Absorption, or absorption rate, is a measurement used in Commercial Real Estate (CRE) to indicate the difference between the amount of space vacated by tenants over a period of time and the commercial space tenants have moved into within a geographic area and time frame. To put it simply, absorption is the rate at which commercial space is “absorbed” (sold or leased) over a specific period of time in a given market, described as positive or negative.
There are two metrics that go hand-in-hand and have a huge impact on CRE. One is the absorption rate, and the other one is vacancy. Vacancy is defined as the units or square feet available in a commercial property, expressed as a percentage or number of available units. Vacancy has a direct effect on the net operating income (NOI) of a commercial property – low vacancy means more rental income being generated. Both absorption and vacancy rates are used by real estate investors as determining factors whether to hold, buy, or sell commercial properties.
Gross Absorption and Net Absorption
When real estate investors talk about absorption rate, it can only be one of the two - Gross Absorption or Net Absorption. In a leasing context, here are the differences between both:
Gross Absorption refers to the total amount of space that a tenant physically moved into in a specific time frame in a given market.
Whereas Net Absorption refers to the total amount of space that a tenant physically moved into minus the amount of space they vacated during the same time period, described as positive or negative. Thus, net absorption is a very important metric used by real estate investors in analyzing the commercial market’s supply and demand trends.
Since net absorption rate is the metric being used by commercial real estate investors most of the time, this article will focus more on understanding net absorption.
Typically, you can gauge the market’s supply and demand dynamics by knowing the net absorption rate, which can be described as either positive or negative.
If the market indicates a positive absorption rate, it means that more space is being leased or occupied than vacated. There is basically a decrease in the supply of commercial space in a given market resulting in a rent increase. If the market indicates a negative absorption rate, it means that more space is vacated than occupied. This means there is an increase in supply for occupancy resulting to rent rates being lowered to attract commercial tenants. With that being said, knowing the absorption rate in a specific area in a given time frame helps real estate investors forecast cash flow in their investments.
Factors that influence Net Absorption
A lot of factors can impact the net absorption rate of a commercial property. As an investor, you should consider these factors so that you could plan the next steps to take for your investments to be successful based on the market’s current status. Here are three major factors that greatly influence the market:
Consider analyzing and taking into account commercial availability in your area. Businesses that recently opened will quickly occupy spaces that were vacated for them to operate in areas with little availability. This means there is a high net absorption rate in that certain area. While in areas with high availability, commercial properties are experiencing low net absorption rates due to competition of occupancy with other properties. Therefore, evaluating overall availability in your geographical area will help you with the decision-making about investments based on the commercial market’s current conditions.
Rent rates relative to leasable space can greatly influence the net absorption of a commercial property. Businesses or tenants will look for spaces that not only fit the needs and day-to-day operations of their business but also spaces having low rent rates. If you are a landlord or an investor, knowing what price to set for your commercial property can prevent high vacancy and negative absorption rates.
3. Economic Conditions
One of the factors that have a strong impact on net absorption is the change in economic conditions. Take for example the time when COVID-19 hit and many people and businesses have suffered globally. During this time of economic struggle and crisis, many businesses decided to close and those that planned to expand or open a new business chose to hold it off because of uncertainties and risks of losing their investments.
In addition, the COVID pandemic shifted the business processes and operations of many companies to remote work. It led to commercial properties being vacated and a decrease in occupancy. Other businesses are trending toward leasing smaller spaces to cut overall costs since employees are now working from home. With this new setup, the net absorption rates of commercial properties are greatly affected.
Commercial real estate is highly competitive, and there are a lot of factors, including net absorption, that impact the market. Gathering data, taking advantage of these elements, and analyzing current market trends can be critical in managing your investments.