Price per Sq Ft and The Costco Principle

Using the wrong comps can lead to the wrong price or value. I realize that’s a no-brainer, but at the same time it’s still a common mistake when using price per sq ft figures to list or appraise a house.

A Recent Scenario: The subject property is a 3-bedroom unit at just about 1500 sq ft. There were zero sales at the contract price and really no reason why it should be selling so high, so I asked the Listing Agent what influenced him to price the property at that level. He shared that the price per sq ft of two nearby homes supported the value. The only problem was that the nearby sales were closer to 1200 sq ft, which was about 300 sq ft less than the subject property. While this might not seem like a big deal, the smaller homes actually had a higher price per sq ft than than 1500 sq ft models. Take a look at the graphs below.

Price per sq ft in nhood 1100-1300 sales

Price per sq ft in nhood model match sales

Price per sq ft in nhood

The smaller units were easily between 180-190 per sq ft, but the houses very close in size to the subject property were much closer to 170-ish. This just goes to show how important it is to compare apples to apples in real estate. Or in other words, it’s vital to use data from similar properties when making a comparison. As a rule of thumb I might suggest using sales 10% or so above and below the square footage of the property you’re working with. In this scenario the smaller units easily had a 5%+ higher price per sq ft. You may wonder of course how a property could get into contract 5% too high. Remember that inventory is still tight, but most of all the offer was from an FHA buyer putting very little money down. When you’re not spending your own money, you tend to offer more, right? That’s how it usually works.

peanut butter costcoThe Costco Principle: Why do smaller homes tend to have a larger price per sq ft? Because they cost more to build. It’s sort of like buying one can of 16 oz peanut butter at your local grocery store for say $4.00, but then going to Costco and getting 96 ounces for $12.00. Just as it can be less expensive to buy groceries in bulk, the same is true in real estate when building. Think about how much less it costs to build a second story on top of a one-story house. During new construction it saves a ton of money to simply add the second level because there is no need for an additional roof, foundation or much infrastructure below because it’s already there. This is also exactly why a house double in size is probably not worth twice as much because it didn’t cost twice as much to build.

Questions: Any thoughts or insight? By the way, chunky or creamy peanut butter? I say chunky all the way.

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Comments

  1. Joe Lynch says

    Ryan,
    George Dell teaches that demand for home size is asymmetrical, What you see is a peak followed by a long tail. The implication for comparable searches is to set search parameters wider for homes bigger than the subject. So I typically search for homes with a GLA range 10% smaller and 15% larger. Take a look at one of the manuals for his classes and you should be able to find his explanation.

    • says

      Well said, Joe. I have always heard the same, which is why I use data in graphs as such usually. When initially searching for comps though, I tend to start out smaller and then expand the parameters.

  2. says

    Great blog topic. Many people don’t understand this. This is also why if, as appraisers, we’re forced to use sales comparables that have a large difference in size, the adjustment for square footage might need to be applied on a curve to account for this factor.

    • says

      Thanks Gary. In truth these charts are straight from a program from Don Macholz (http://donsappraisals.com/). His program is great to help make some quick graphs for a neighborhood. I use Excel and Gnumeric all the time for other graphs, but quickies like this are perfect with Don’s 1004MC software.

  3. Joe Lynch says

    I guess you work in more conforming neighborhoods than me…I’m almost always scrambling for comps.

    • says

      Thanks Bill. Agreed. Many times the real estate community thinks appraisers don’t use price per sq ft. They don’t use it the same way Realtors do, but they definitely still use it. Enjoy creamy PB.

  4. says

    Very Well Written and the Word pictures really helped, Ryan! I shared your insight with a local RE Broker. He contacted me about a month ago to re list a home that had expired 2 years ago that I performed the Pre-Listing Appraisal on in 2012. The owner / seller just can’t understand that his 2,800sf home is over built when the average home in his subdivision is 1,800sf and isn’t going to sell for the $339,000 he wants. It’s listed for $299,000 and still has no buyer interest. Hopefully this will help that seller understand how the market prices differences in sq. ft.. Thanks so much, Bill

    • says

      Thanks so much Bill. I appreciate that. The world of value sure is interesting. It’s important to understand the dynamics of a neighborhood and how value works. I bet the owner or agent in this case was probably applying a price per sq ft to this 2800 sq ft property that made sense for an 1800 sq ft property. It’s an easy mistake to make.

      Tonight I’m a guest speaker at a local community college for a real estate class. I’ll have about an hour to babble, so I’ll be sure to share about how to use price per sq ft and the importance of comparing competitive sales.

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