5 things to remember when using price per sq ft in real estate

Using price per sq ft can be very dangerous. I know that sounds odd because price per sq ft is about as common as anything in real estate. Home owners ask, “How much is the price per sq ft in the neighborhood?”, and real estate agents might say, “I priced this property based on the price per sq ft in the area.” But having a correct understanding about the way price per sq ft works can revolutionize the way we see the market and value properties. Let’s unpack five principles below, and I’d love to hear your take in the comments.

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5 principles to remember when using price per sq ft in real estate:

1) There is a price per sq ft spectrum in a neighborhood: There is never just one price per sq ft figure that applies to every property in a neighborhood. For instance, a neighborhood might easily see a price per sq ft range from $100 to $250 when looking at all sales.

2) Similar houses tend to have a similar price per sq ft: When homes are similar in size, location, bed/bath count, etc…, they tend to have a similar price per sq ft. That’s obvious, but the contrasting factor is that non-similar homes might have a VERY different price per sq ft that shouldn’t be used to value your home.

3) Property characteristics can quickly change the price per sq ft: When there are differences in condition, location, lot size, quality of upgrades, bed/bath count, size, etc… the price per sq ft can change dramatically. We might see a small remodeled home selling at $250 per sq ft, a model match fixer selling at $175 per sq ft, a short sale model selling at $185 per sq ft, and a home with an adverse location selling at $215 per sq ft. Thus even for one model there could be a price per sq ft range from $175 to $250.

4) Smaller homes tend to have a higher price per sq ft: It costs more to build smaller homes, so smaller homes tend to have a higher price per sq ft than larger homes. This is why it’s dangerous to use a price per sq ft figure from a smaller sale to value a larger home. A smaller home might sell at $250 per sq ft, but a larger home might be closer $150 per sq ft. Here is a quick video below (or here):

5) Price per sq ft provides a valuable context: When you can talk through price per sq ft figures in a neighborhood, and explain the above points, you are an incredible resource. Appraisers, pay close attention to the price per sq ft range in a neighborhood. Some appraisers treat price per sq ft as a meaningless metric, but it’s actually valuable. If your value does not fall within the range (especially the competitive price per sq ft range), it’s important to be able to explain that.

CONCLUSION: Be careful about using price per sq ft to price a property because sometimes it’s like putting the cart before the horse. I recommend starting a valuation with an “apples to apples” approach where you first and foremost try to find other similar sales and listings in the neighborhood, and then subtract and add value based on any differences with your property. After you have a grasp of similar sales, research price per sq ft figures for the entire neighborhood as well as competitive properties. Ask yourself if your value makes sense in light of price per sq ft figures.

Questions: Any thoughts or insight? I’d love to hear your take.

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Comments

  1. says

    Realtors tend to ignore or minimize the impact of your items #2 and #4 when they price a property or try to justify the contract price using cost per sq ft. As an appraiser I have only exceeded the range twice in over 8,000 reports. Both were easy to justify. So, yeah, I tend to dismiss it as a cross-check.

    • says

      Mike, thanks for the comment. I always appreciate your take and honesty. You’re right about the errors with #2 and #4. Those two times sound like they were probably interesting appraisals to say the least.

      For me, I guess I ask myself why I wouldn’t pay attention to the price per sq ft range in the neighborhood as an appraiser. I am not using it as my primary tool to value properties of course, but I am using it to help establish context. It sounds like you do this too since you are aware of exceeding that range twice. Overall the appraisal industry seems stuck in this notion that price per sq ft is utterly meaningless. We tend to discount there being any value in any way, and so we perpetuate the price per sq ft rant that has been passed through the ages. I just think there can be some valuable insight when we look at the numbers – especially for competitive sales. I am more concerned about appraisals that come in below the range and there being justification for that. Being able to see the market in different ways and with different metrics can be very powerful (like with these graphs I used in a different price per sq ft post: http://sacramentoappraisalblog.com/2013/03/13/the-danger-of-using-price-per-square-foot-to-determine-value/).

