Absorption rates and vacancy levels are the two metrics that have the greatest impact on commercial real estate. They have a direct effect on net operating income and property cap rates, IRRs and cash-on-cash returns, and purchase and sales prices.
Absorption rates and vacancy levels are also used by commercial real estate developers to determine whether the time is right to build, and by real estate investors to decide between buying, selling, or holding.
Understanding The Difference Between Real Estate Absorption And Vacancy
The vacancy level is a snapshot of a market, submarket, or building at a specific point in time. It can be expressed as a percentage of available square feet or by the number of available units. Vacancy levels are described as increasing or decreasing.
Absorption is measured over a period of time and is expressed as a percentage of available property or space that is ‘taken up’ by being leased or sold. That’s where the notion of commercial space being ‘absorbed’ comes from. Just as with vacancy, absorption can measure the performance of a market, submarket, or even a large building over a period of time. Absorption rates are described as being flat, positive, or negative.
How To Calculate The Vacancy Level In Real Estate
Vacancy is the concept that most real estate investors are familiar with because it has a direct effect on the net operating income of a building. A low vacancy level means more space is occupied and more gross rental income is being generated.
Let’s use the office building on 150 West 30th Street in the Midtown Manhattan office market as an example. This Class B office building encompasses 216,841 square feet of leasable space and 15,800 available square feet from four individual spaces. To calculate the vacancy rate, we divide the amount of available square feet by the amount of total leasable square feet: 15,800 square feet (vacant) / 216,841 square feet (total leasable) = a vacancy rate of 7.3%.
How To Calculate A Real Estate Absorption Rate
Now let’s assume that our office building on West 30th Street has had the same 15,800 square feet of space available throughout this year. Leasing activity in the Manhattan Chelsea office submarket where the property is located has been picking up. We learn that a new lease has been signed with a tenant taking the entire 19th floor, which is 6,700 square feet of space.
Two things have occurred. First, our vacancy rate has decreased to 4.2%: (the 15,800 square feet available minus the 6,700 square feet that were just leased), which means that 9,100 square feet are now available, out of the 216,841 square feet total leasable.
Second, with the new lease for 6,700 square feet, more space was absorbed in the building – or had more space ‘taken up’. Remember that absorption is tracked over a period of time. We’ve had 15,800 square feet available throughout the year, and 6,700 square feet has just been leased or absorbed. This creates a positive annual absorption rate for the building of 42% (6,700 SF of 15,800 SF).
How Vacancy Levels And Absorption Rates Measure Property Performance
Our examples above used a single large office building in Midtown Manhattan. Vacancy levels and absorption rates can also be used to compare the performance of similar properties to one another, and to measure commercial real estate activity in individual submarkets and entire markets.
If the vacancy level for similar Class B office buildings in the Chelsea submarket is 10% and the property on 150 West 30th Street has a vacancy level of 7.3%, this means the property management team is doing a pretty good job. Tenants are staying and renewing their leases, rents are competitive, property amenities are attractive, and management is responsive.
But what would it mean if the annual absorption rate for office space in Chelsea were 66% compared to the 42% absorption rate at the West 30th Street property? If space in the submarket is being absorbed at a rate of 57% higher (66% / 42% = 1.57) than in our building of reference, the property is underperforming compared to the submarket. Reasons for this could include: the available space is not showing well, the vacant suites are in a less desirable part of the building, or that the leasing team isn’t doing their job well enough.
Using Vacancy And Absorption Rates To Forecast Market Trends
Vacancy levels and absorption rates also provide key metrics for commercial real estate developers and investors.
Let us suppose that the year-over-year office vacancy rate in Chelsea has trended downward by 1%, from 8% last year to 7% this year. At the same time, the net absorption of Chelsea office space – which includes existing available space plus new office space brought to market – has trended upward 10%, from a positive 30% absorption to 40% this year. The combination of decreasing vacancy levels and increasing absorption rates indicates that demand for office space in this Manhattan office submarket is greater than the supply.
The opposite can also occur. If too much product is brought to market at the same time, absorption rates can be negative and vacancy levels can temporarily increase, as the leasing market struggles to lease-up the increased amount of available space in the market.