Business
Are You Correctly Understanding Net Absorption?
Offers a comprehensive understanding of net absorption in commercial real estate, detailing its calculation, significance, and impact on market dynamics. An essential resource for investors, developers, and analysts seeking to gauge property demand and investment viability.
Successful products require demand, and demand establishes value. Commercial real estate is no different because after all, it is a product. It stands to reason that in order to evaluate the worthiness of an investment, one must be able to determine the demand level. That’s where net absorption enters the evaluation process.
The basics of “net”
“Net” is used in a lot of situations. The basic meaning is: What you have left after all the incoming has been added, and all the outgoing items have been subtracted. In simple business, net profit is simply after all the sales (revenue streams) have come in, and all the expenditures have gone out. What is left is your net profit.
The critical part is that in order to properly convey an accurate position, BOTH the incoming and the outgoing have to be accounted for. For example, if you have a movie theater, and 100 people get seated for each of 3 hours in a row, how many people are in the theater. 300? Maybe. Maybe not. How many left/vacated either during the show, or at the end of their show. Perhaps 50% of people left, so you may currently only have a net attendance of 150 people at this moment. Net is what you have left after subtracting the outgoing from the incoming.
Absorption is what?
If we are going to fully understand this, then let us be sure of the understanding of “absorption”. Absorption is an everyday term that simply means the process by which one thing absorbs another… like a sponge absorbing water. Consumed or held, if you will. In the case of leased real estate, the available inventory of space is absorbed by tenants. It is essentially consumed (temporarily) through the enaction of leases thereby making it unavailable. The absorption rate and net absorption serve as indicators of the supply and demand levels for an area, property type, or any other niche classification you want to use.
The importance of the calculation
Would you agree that stats need a reference point to put them in perspective? Net absorption is no exception. Investors either need an established reference point such as an industry standard, or a point that specifically relates to the investment they are considering. That may be for the area, type of property, type of industry, etc. It serves as the benchmark for the comparison and evaluation. If a benchmark is not known, conversions may be possible to reconcile the data with knowns from other established sources which then allow it to be put in perspective. Another great value of net absorption is the ability to document and monitor trends that may be crucial to decisions.
Calculating net absorption
Recall the movie theater example? Let us substitute “leased space” for “movie theater seats”. Instead of tracking how many movie visitors came and left to determine how many are left at the end, we are instead going to track how much leased space comes and goes by way of tenants consuming (leasing) or vacating the spaces. The resulting formula is:
Net Absorption = Total Space Leased – Total Space Vacated – New Space
Total space leased is the same as all the guests arriving and taking movie theater seats. Total space vacated is the same as the guests leaving and freeing up seats. You will notice that the formula also subtracts “new space”. This is newly constructed space which is subtracted out because it has not yet been leased, so it is not part of the existing consumed & freeing-up process, and could provide misleading results if included.
One great aspect to this calculation is the simplicity of it. It is not rocket science. It simply shows how much you had before, and how much you have now relative to a specific duration of time.
Net absorption vs. absorption
Remember when we clarified what is meant by “net”? This is a fantastic time to clarify something else: Net absorption and absorption are not the same, but easily confused by people, or they mistakenly interchange the terms. In the movie theater example, absorption would be all the people who arrived. Net absorption is the number of people who arrived minus the people who left. Each result has its purpose when evaluating movie seat sales, but they are not to be confused. The same applies in CRE. Absorption (also known as gross absorption – meaning ALL) would be all the space leased over a specific period. This does NOT account for new vacancies. Net absorption subtracts the vacancies from absorption (gross absorption).
Interpreting net absorption
Although the formula produces specific data, what it means can sometimes fall into subjective opinion based on what other factors and experience are at play. As areas or industries experience economic growth that has a domino effect on the consumption of lease space. The opposite is also true. As areas experience decline, demand generally drops.
Positive Net Absorption
This is when more space was leased than became available which indicates the demand was stronger than the supply for that period. Consequently, this establishes a stronger position for the owner which may result in prices trending upward. This is often an attractive trend for investors and developers.
Negative Net Absorption
This is when more space was vacated than leased indicating a decline in demand for that period. Successive periods with the same result will indicate a downward trend of demand in that area. Pricing is likely to adjust downward if the trend holds true for extended periods. A negative trend my cause investors and developers to remain on the sidelines.
What does it all mean?
You have heard the old saying “well, it depends”, right? That holds true here as well. The purpose of calculating net absorption is to determine the supply and demand trends for lease space. The process can indicate trends for both aspects. Now, how to interpret those is going to depend on the objectives of the investor.
To some, a negative net absorption may mean to stay clear, but to another it may mean properties will not only be “for sale” soon, but also “on sale”, so to them it may spell future opportunity.
A positive net absorption trend may be interpreted by one investor that it is time to move forward with projects or acquisitions in an area, but to another it may indicate that prices will rise and they will wait.
As you can see, the information has a wide range of applications, so it comes down to your own strategies, and how the results can help guide your journey.
