The Fatal Flaw With Absorption Rate Pricing (Part 1 of 3)
This is part 1, of a three-part series on the, “Fatal Flaw with Absorption Rate Pricing.” Now in this part 1 session, we will be discussing what Absorption Rate Pricing is, how to calculate the Absorption Rate Pricing and how to use it. Before we do, let’s talk about why use Absorption Rate Pricing and what the intent of it is.
When Pricing properties, you would generally start off with comparing the subject property to other comparable properties in the area. This is a great starting point, and you can usually do a pretty good job of pricing using this strategy. However, this strategy doesn’t work very well when the market is moving quickly, either up or down. If you solely use the pricing strategy and the market is moving up, then you may leave some money on the table. However, if the market is moving down, you will end up overpricing the property and you’ll have to continuously chase a down market, which means that you will lose time and money. Definitely not what you want to do. So, ideally what you’d like to do is to figure out where the market is going. If it is moving up, then you can be a little more aggressive on pricing the property at the higher end. Whereas if the market is going down you would then be pricing it more towards the lower end of what you are thinking. As you can see once you know which way the market is moving, that information will play into your pricing strategy.
So, the key question is, how do you determine if the market is moving up or down, or if it is just stable and not moving at all?
This is where the concept of Absorption Rate Pricing comes into play. Absorption Rate Pricing is the process that is used to help you determine the market trend and once you understand that market trend, you can use that information to allow you to adjust your pricing strategy accordingly.
Who uses Absorption Rate Pricing and where did it come from?
Absorption Rate Pricing has been taught in the Real Estate community for several years by lot of instructors. I first heard about it from the Ninja Master, Larry Kendal. It is also used in the development of the 1004 MC form required and used by appraisers in the appraisal process.
What is Absorption Rate Pricing?
Of course, the Absorption Rate Pricing is based on the knowledge of the Absorption Rate. The Absorption Rate is a value that is based on the number of homes sold for a period divided by that period. For example, if 12 homes sold in the last 12 months in a given market, that means that the market will absorb 1 home per month on average. The Absorption Rate Pricing process is based on looking over the Absorption Rate over a period of time and determining if the rate is increasing or declining. If the rate is increasing (more homes are selling in a period of time) than the market is increasing.
Generally, it is recommended that the period of time to evaluate the Absorption Rate should be a 12-month period, then a 6-month period, and then a 3-month period. Then compare the results to determine if the rate is increasing, declining, or staying the same.
In many cases, the term “Months’ Supply” is used along with the Absorption Rate. Months’ supply is basically the number of properties currently available for sale divided by the Absorption Rate. For example, if the Absorption Rate is 1 home sold per month on average, and if there are 10 homes currently on the market, there is a 10-month supply. Or it would take 10 months to sell the current inventory of homes (assuming no new homes come on the market). A 6-month supply is often referred to as a balanced market. A less than 6-month supply is a seller’s market and a greater than 6-month supply is a buyer’s market.
Let’s go through an example to help you better understand the concept. Let’s take a look at a condo area called Sidehill.
When we look at the Market Trend, the Month supply is going from .7 to .7 to .4, what is the Market doing? In this case, of course, the market is increasing or becoming more of a Seller’s Market. There is less becoming inventory and homes are sitting on the market much less. As you can see for this example, the Absorption Rate Pricing is helpful in understanding where the market is going and if it is increasing or declining. That being the case, this analysis requires that you do several searches from your MLS to determine the number of properties for sale, the number of properties that have sold in 3, 6, and 9-month periods and the number of properties under contract. Then you have to do some basic math to complete the analysis. This can take a few minutes to do. We do want you to know that the Visual Pricing System has the feature to automatically do this with the data the you read in. Using the “Settings” function you can set the Odds of Selling graph to show the 3, 6 and 12 month Odds of Selling. Additionally, you can set the option to treat properties under contract the same as properties that have sold.
If you set these two options and then read in the data, you will obtain a graph that looks something like that shown below
Notice that on this graph we automatically calculate both the Absorption Rate and the Month’s Supply (shows as the months of inventory). If you are using the Absorption Rate Pricing method, you can use the Visual Pricing System to automatically calculate the values for you.
Ok, this ends part one, which is meant to describe what Absorption Rate Pricing is and how to use it. In part two we will go in detail on what the fatal flaw of using the Absorption Rate Pricing is and how to predict if the current market situation is exposed to that flaw. With that, we will see you in part two.