Net absorption is an important and closely monitored statistic when measuring performance in commercial real estate. In such a competitive market, being able to navigate your net absorption can help determine whether your investments are prosperous or folding. What is net absorption in commercial real estate, and how do you calculate it?
Net absorption in commercial real estate is the change in the amount of space leased in a specific market during a given period. It accounts for space vacated and new additions over the same period. Net absorption metrics help determine the net change in tenant demand respective to supply.
In this article, we’ll cover what commercial real estate net absorption is, how it impacts your investments, and how to calculate it.
What is Net Absorption in Commercial Real Estate?
Net absorption in commercial real estate is a concept that describes the change in the amount of space leased or occupied in a specific commercial market or locality during a given period (often fiscal quarters). Simply put, it’s the net change in physical occupancy over a particular time.
Net absorption does not remain static like vacancy. It is a dynamic statistic that changes over time, making it an effective proxy to measure the supply and demand and the overall health of a commercial rental market.
How to Calculate Net Absorption in Commercial Real Estate?
Net absorption metrics in commercial real estate help determine the approximate net change in tenant demand respective to supply. It is the difference between three criteria, namely:
- The occupied/leased space
- The unoccupied/vacant space
- The new space (e.g., new construction or buildings)
Here’s how to calculate net absorption in three simple steps:
- Determine the Leased Space (physically occupied square footage)
- Calculate the Vacant Space (physically unoccupied square footage)
- Subtract the unoccupied space and new space from the occupied space.
Here is the formula for calculating net absorption:
- Net absorption = Total Space Leased (sq. ft.) – Total Space Vacated (sq. ft.) – New Space (sq. ft.)
For the net absorption rate, divide the net absorption by the property’s total leasable space in square feet.
For example:
A commercial market has 1,000,000 square feet of available space. 60,000 square feet is leased to tenants, of which 10,000 square feet of occupied space is vacated during the given period. The investors also built a new construction property of 30,000 square feet.
Net absorption = 60,000 sf – 10,000 sf – 30,000
= 20,000 sf
There is a positive net absorption of 20,000 sf. This indicates that there is a strong tenant demand.
The net absorption rate = 20,000 sf ¸ 1,000,000
= 0,02 ´ 100
= 2%
Positive vs. Negative Net Absorption in Commercial Real Estate
Tracking net absorption metrics provides valuable insights regarding the commercial real estate market. It is especially useful in determining the present market demand.
Positive Net Absorption: Reflects a decline in the supply of available commercial space. This results from a greater amount of space occupied or leased compared to the amount of space that became available on the market.
In view of a positive rate, lease prices are more inclined to increase, which can encourage commercial real estate investors and developers to actively engage in the market to meet tenant demand.
Negative Net Absorption: Denotes a decline in the demand for commercial space relative to the supply. This results from a greater amount of vacant spaces that are now available on the market compared to occupied or leased space.
In view of a negative rate, lease prices are more inclined to drop. Due to less profitable rates, commercial real estate investors and developers are less likely to engage in the market.
Gross Absorption vs. Net Absorption
Real estate investors and developers often talk about gross absorption and net absorption; these two terms are to be mistaken for each other.
Gross absorption is the total amount of space tenants physically move into during a specific period in a given market or geographical area. It cannot be used to measure net growth or commercial market trends as it only provides information on the amount of leased space. For that, you’ll need to use net absorption.
Net absorption accounts for vacated space, too, capturing the net change in demand and supply in the commercial real estate market. It is the total amount of space that tenants physically move into minus the total space that they vacated during the same time.
Why is Net Absorption Important?
Net absorption is an important metric that allows real estate investors, developers, and brokers to gauge a market’s supply and demand dynamics by determining if it’s positive or negative. A positive absorption rate indicates that there’s more space being occupied or leased than vacated. Whereas a negative absorption rate means that more space is vacated than occupied.
Determining the net absorption rate in a specific market area in a given duration helps real estate investors and developers forecast potential cash flow in their investments.
Factors that Impact Net Absorption
Commercial real estate is a highly competitive market, and many factors impact commercial properties’ net absorption. As a real estate investor, it’s essential to consider the following factors that significantly influence net absorption:
- Economic conditions: Economic circumstances greatly affect net absorption. Economic expansion can increase the demand for commercial space, boosting occupancy rates and net absorption. Whereas times of crisis and economic struggle can cause businesses to close or pause expansions due to high risk and uncertainties, resulting in a decreased demand for commercial properties and a negative net absorption.
- Availability: Availability There is generally a high net absorption rate in areas with little availability. Areas with high commercial property availability may experience low absorption rates due to competition with other properties.
- Location: Commercial properties located in strong demographic areas (e.g., high population density and many businesses) are more likely to have favorable net absorption rates due to high demand. On the contrary, properties in weaker demographic areas might have a tough time attracting tenants.
- Tenant movement: Tenants relocating to newly built premises will result in positive and negative absorption in a market area.
- Competition: Commercial properties with robust competition might struggle to attract and retain tenants. If there’s potential for future growth and new developments, properties are likely to appreciate and boost net absorption over time.
- Lease conditions: Lease lengths, rent rates, and conditions of commercial real estate leases can affect a particular market or asset’s net absorption. Investors and landlords need to set appropriate prices for their commercial properties to prevent negative absorption and high vacancy rates.
Conclusion
Essentially, net absorption determines the supply and demand in commercial real estate by calculating the change in tenant demand versus the supply available in a given market. Tracking net absorption can help you analyze current market trends and manage your investments.