Why price per square foot can be an agent’s worst enemy when pricing a home

Do you use price per square foot to list a home?

One question I get a lot from agents is “what price per square foot are homes selling for  in such and such neighborhood”? Whenever I get this question I cringe because in and of itself price per square foot is not always the best indicator of value. Today we’re going to discuss why this is the case and how price per square foot should be looked at when pricing a home for sale.

What is price per square foot?

Price per square foot is a unit value indicator that can be used to extrapolate the overall value of home. It is calculated by dividing the sale price by the gross living area. For example, a home selling for $100,000 that is 1,000 square foot is selling for $100 per square foot.

Most people will then take the price per square foot of $100 and use it to determine the value of another home. Let’s say you have a 1,500 square foot home and want to know what it is worth. They will then multiply the gross living area 0f 1,500 by the price per square foot of $100 to arrive at a value of $150,000. So you may ask “what is wrong with using price per square foot to arrive at a value”? Let’s take a closer look at everything the price per square foot indicator includes.

What is included in price per square foot?

The price per square foot of a home includes everything about the house such as its condition, any updates it has had, all the features it has, as well as the lot it is on, and its location. Let’s say the house we discussed before has been remodeled and has new flooring, a new kitchen, and updated bathrooms. The price per square foot that it sold for considers this because the buyers looked at the house and used its condition to make an offer.

Now let’s also consider the fact that there is another house on the same street that is identical to the first one in square footage and other features, but it did not have any updates. It sold for $80,000, which is $80 per square foot. Its price reflected the fact that the interior was more dated and not as new as the first sale.

These two homes are very similar in physical characteristics but different in updates and renovations, which resulted in a price difference of $20,000. The sales price, and price per square foot, reflects these differences.

This is where only looking at price per square foot can give you the wrong value indication for a property. If you used the first price per square foot of $100 to price your home that had not been updated then you would most likely be over valuing it. The opposite is also true, if you used the second price per square foot of $80 to value a home that had updates you would be under valuing it.

The range of price per square arrived at when looking at multiple sales must be considered, while taking into consideration which of the sales used were most similar to the subject property. This is all a part of the reconciliation process.

Law of diminishing returns

If you’re like me your eyes may have been glazing over whenever your economics teacher covered this topic in school, but it is relevant to our discussion here.

The law of diminishing returns simply states that as you buy more and more of something the price per unit that you pay for it goes down. My appraiser friend Ryan Lundquist, who works in the Sacramento market, recently wrote a very good article on this very topic but put it in the context of buying coffee at Starbucks. His article helps to simplify a sometimes confusing topic.

If you have two homes, one being 1,000 square feet and another at 2,000 square feet, and everything else being the same (rooms are just bigger), the 2,000 square foot home will sell for less on a price per square foot basis. This is why it is very important to bracket the sale comparables when pricing homes. You should always try to use homes that are slightly larger, smaller, and approximately the same to get a range of price per square foot values that you can then reconcile.

If you do not use the method of bracketing you can over price your listings if you just use smaller homes as comps, because their price per square foot is always higher when everything else is the same except for square footage.

All homes are not created equal

All homes are not the same. Some have finished basements, varying levels of quality, more bedrooms,etc. As I stated previously, bracketing is very important during comp selection because if you don’t do it correctly you can steer the value of a home in the wrong direction.

The price per square foot of a home with a finished basement will be higher than another similar home that does not have a finished basement. This seems straightforward but I mention it because I’ve seen agents use comps with finished basements to price homes that did not have the same.

Other things that you will need to consider when analyzing the price per square foot include how many bedrooms and bathrooms the home has, the quality level of construction, and even site improvements like swimming pools and barn or storage buildings.

Because price per square foot is affected by so many factors it is critical that comps be as similar as possible. Whenever there is a high level of similarity between the home you’re pricing and the sales the price per square foot becomes more relevant, however when there is greater variety it should not be given as much consideration.

So what is the solution if you can’t use price per square foot?

Price per square foot should never be looked at by itself. It should always be considered in context with other value indicators. If the price per square foot points you to a value that is way above what all other homes are selling for and listed at then it should not be considered a reliable value estimate.

If you believe that price per square foot may not be a good indication of value for the home you are pricing then you need to utilize other methods. One solution I have written about involves using qualitative analysis. This does not consider price per square foot or even adjustment amounts but instead looks at feature and quality differences between properties to arrive at a list price.

The last solution I will mention for pricing a home is to get a pre-listing appraisal from a knowledgeable and professional appraiser. They will be able to provide a market supported value that does not consider just price per square foot but other factors that are important to buyers.

By getting an appraisal prior to listing the likelihood of a deal falling through on the back end will be reduced because the sales used by the pre-listing appraiser will be more similar to the what the mortgage appraisal will contain. Give me a call if I can help you out with a pre-listing appraisal.

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