Net absorption: what is it and why does it matter in commercial real estate?
The Denver commercial real estate market is a highly competitive market, one of many across the U.S. There are lots of factors that determine the success of such an investment.
Understanding the elements – such as net absorption – that affect commercial real estate makes all the difference in whether you end up with a successful investment or a flop.
Understanding all the factors that affect commercial real estate can be tough – especially when you are starting out. Learning about investment waterfalls, your local market, net absorption and more – its a lot to wrap your head around.
To make things simple, we have put together this simple guide to net absorption for commercial real estate. You will learn what net absorption is, how to calculate it and the impact it has on your real estate business.
What is Net Absorption?
Net absorption rate refers to the rate of difference between how much commercial real estate space tenants vacated in a certain time in the same location.
For example, a positive net absorption rate means that there is a decrease in the supply of commercial space in a particular area. More space was leased than vacated.
Net absorption is measured in square footage. In simple terms, the calculation involves taking the amount of square footage leased in an area and deducting the square footage vacated.
Why Do You Need To Understand Net Absorption?
Whether you are a landlord or a commercial real estate investor, understanding net absorption can help you make a smart decision.
Understanding how to calculate net absorption and what it means helps you:
- Figure out when you are in a buyer’s market versus in a seller’s market.
- Make informed commercial real estate purchases or sales.
- Set a fair price for your property based on the current demand in your area.
- Make smart choices around when is the right time to invest in new commercial real estate properties, and when is a good time to covert current properties to commercial real estate.
Square footage is a key metric in commercial real estate and often accounts for a lot of the value of the property than in other real estate markets. Spaces can be split or expanded based on the absorption needs in a location.
COVID and Net Absorption Rates
COVID has changed the commercial real estate market.
According to Pew Research, at the height of the pandemic over 70% of US workers were working from home. The pandemic has calmed somewhat, but this shift to working from home looks like it is here to stay.
Employees are demanding more flexibility and many want to maintain at least some of their working hours outside of the office.
Employers don’t need the same amount of space that they did pre-pandemic. They need fewer square feet of office space as many employees will not be in the office from 9-5, Monday-Friday.
This in turn means they are vacating their current offices and downsizing to smaller locations. Or simply reducing the amount of square footage they currently occupy in their building.
However, this does not mean that all over the country we are experiencing negative net absorption (more space vacated than leased). COVID has also brought growth – so in some industries and in certain areas businesses are using this period of growth to expand their office or retail space.
Understanding net absorption is key to making smart investments in these times. A look at net absorption rates in your area will show you what the commercial real estate market is doing. You may discover, for example, that in your area there is currently a high demand for small properties. You can then set higher prices for rent on your small commercial property without impacting demand.
In contrast, if there are many vacancies and a negative net absorption rate, you may need to look to lower pricing to increase demand, or change the layout of your property to meet the expectation of the changing market.
How to Calculate Net Absorption
Now you know what net absorption is and how it can help you make smart decisions regarding your commercial real estate, you are likely wondering how to calculate the hard numbers.
To work out net absorption, the first thing you need is a solid understanding of your local commercial real estate market.
You can work out net absorption for any area. Perhaps you want to calculate for specific property types in a zip code. Or maybe you want to calculate all the commercial property in a larger area. Either way, the formula is the same.
How Many Square Feet Of Real Estate is Available In Your Local Market?
You will want to calculate the specific amount of square footage for the property type in your area. This includes both leased and vacant lots.
For example, if you are looking for a specific property type such as a shopping mall, you may want to consider the total stores available in the center that can be leased to tenants, as well as the total space available.
If you’re looking at a wider geographic area, like a specific neighbourhood or city, you may want to consider the total square footage available for occupancy in the whole area.
- How Many Square Feet of Commerical Real Estate is Vacant?
Calculate the number of both vacant properties and properties being underutilized.
A property can be underutilized by only having half of the available space rented out and half vacant. This creates additional costs because the space is not occupied by the tenant.
- Deduct Unoccupied Square Footage From Total Square Footage
Take the two numbers you have calculated above and subtract the second from the first.
By deducting the amount of vacant/unused space from the total amount of space in the area you will be left with the net absorption.
From working out this number you should also gain insights into rental rates in your area, where vacant properties are, future investment opportunities in new spaces and more data that your commercial real estate business can use.
What Impacts Net Absorption In Your Commercial Real Estate Business?
We discussed above how COVID has impacted net absorption rates. However, there are many factors that can change the net absorption in a specific area.
Here are some of the most impactful factors that change the market:
Price has a big impact on net absorption. Businesses want to lease their property for the lowest price possible while still finding a property that meets all of their needs.
High rents can make it difficult for a business to find the larger spaces they want. Instead, they rent out smaller spaces which leads to more vacant or underused properties.
Business practices affect occupancy rates. For example, as we have mentioned, the current shift to remote work has changed the demand for office space.
However, there are also other factors to keep an eye on. Technologies are constantly evolving. Many industries have seen their workforce shrink in the past decades as the need for labour has decreased and automation has become more common. This in turn can mean that businesses have a lesser need for larger spaces.
Another example is that online shopping has become the go-to way to make a purchase. E-commerce giants like Amazon mean that there is less foot traffic in shopping centres and businesses have reduced their number of brick and mortar stores, switching instead to an online model.
When the economy is thriving, businesses owners look to invest more in their business. They look to expand and increase profit, often requiring more commercial space. When the economy booms, new spaces not only for offices, but also warehouses, factories, retail and more are in higher demand.
In times of economic struggle, businesses look to cut costs. This can be done by reducing their overheads from rents and shrinking their workforce.
In locations with little commercial real estate, businesses look to make decisions fast in order to not lose out when a space is vacated.
Properties fill up fast in these places and when new properties are built they can often be let fast.
However, in locations with an abundance of commercial real estate, businesses can take their time to make decisions. They will look for a property that meets all of their needs. This often leads to properties staying on the market longer.
To Sum Up
Understanding net absorption will give you helpful insights into how to invest in commercial real estate. The simple way to calculate it is by taking the square footage of total commercial property in the area and subtracting the square footage of the vacant commercial property.
Are you looking to make a Denver commercial real estate transaction? U-Collective is an expert team of local real estate brokers who are ready to guide you, specializing in everything from industrial and retail to office properties. Get in touch with our team today to get started.