      For any appraisers looking on, I recommend using Don Macholz’s 1004MC software to quickly see the price per sq ft range in a neighborhood (along with scatter graphs and other metrics). Run the 1004MC for the past year as you need to for your appraisal, but also pull the past 5 or so years of sales in a specific neighborhood so you can see the market. The program will include all those sales you include and spit out graphs by sales price, price per sq ft, size of sales over time, REOs vs Short Sales vs Traditional Sales, etc…. Better yet, pull competitive sales too so you can see the competitive trend. This is an incredible way to produce some very quick graphs for reports, and some visual context to help support or explain your rationale or value conclusion in the appraisal. The free version is fine, but it is very limited compared to the paid version. I believe the paid version is only $60 (no, I don’t get anything for mentioning this, but I am an evangelist by choice for this program). When we can better see the market and pay attention to different metrics, it simply makes us better. Moreover, when we pay attention to metrics that some clients and prospective clients are watching, it can help open up communication with them. http://donsappraisals.com/1004_MC_Spreadsheet_1.html

  2. says

    I like to start with the price per square foot range of a neighborhood and then look at what makes the home different from the others in the neighborhood. Maybe it comes from my investing background and looking at valuation metrics like the price to earnings ratios, etc., but it has served me well.

    • says

      That’s good, Ray. I’m glad you are really thinking critically, and it sounds like it is working well. Congrats on your success!

      I should clarify for any onlookers that there is no one right way to start or finish a valuation. I think in the end we must really consider multiple metrics and of course what competitive sales and listings are actually selling for. My concern about price per sq ft is that sometimes an inapplicable price per sq ft is imposed on a property instead of drawn out from the market. This can end up leading to marketing and/or valuation problems.

      At the end of the day the market is complex, so I sure do enjoy looking at it from different perspectives.

      Thanks again Ray.

  3. says

    Very insightful article with some great tips! I especially like your “cart before the horse” analogy at the end there… perfectly describes what it can be like depending on the property.

  4. says

    Hi Ryan,

    Price per square foot seems to be all over the place these days. Even in the same neighborhoods. It’s definitely complicated to say the least!

    Great post, thanks so much for sharing it!!!

    DeeDee

  5. says

    Great subject. Really great points, Ryan… and great blog!
    In response to DeeDee’s mention about prices per square foot being all over the place, I agree that if you simply review the prices per square foot by themselves, they do appear to be all over the place. However, the key is to recognize the relationship or pattern between them… and there is one, trust me. Starting with the sales that you intend to use, if you simply put the size (SF) of the building and the price/SF for each sale and create a simple scatter graph in excel, you will almost always recognize the trend. The trend will almost invariably reflect the inverse relationship between house size and price per square foot. Simply stated, as house size increases, price/SF tends to decline. In many cases, if you add a trend-line, it will not perfectly go though the middle of each data point… but the variance from that trend-line is generally related to the elements of comparison (all those things that you adjust for). After adjustment, you will tend to see all the data points moving closer to the overall trend-line. As Ryan astutely points out, using all the sales that you can find from the past few years will enhance the strength of the data. You can then use this graph, and the visible variance exhibited by each sale to support adjustments. The Appraisal Industry is finally more in the direction of this method of quantifying adjustments and supporting values, as evidenced by the most recent Appraisal of Real Estate text (14th Edition), which unlike the previous versions, has included numerous examples of graphic analysis throughout the text, and has even included an entire chapter sized section within the addendum of the text.

    • says

      Bruce. thank you for the comment. This is exactly how I use price per sq ft. I want to see the entire neighborhood, and then I want to see the competitive range. I typically graph the past six years of sales for both categories, and I find it to be a very powerful way to look at the market. I like seeing a scatter graph of all sales of course, but price per sq ft tends to feel tighter at times, which helps paint context and a plausible range of values. Again, for any onlookers, don’t put all your eggs in the price per sq ft basket, but do glean what it offers by letting it work for you. Thank you Bruce for an insightful and helpful comment.

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