Market Conditions: Supply, Demand and Absorption

Closed sales establish the price range. Where the list price is positioned within that range, and how the listing is managed once it is on the market, depends on the condition of the market the subject is entering: how many competing properties are for sale, how quickly buyers are taking them, and whether the balance between the two is shifting. Two figures describe that condition, the absorption rate and months of inventory, and both are simple to compute. What makes them useful or misleading is the set of properties they are computed from. The office relies on the figures for the subject’s segment and shows the town’s figures beside them for comparison, and this lesson sets out how and why.

Supply and demand in a residential segment

Supply is the number of properties currently offered for sale that compete with the subject. Demand is expressed through the rate at which buyers take such properties off the market. Neither can be observed directly for a single house, so both are read from a group of properties that share the subject’s market position: the same property type, a similar size band, the same price tier, a similar condition level, and the same competitive market area or, where the area is too small to yield a count, the same kind of area within the town. That group is the subject’s segment. A four-bedroom colonial in the $600,000 to $700,000 tier and a two-bedroom condominium unit in the $250,000 tier are in the same town and in different markets, and a figure that combines them describes neither.

The absorption rate

The absorption rate is the number of closed sales in the segment per month, measured over a trailing period long enough to smooth out single months. Six months is the usual period; twelve is used where the segment is small or seasonality is strong, although a twelve-month figure lags the present. The arithmetic is a division. A segment with 84 closed sales over the past six months has an absorption rate of 14 sales per month.

The rate describes demand at the prices buyers have been paying. It is not a forecast, and it changes: a segment that absorbed 14 a month through the spring may absorb 9 a month in the autumn, and the trailing figure will show that change only after it has happened.

Months of inventory

Months of inventory is the current supply divided by the absorption rate: the number of months the properties now for sale would take to sell at the current pace, if nothing new came on the market. With 42 active listings in the segment and an absorption rate of 14 per month, the segment has 3.0 months of inventory.

A low figure describes a market in which buyers have few alternatives and properties priced within their range go under contract quickly; a high figure describes a market in which buyers have many alternatives and the subject is generally positioned to be among the first considered. Where the line falls between them is not fixed. A commonly used rule of thumb treats something under four months as favoring sellers and something over six as favoring buyers, but the thresholds shift by tier and by property type, and the office reads the segment’s figure against that segment’s own history rather than against a universal cutoff. A top-tier segment that has carried eight months of inventory for years is not in distress at eight months, and a starter-tier segment that has carried two months is under strain at four.

Pending sales refine the reading. A count of pendings in the segment shows demand that has been committed but not yet closed; a segment with 42 actives and 18 pendings is tighter than the 3.0 months suggests, and a segment with 42 actives and 3 pendings is looser.

Why the segment and not the town

A town-wide inventory figure is available from every MLS and appears in most market reports, and it is a figure agents often quote. It combines every property type and price tier in the town, and where the tiers are moving differently, as they often do, it describes an average that no listing is in.

Consider a town with 130 active listings of all kinds and 372 closed sales over six months, an absorption rate of 62 per month and 2.1 months of inventory. The subject is a four-bedroom colonial in the $600,000 to $700,000 tier. That segment has 27 actives and 30 closings in six months, an absorption rate of 5 per month and 5.4 months of inventory. The tier above it, $700,000 and up, has 18 actives and 12 closings in six months, 2 per month and 9.0 months of inventory. The town figure says buyers have few alternatives. The subject’s buyer has 27.

The town figure in this example is driven by the lower tiers, where the counts are large and the pace is fast. An analysis that positions a $650,000 listing on the strength of 2.1 months of inventory is positioning it for a market it is not in.

What the figures mean for the range and the strategy

The closed sales produce the range; the segment’s condition decides the position within it. In a segment with low inventory and a strong absorption rate, the list price is positioned in the upper part of the range, because buyers have few alternatives, and the recent pendings will generally show short times to contract with few reductions before contract. In a segment with inventory near the upper end of the four-to-six-month band or above, and listings slow to reach a contract, the list price is positioned in the middle or lower part of the range, so that the subject is among the first properties seen by a buyer with 27 alternatives. Positioning at the top of the range in a slow segment tends to produce a listing that is shown after its competitors and may need a reduction after they have sold.

The figures also set the listing strategy that the seller agrees to before the listing goes live. The absorption rate and the segment’s median time to contract give the expected pace, and the file records two checkpoints at which the price is reviewed: the first at roughly half the segment’s median time to contract, the second at the median itself. Checkpoints set at the outset are a strategy; a reduction improvised after three months is a consequence.

Application

A market analysis for a 2,600-square-foot four-bedroom colonial shows closed sales supporting a range of $640,000 to $680,000 and recommends $689,900, stating that the town has “2.1 months of inventory, a strong sellers’ market, so we can price above the range and let the market come to us.”

Recomputed for the segment, the figures differ. Four-bedroom colonials between $600,000 and $700,000 in the subject’s kind of area: 27 actives, 6 pendings, 30 closings over six months. The absorption rate is 5 per month and the inventory is 5.4 months. The segment’s median time to contract is 38 days, two of the last four pendings were reduced before they went under contract, and the segment’s closed sales over the past three months sold at a median of 97 percent of list. This is not the market the analysis described. A buyer in this segment has 27 alternatives to see, and listings are taking more than a month to reach a contract.

The recommendation changes to $659,900, in the middle of the supported range, with the seller shown the segment figures alongside the town figure and told why the town figure does not apply. The listing strategy in the file sets checkpoints at about day 19 and day 38, half the segment’s median time to contract and the median itself, at which the price is reviewed. The question of the town’s 2.1 months is answered with the table: the town number is true and belongs to the lower tiers.

Summary

The absorption rate is the number of closed sales per month in the subject’s segment over a trailing period, and months of inventory is the current supply divided by that rate; a segment with 42 actives and 14 closings a month has 3.0 months of inventory. Both are read for the subject’s segment, defined by type, size, tier, condition and area, with the town’s figures shown beside them, because a town-wide figure averages tiers that move differently and describes a market the subject is not in. The closed sales establish the range; the segment’s condition decides where in the range the list price is positioned and sets the checkpoint dates the seller agrees to before the listing goes live.