A brief history of local real estate, part 2:  absorption.

In part 1, we looked at local trends in home prices over the past decade.  In part 2, we'll look at my favorite market indicator, absorption.

As long-time readers (both of them) know, absorption is a simple but telling measure of the pulse of real estate.  Want to know if it's a buyer's or seller's market?  Of course you do, and absorption will tell you, better and more quickly than any other indicator.

Absorption is calculated by dividing sales, both pending and closed, for any period—in the example below, one calendar month—by total inventory for that period.  Here's the absorption chart you'll find in the latest edition of that popular monthly newsletter See what local real estate is doing now:

Okay, lots of pretty colors, but what's it mean?

We'll begin at the beginning, Spring 2000, the tail end of the dot-com boom, or at least the tail end of the zoom-zoom days of dot-com.  Note that absorption for two sub-markets on the chart, condos and townhouses, is almost off the chart.  A third, top-end SFR, soars to heights never since equaled, while low-end and midrange SFR don't fare badly either.  So how do these trend lines translate into plain English?

First, realize that an absorption rate of .4—that is, four of every ten homes for sale in a month sell that month—is a rip-roaring bona fide seller's market.  When absorption reaches .4, buyers complain about multiple offers, escalating prices and a shrinking selection of good homes.  When absorption reaches .5, .6, even .7 and beyond, as it did in the dot-boom, sellers and their agents can do no wrong—almost.  It means that you can grille your burger on the market.

You might ask, "When real estate is that sizzling, why doesn't every home sell?"  In other words, why doesn't absorption in an extreme seller's market rise to 1.0, a one-to-one ratio between sales and inventory.  Mostly it's a matter of how absorption is calculated.  Homes that go on the market the last day of, say, September, aren't likely to sell in September, no matter how sizzling real estate is, yet they're still counted as September inventory.  Even in the red-hot market of early 2000, homes generally took an average of seven days to get in contract.          

You'll also never see 1.0 absorption because, in even the most overheated of markets, some homes don't sell—not this month, not next month, not ever.  Yes, even in a you-could-grille-a-burger-on-it market, some homes are so overpriced for their size, condition, location etc., that no buyer, not even the most optimistic of the optimists who drive a boom market, thinks they're worth what sellers want.  Never underestimate the ability of seller greed, or at least its forward outposts, to stay one step ahead of the market.

Next let's compare the decline in absorption, first from dot-boom to dot-bust, then from the market's 2005 peak to its recent lows.  In other words, let's see how resilient each sub-market has been in each decline.  Does one stand out as the bullet-proof "investment" in any downturn?  Remember, we're not measuring price changes here, just changes in absorption, or what might be called "momentum", in this case negative.

First the dot-boom/dot-bust cycle, from peak seller's to peak buyer's market: 

Next, the most recent boom/bust swing from sellers to buyers:

Now let's summarize the data:

Again, you ask, what's it all mean?

For one thing, the data tell us that the momentum of the two most recent boom/bust cycles was quite different, not only between cycles but often between sub-markets in each cycle, which lends credence to the inconvenient notions that (a) every market is different, and (b) every moving part of every market moves differently, from each other and from what it did in the previous cycle.  Which limits the insight into the present market to be gained from the last.  Which is a big lesson in humility that the armchair real estate economists, like generals fighting the last war, will never learn.  Assuming they have any insight into the last market, let alone the present one.

For another, it shows how gradually the air was let out of the most recent boom.  Averages are only averages, of course, but a decline in absorption averaging 2 percent to 3 percent per month gives sellers fair warning that market momentum is slipping.  It's not like your computer is working fine and then one day all you see is the blue screen of death, which, come to think of it, is an apt analogy for the dot-boom/-bust cycle.

And finally, does this area have a bust-resistant sub-market, one immune to catastrophic collapse?  If it does, its name won't surprise anyone who's followed local real estate since the late 1990s:  midrange SFR, the sub-market that's least needed and least received Mickey Mouse pump priming, either with overnight dot-com wealth or overly lenient loan underwriting.    

So what else can the chart tell us?  Probably enough to write a short book, or at least a lengthy and dense academic study, but I think the most interesting insights might be gained by looking for a correlation between absorption and sales price.  After all, the Holy Grail of real estate statistical analysis is the ability to predict price trends, but thirty-day escrows make today's closing prices a well-kept secret until they may well be irrelevant in a market as volatile and pricey as ours.  It's not unusual for local prices to change by several percentage points or more in a month, and that's real money in an area where a "starter home" can cost close to $1M.  Absorption, on the other hand, can be calculated immediately, without waiting for pending sales to close and become public knowledge.

Aside from offering the possibility of predicting near-term price trends, a topic I'll tackle as soon as I figure out how to charge you for reading it (just kidding, a little) it's low-end SFR absorption from early 2005 on that really stands out on the chart.  First, note that at the very time subprime was inflating low-end SFR prices, subprime wasn't inflating low-end SFR absorption.  Prices rose even as absorption nose-dived and the market shifted from seller's to buyer's market—a situation difficult to explain if not theoretically impossible.  In fact, it wasn't until low-end SFR absorption capped two years of general and often steep decline with a face plant in early 2007 that low-end SFR prices tanked. 

Second, check out that frigid .02 absorption rate in September 2007 as subprime froze up (and, for that matter, the top end's frosty .03 rate following the global financial collapse of late 2008).  In any previous downturn I've analyzed, going back to the early '90s, enough homes sold to keep the market's heart barely pumping—there were always enough homeowners who had to sell and enough buyers opportunistic enough to buy—but a .02 absorption rate is a real estate market that's clinically dead.  A .02 absorption rate is a real estate market that has, for all intents and purposes, closed its doors, boarded up the store and gone home.  It's a graphic illustration of what extreme panic and illiquidity can do to real estate.

To me, absorption is the most dramatic of real estate market indicators.  And, as the chart shows, we've had some dramatic moments in real estate over the past decade.

In two weeks, A brief history of local real estate, part 3:  sales.       

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