Real Estate by Numbers: What every home buyer and seller should know

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1 Real Estate by Numbers: What every home buyer and seller should know In the real estate business, understanding local market data and statistics can be invaluable to savvy buyers and sellers of residential property. It is even more important for real estate agents to know and understand this information to properly inform and advise their clients. As the market continues to shift, three terms that have moved to the forefront of discussion among real estate professionals are the statistical measures known as Absorption, Absorption Rate, and Months Supply of Inventory. In this article, I ll discuss the meaning and limitations affecting the appropriate use of these and other statistical measures that have traditionally been employed by real estate professionals in assisting buyers and sellers in their decision-making process. Absorption Just as absorption is the term used to describe Sponge Bob s ability to soak up water, absorption in real estate parlance describes the ability of the real estate marketplace to absorb (i.e., sell) homes as they enter the market. As used in the real estate profession, absorption simply refers to the number of homes sold during some specified time period. Generally speaking, the higher the degree of absorption in a defined market area, the healthier the market. Absorption is most often expressed in terms of the average number of homes sold in a particular market area each month, during some specified time-frame (e.g., one year or one quarter of a year). For example, if 1,000 homes were sold in a particular market during the year 2011, absorption would be calculated like this: 1,000 Homes Sold / 12 Months = 83.3 Homes Sold Per Month Tracking changes in absorption over time can be a useful measure of past real estate market activity and of historical changes to the overall health of the marketplace. However, this simple measure of market activity is rather imprecise as it is based primarily on data reflecting past market activity. It therefore has limited value in assisting sellers decide what price to list a home on the current market or in helping buyers decide what price to offer for particular properties currently on the market. 1

2 Absorption Rate A much more useful measure of real estate market activity involves determining the current rate at which real estate is sold, or absorbed, in a specific market area. This measure of market activity is referred to as the Absorption Rate. The Absorption Rate is expressed as the percentage of homes sold (typically during the past 30 days) relative to the number of current homes available for sale. For example, if there are 100 homes currently available for sale in a particular market area (inventory) and 20 homes sold during the previous month in that market area (absorption), the Absorption Rate would be calculated as follows: (Absorption / Inventory = Absorption Rate) 20 Homes Sold Last Month / 100 Homes Currently For Sale =.2 or 20% This means that, under current market conditions, one can expect that 20% of the homes currently on the market in the area under consideration will sell within a month s time. Because the calculation of Absorption Rate is based upon data that reflects more current real estate market activity, this measure can be much more useful than the simple measure of Absorption in assisting sellers and buyers in making solid decisions regarding list and offer pricing. Months Supply of Inventory (MSI) An alternative measure used to express absorption within a particular real estate market area, one that is perfectly correlated with and, thus, often used interchangeably with Absorption Rate, is referred to as Months Supply of Inventory (MSI). Rather than being expressed as a percentage, MSI is expressed in terms of the number of months it would take to deplete the current inventory of available homes at the current rate of absorption (i.e., sales). 2

3 For example, using the above data for calculating Absorption Rate, if there are 100 homes currently available for sale in a particular market area (inventory) and 20 homes were sold during the previous month in that market area (absorption), the MSI would be 5 months: (Inventory / Absorption = Months Supply of Inventory) 100 Homes Currently for Sale / 20 Homes Sold Last Month = 5 months This means that, under current market conditions, it would take five months at the current rate of sales to sell all the homes currently on the market in the area under consideration. One should note the similarity in the formulas for calculating Absorption Rate and MSI. Both formulas rely on exactly the same data i.e., current inventory and absorption. By simply flipflopping the numerator and denominator in the equation, one can calculate either Absorption Rate or Months Supply of Inventory. Real estate professionals will often use the term Absorption Rate but actually present data expressed in terms of Months Supply of Inventory (MSI) data. Technically, there is no problem in doing this because, as described above, despite being expressed in different units of measurement both measures of absorption are essentially identical, with one simply being the reciprocal of the other. Analyses based on either measure will lead to identical market price decisions. In the presentation that follows, I will continue to follow the convention which has evolved among real estate professionals and will use the term Absorption Rate while presenting data expressed in MSI units. How is this information useful? We re all familiar with the terms Buyer s Market and Sellers Market. In fact, many of us use these terms in discussing real estate market conditions without actually stopping to think about what these terms really mean. Absorption Rate (here expressed in terms of Months Supply of Inventory or MSI) is used by members of the real estate profession to objectively define whether a particular market is currently a seller s market, a buyer s market, or a balanced market. 3

