The danger of using price per square foot to determine value

I talked with a really excited home owner recently about his property value. He put on his real estate thinking cap, found a recent sale in the neighborhood and determined the price per square foot (sales price divided by square footage) was $140 in his subdivision. He was ecstatic because this meant his 2800 square foot home would be worth $392,000, which would  open doors to remove PMI and maybe even pull out some equity. Or was it worth that much?

comparing apples to oranges - photo by Ryan Lundquist - Sacramento Appraisal Blog

Let’s take a quick look at some data in the neighborhood to understand how important it is to know the local market and compare apples to apples.

all price per sq ft in defined neighborhood - by sacramento appraisal blog

All Neighborhood Sales: Here are all sales in this man’s neighborhood in Elk Grove. We can see an increase of values over the course of the year, less sales at the bottom during the past two quarters and notably a fairly significant range of values. It looks like at any given moment the range in price per square foot in the neighborhood is roughly about $40.

all sales price per sq ft 2500-3500 GLA - by sacramento appraisal blog

Larger Sales in the Neighborhood: Let’s look at all sales with a gross living area between 2500-3500. This is a big range for size, but it helps make the point. Do you see any $140 per square foot sales in this graph? No. This tells us the market is not willing to pay $140 per square foot for larger properties. The price per square foot range is really mostly between $100-115, which would theoretically put a value range on this guy’s property between $280,000 to $322,000 ($100 x 2800 sq ft = $280,000 / $115 x 2800 sq ft = $322,000). That’s quite a bit lower than what the owner thought at $392,000.

all sales price per sq ft 1500-2000 GLA - by sacramento appraisal blog

Smaller Sales in the Neighborhood: So where did this guy get the $140 price figure for his neighborhood? He was looking at a much smaller sale. His rationale was that if a 1700 square foot house closed at $238,000 (which shows a price per square foot at $140), his house would be worth $392,000 by simply applying the same price per square foot metric. However, when we graph all sales between 1500-2000 square feet, we see a HUGE price difference in the neighborhood market. Smaller houses in the neighborhood actually have a much higher price per square foot than larger homes. The range for these smaller homes lately is roughly $120 to $145 per square foot compared to $100 to $115 for the largest homes in the subdivision. While it might seem odd that smaller houses would have a higher price per square foot, this is very common in real estate and something I see in almost every tract neighborhood. Price per square foot is not something constant, but rather fluid depending on the size of the house as well as what a house has to offer such as upgrades, location, lot size, layout, etc…

Apples to Apples: Can you see how errors in value can occur when we use improper comparisons? This underscores how important it is to make comparisons to similar properties in a neighborhood rather than just using a metric like $140 that might apply to a different type of property or a much larger or smaller home. This reminds us too to not apply county-wide or state-wide metrics to a specific neighborhood (which I’ve talked about lately). Ultimately, if the owner in this situation wanted to get a quick estimate of value for his property in terms of price per square foot, it would have been best to pull all recent competitive sales (2500 sq ft or more) and find out what the price per square foot was for those sales instead of much smaller sales in the neighborhood.

Questions: Why do you think smaller houses tend to have a higher price per square foot? Any stories or scenarios to share? I’d love to hear your thoughts below.

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Comments

  1. says

    You got it Ryan, they must compare similar footages, model matches if possible, as larger homes in the same project usually have lower prices per foot, due to economies of scale.

    Price per foot is a long time oversimplification we’ve dealt with is both selling real estate as well as building homes. The first thing people need to accept is that there are many costs (price) that will not vary in the neighborhood along with the square footage of the house…. such as
    1. the price of the land
    2. the utility connections
    3. much of the permit costs
    4. the cost of a 2 car garage
    5. the cost of a front door
    6. the cost of a utility room, bathroom or kitchen, except for size and finish differences
    7. etc

    So the “model” should be a simple algebra model like this:

    Fixed cost + (square feet x variable cost per foot) = value

    Typically, like a new home subdivision, that will give you a higher price per foot for the smaller homes. The cost side of your appraisal actually works like that already.

    • says

      Jeff, fantastic comment. I should have had you write the post. I know you’ve walked both sides of the aisle with building houses and listing/selling, so you have a well-grounded perspective.

      In this current market with such rapid appreciation, I’m finding it especially relevant for home owner’s to pay attention to competitive price per square foot (and take it with a grain of salt of course). I’ve seen multiple owners wanting to refinance in light of written news that the market has increased by 22%. But that county-wide metric just doesn’t apply to every neighborhood. This sounds a bit off-topic, but what will happen is a home owner will read a stat like that, check out a price per square foot in their neighborhood (for a smaller or non-competitive model) and then come up with a value that is off-base that makes PMI removal look like a walk in the park (it might be, but maybe not too). I’m sure the owner I talked with recently was not happy about a “lower” appraised value, but he was basing his extremely high value on information that wasn’t any good. Numbers must be interpreted in the right context.

      By the way, I mentioned you in my post two days ago after our Suncountry conversation (thanks for that).

      Much thanks again.

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