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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The 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.