4 By convention, an Absorption Rate of 5 or below is considered a seller s market. A seller s market exists when homes are more in demand (high demand, low supply) allowing sellers to ask for and command a greater price for their real estate property. Of course, these values are based upon a continuum so that if the Absorption Rate is 4.9 (a seller s market) this doesn t mean that sellers can just name their price and buyers will buy at that price. Obviously, a 1.0 Absorption Rate is more indicative of a strong seller s market whereas a 4.9 is considered a weak seller s market. A buyer s market is typically defined as an Absorption Rate of greater than 7 where there is a bountiful supply of homes on the market (high supply) and not much activity to consume or absorb these homes (low demand). The further the Absorption Rate increases from 7, the stronger the buyer s market and the more likely it is that prices will decline. Under this convention, a balanced market is defined as an Absorption Rate between 5 and 7 and describes a market area where neither supply nor demand is in excess. From a seller s perspective, the current Absorption Rate indicates how much competition the seller has in the market place. Knowing the Absorption Rate can be an invaluable tool that will help inform sellers where their homes need to be priced for a quick sale. For example, let s consider a seller with a $500,000 listing in Farmington and assume an Absorption Rate of 10. With 10 months of inventory in the market (a strong buyer s market), the seller would be wise to think about some serious price reductions if the seller wants to sell his/her home soon. The seller with a sub-$300,000 listing in an area with a 4-5 month supply of inventory might also want to consider a price cut to sell quickly but has a greater chance of getting lucky and finding a buyer who loves his/her home and qualifies for a loan. From a buyer s perspective, the Absorption Rate will indicate how negotiable sellers may be in different markets. If there are 4 months of inventory in West Hartford and 10 months of inventory in Farmington, buyers will likely find sellers in Farmington to be more negotiable. For purposes of illustration and edification, the Table immediately below presents the Absorption Rates for various towns in the greater Hartford, Connecticut area for both 4

5 December, 2010 and December, TOWN MONTHS OF SUPPLY Dec Dec West Hartford Farmington Avon Simsbury Bloomfield Newington All Real Estate is Local Location, Location, Location! Everyone knows location is the most important consideration affecting value in real estate. But there is even more to it than that. The most basic principle for understanding and evaluating real estate is this: All Real Estate is Local. In fact, it is very, very local, right down to the individual property. Because of this, the more global and general the measure of real estate market activity used to assess market conditions, the less valid such measures are likely to be for accurately pricing a particular property. Regarding the value of statistical measures in general for basing real estate decisions, buyers and sellers must be careful when anyone quotes a specific number every transaction is unique. It is also important to understand what statistical measures do and don't tell you. When Statistics Can Lead to Confusion and Bad Decision-Making It's not uncommon for cities in Connecticut (or in any other state) to be experiencing different market conditions at the same time. The Table above illustrates the degree of variability in Absorption Rates that can exist even in a relatively small geographic portion of a small state. Further, there can even be significant variability in such measures within a given city or town. What's occurring in one area of a town or even a neighborhood may not reflect the conditions elsewhere in the town. To complicate matters even further, what was a seller's market one month in a particular area may be shifting toward a buyer's market the next, or visa versa. Due to the dynamic nature of real estate markets, caution must be taken when relying on statistical information to make important real estate decisions, particularly with respect to pricing. Keep in mind that Absorption Rate, like all statistical measures of market activity, should only be used as a guide in assisting buyers and sellers of real estate in their decision- 5

6 making. There are many important factors that such measures don t take into consideration; factors that can significantly affect market activity and, therefore, price. For example, Absorption Rate calculations do not factor-in the effect of any new homes that come into the market during the time period when a home is listed on the market. Such measures also don t factor-in the effects of certain market events such as a sudden increase in foreclosures or short-sales occurring in a target market area. Further, such measures don t reflect the particular benefits or drawbacks associated with a particular home, which can greatly affect desirability and price and can actually have more influence in determining how fast a home will sell than any single mathematical formula could accurately predict. Therefore, it would be a mistake to assume that a single statistical measure such as Absorption Rate is all you need to consider in assessing the condition of the current market and in deciding or giving advice to others regarding what price to either sell or buy real estate property. As typically employed, measures like Absorption Rate reflect more general market conditions to the extent they are based on data from a broadly defined geographic region. As a result, such measures, by themselves, are often not precise enough to be relied upon for determining a competitive price at which to either sell or buy a particular home. Failure to look at more localized data can produce an unclear picture of a particular target market. An agent, for example, can easily, albeit inadvertently, render poor advice to clients simply because the statistical information relied on is too broad in scope and not specific enough to the seller s or buyer s situation. In addition to geographic variability, there is also another important factor that must be considered in assessing local real estate market conditions using statistical information. Regardless of the size of the geographic region upon which a market statistic is based, the values of that statistical measure are likely to vary (sometimes dramatically) with price-point within the defined market area. It is therefore imperative that any market analysis based on statistical information be broken-down by price-range. For example, informing buyers that they are in a strong buyers market because the town-wide or neighborhood Absorption Rate is 10.6, will ill prepare them for the reality of negotiating the purchase of a $200,000 home if the Absorption Rate in that price-range is actually 1.5. To obtain a full and accurate picture of current market conditions, buyers and sellers need to look at not just the overall market conditions for a particular market area; they also must determine and consider the price-range specific conditions associated with that area. 6

