The Fatal Flaw With Absorption Rate Pricing (Part 2 of 3)
This is part 2, of a three-part series on the “Fatal Flaw with Absorption Rate Pricing.” We are assuming that you understand what Absorption Rate Pricing is and what is it trying to do. If you need more detail on Absorption Rate Pricing, then take a look at the previous Blog. In summary, Absorption Rate Pricing is looking at the Absorption Rate and the months’ supply to determine if the market is increasing or declining. You calculate the Absorption Rate for the previous 3 months, 6 months, 12 months, and determine if the Absorption Rate is increasing or decreasing. This will help you determine if the market is increasing or declining. Once you understand if the market is increasing or declining you can use this information to help create your pricing strategy.
So, what is the “Fatal Flaw with Absorption Rate Pricing?”
The problem is that the Absorption Rate Pricing may give you wrong conclusions when there is a strong Buying Pattern in the area (which there is quite often). For example, let’s take a look at the data below. This is data taken from a neighborhood and it shows the price homes sold at and the time of the calendar year when home sold. This is a “classic” graph and comparable to graphs we have seen all over the nation. In many cases this type of graph occurs due to seasonality or in other cases exists for other reasons. Now in looking at this example, what happens if we do our Absorption Rate Pricing analysis at two different times of the year? In the first example, we will do the Absorption Rate Pricing analysis on the October 1st timeframe, and then we will compare that to the analysis that we do on the April 1st timeframe.
For our analysis, let’s assume that the previous year’s sold pattern is exactly the same as this year. This means that for our analysis, this is a consistent level market. In other words, the market is neither increasing nor declining, but staying at the same level.
So that being the case, what does our Absorption Rate Pricing analysis show us? Again, focusing on the October Analysis, when we look at the Absorption Rate for the last 12 months, we can see that 16 properties have sold so we have an Absorption Rate of 1.3 properties sold per month.
When we look at the Absorption Rate for the last 6 months, we can see that 13 properties sold, so we have an Absorption Rate of 2.2 properties sold per month.
And lastly, when we look at the last 3 months we can see 8 properties sold, so we have an Absorption Rate or 2.7.
From this analysis, we go from 1.3, to 2.2, to 2.7, and it looks like the market is up. However, if we look at our pattern what do we see is actually about to occur? The buying pattern shows that very little homes will be sold in the next few months. So, our analysis actually gives us the wrong perspective and will create an incorrect perspective of the market.
Let’s take a look at our analysis focusing on the April timeframe. As before, when we look at the Absorption Rate for the last 12 months, we can see that it is a rate of 1.3 properties sold per month. When we look at the Absorption Rate for the last 6 months, we can see that 3 properties sold. So, we have an Absorption Rate of .5 properties sold per month.
And lastly, when we look at the last 3 months, we get an absorption rate of .5 as well.
From this analysis we go from 1.3, to .5, to .3. It looks like the market is down. However, if we look at the pattern, what do we see is actually about to occur? The Buying Pattern shows that we are just about to hit the brunt of the market where homes will be selling quite well. So, again our analysis gives us the wrong perspective and will create an incorrect idea on what the market will be doing.
We’ve just shown you when you have a strong “seasonal” market or where you have a distinct buying pattern, you can easily come to the wrong conclusion when using the Absorption Rating Pricing method. So, when does it work the best? The Absorption Rate Pricing works the best when you have a consistent rate of sales throughout the year. This can happen when you are pricing properties near the West or East coast. However, we’ve seen several examples where this isn’t the case for areas on the coast, making the usage of the Absorption Rate Pricing method inconsistent. Of course, you can easily look at the “Buying Pattern” to see if using the Absorption Rate Pricing will be effective or not. So, if this isn’t an effective and dependable method for determining if the market is increasing or decreasing, what is? We will discuss that in part 3 of, “The Fatal Flaw with Absorption Rate Pricing.”