribers, who then use the data to plug accurate values into their models.
Interested In Learning More?
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