7 Beware of the Law of Small Numbers As explained above, more global measures of real estate activity are generally fine for describing broad market conditions but can have limited value to buyers and sellers for basing decisions regarding the purchase or sale of a particular home. This is because such global measures typically include in their calculation data from a relatively large geographic region or for a relatively long time-period (or both). Because All Real Estate is Local, to accurately assess the market value of a particular home, it is imperative that such measures be based on more current and geographically limited real estate activity. That being said, it is important to also realize that as one narrows the time-frame or geographic region used for analysis, the number of homes that are included in the calculation of a statistical measure become smaller. In fact, depending on how active the particular market area under consideration is, the number of homes to be included in a statistical calculation may be too small to be of value for solid decision-making. In calculating any statistical measure, the smaller the number of data points included in the calculation, the less reliable such a measure becomes and the greater the chance for error when decisions are based upon such a measure. For example, if the average sales price for homes in a particular neighborhood during the past three months is determined to be $350,000 but is based upon only six sales, the average sales price figure can be fairly deceiving. One or two sales at either a high or low sales price can have a fairly dramatic effect on the calculated average value rendering it less representative of the true average sales price. You can see that there is an inherent trade-off in utilizing statistical measures for making market decisions in the real estate business. Measures based on large samples of data are typically more reliable (less influenced by aberrant market activity) but can be less valid because they are based on too broad a geographic area or time-frame. Conversely, measures based on a more narrow set of geographic and/or time based parameters can be deceptive because of the small sample size used in calculating the measures. Average Sale to List Price Ratio Another important statistical measure used by real estate professionals to assess local real estate market conditions and, accordingly, to assist buyers and sellers in developing their negotiating strategy, is known as the average Sale to List Price Ratio (SLPR). 7

8 The SLPR is calculated for a specific market area, for similar homes, and for a particular time period as follows: Average Sale Price / Average List Price = Average SLPR This measure, expressed as a percentage, reflects changing market conditions in a specific market area by indicating whether the sale prices or the closing prices of homes in that area tend to be lower or higher than the listing prices. It tells, on average, how close to the original asking price sellers got for their homes. If the SLPR is less than 100 percent, this suggests buyers might have more negotiating power; if the ratio is greater than 100 percent, this suggests sellers might have the upper hand. The average SLPR measure is susceptible to all the limitations described above that can affect statistical measures in general. There is, however, one additional concern with this statistical measure. This concern has less to do with size of the geographic area used, the length of time examined, the size of the sample involved, or price point range and more to do with how listing price is defined and used in calculating this statistic. For a concrete example (you should be able to follow me on this one, Patrick), let's take a property listed for $300,000. It sells for $290,000. It thus would appear that it sold for 97% of the list price. However, let's say it had been originally listed at $310,000 and that a month after going on the market the seller dropped the list price to $300,000. In this case, it sold for only 94% of the list price ($290,000 divided by $310,000). To make things more interesting, let's suppose that the buyer successfully negotiated a 2% seller concession in the transaction. So, while the house "sold" for $290,000, at closing the seller actually gave a credit to the buyer in the amount of $6,000. So the real net (before any other expenses, fees, commissions, etc.) to the seller was $284,000. If the house had originally been listed at $310,000, then it actually sold for 92% of the original listing price. So, what is the Sale to List Price Ratio for this transaction? Is it 97%, 94% or 92%? The answer is: It depends! It depends on how one chooses to define list price. And does the choice of definition make any difference to a buyer or seller? The answer is: Yes! Buyers must use great caution when relying on Sale to List Price Ratios to make offers. If a buyer looked at our hypothetical house when it first came on the market at $310,000, figured 8

9 an acceptable purchase price was 97% of list, and ended up buying the house for $300,700 (rather than $284,000), that buyer could have overpaid by $16,700. Conclusion So with all of the complexities and interpretive limitations associated with the use of real estate statistics, how does a buyer or seller get a firm handle on this important information and use this information to make sound decisions? Your best source is a local REALTOR who works in the area where you want to buy or sell a home. As a professional who closely monitors local real estate activity and prices, your local REALTOR can provide you with objective information about whether you're in a buyer's market or a seller's market, explain how to accurately interpret local real estate statistics, and advise you on how best to use this information in your decision-making. When you know and understand the current local market conditions, you can make smart decisions that give you the best chance of buying the property you want, or sell your home quickly, at the best possible price. To discuss the numbers in your neighborhood, call me on my cell phone at or me at jimpapillo@comcast.net. 9