Do You Use Price Per Square Foot To Price Your Listings?
Are you guilty of using price per square foot to price your listings or estimate your home’s value? If you are then please keep reading because I’ll give you 6 reasons why this is not a good idea.
First off, for those that may not be totally familiar with what price per square foot is, let me explain what it is and how it is used. Price per square foot is a value metric that is commonly used to express the value of a house on a per-unit basis.
The unit is the home’s square footage and is simply calculated by taking the sale price and dividing it by the gross living area of the home to arrive at the price per square foot. A 1,000 square foot (SF) home that sells for $100,000 would have a price per square foot of $100.
This price per square foot is then used to estimate the value of other homes by multiplying the square footage of the home by the price per square foot. If you have a 1,500 SF home and multiply it by the $100 price per square foot you get an estimated value of $150,000, right?
Hold On, Not So Fast
Mathematically speaking this is correct, however, in today’s post, I hope to explain why this does not always provide the most accurate indication of value. If you have anything to add after reading please leave a comment below.
1) You don’t have accurate square footage – As you might expect, this approach is only as accurate as the information you have. Whether it is inaccurate square footage on the sales you are looking at or for the property you are pricing if your square footage is wrong your value will be wrong.
If both are wrong then the inaccuracies will be multiplied and the value indication you get should not be relied upon. If the data you are using is not from a reliable source and you are not sure of the accuracy then you should avoid using this metric.
2) Sales are diverse – By diverse I mean that the sales vary in their square footage and features. This is not a good scenario to use price per square foot as a prime indicator of value.
The reason I say this is because if the size of the sales varies significantly then the price per square foot will also vary and will not provide a tight range of value to apply to your property. In addition, if the features of the comparables are different than the subject property the price per square foot will reflect these additional features.
Using a comparable with a finished basement, a swimming pool, or additional land will result in the price per square foot being higher. This will provide a higher value for the property in question and will result in overpricing.
3) Price per square foot varies for different price ranges – Homes within different price ranges can sell for a different price per square foot amount. Using only sales that are within a specific price range will give you a skewed estimate of value.
This is one of the main reasons you should never price a home based on what you think it might sell for. You will always find support for your initial assumption, which is known as confirmation bias.
The best way to price a property is by using the physical characteristics of the property such as age, size, bedroom/bath count, and features of the home to name a few. When comparables are chosen this way the indication of value provided is more accurate because it shows what buyers are willing to pay for homes with similar features to the subject property.
4) Not all areas should be included in the gross living area – If you are including questionable areas in the gross living area of the home and then multiply that by the price per square foot your value estimate will not reflect an accurate indication of value.
Most real estate appraisers follow the ANSI standard when measuring houses so there is a consistency in what is included. It is important to compare apples to apples and by following a set standard it is easier to do this.
Some areas should not be lumped together with the gross living area and the ANSI standard provides guidelines to follow. While most real estate agents I know do not measure their listings they can at least be aware of what areas are acceptable to include in the gross living area figure that you use to calculate the price per square foot.
5) The law of diminishing returns – If you use price per square foot and are not aware of the law of diminishing returns then you can make a huge mistake in pricing.
The law of diminishing returns states that with everything else being the same (such as quality, condition, size, and features) a larger property will sell for less per square foot. The added value for each additional square foot will continue to decline.
This means that you should not only use larger homes as comps because when you apply their price per square foot to your smaller home the price indication will be too low. This is also true for smaller homes except that the price indication will be too high.
6) Functionality may not be reflected – The last thing I would like to mention involves the topic of functionality. Like I mentioned previously, the price paid for a property reflects everything about the property.
What this means is that if a house has a chopped-up funky floor plan it may have less market appeal than one that has a more traditional floor plan that flows better. If you use the price per square foot of homes with superior floor plans and apply that to a home with a less desirable layout the value indication may be inaccurate.
Conclusion
As you can see there are a lot of things to consider when pricing a home using price per square foot. This metric can be helpful if you use it along with other price indicators, however, if you use it exclusively it may not provide you with the most accurate estimate of value.
If you are an appraiser can you think of any other reasons not to use price per square foot to price a listing? If you are an agent do the points I covered above make sense? If you have any questions feel free to leave a comment below and as always thanks for reading.
To borrow from the legal domain, I partly concur and partly dissent from your opinion. I definitely agree that price per square foot can be useful in conjunction with other indicators (a sales comparison grid, for example), and agree that it tends to have less utility in cases where the market is decidedly non-homogenous.
However, the reality is that it is used in the marketplace – many residential agents quote price per square foot numbers when analyzing the market. As an appraiser, my job is to reflect the market; and if market participants use a particular metric, I have to at least address it. I’d also argue that for markets with relatively homogenous properties, it can be a very useful metric, particularly for homes of similar size. And from fairly extensive experience using multiple regression to evaluate coefficients that affect value, gross living area (square footage) is usually one of the highest impact variables. If a dataset is arrayed from high to low using price per square foot, it is usually pretty clear why some are higher and some are lower, based on condition, amenities, etc.
So I wouldn’t completely disregard price per square foot as a valuation metric for homes. It is widely used to value other types of properties (multi-family, commercial, industrial and vacant land), and giving it proper consideration isn’t necessarily a bad idea.
Everything you say is correct and I agree with it, however, many real estate agents do not understand the concepts you describe. They apply a price per square foot to their listings with little regard to all that is included in the price per square foot. Price per square foot is influenced by the size of the house, the size of the land the house sits on, the view the home has, the features of the home, etc. Price per square foot can be a reliable indicator of value if the houses and property have a high degree of comparability, including the size of the home. If that is not the case then it would be wise to not place all of your eggs in the price per square foot basket. It can be considered but you would need to reconcile that with numerous other value indicators to get a more accurate value estimate.
It’s easy to get distracted by price per sq ft. At some point it’s so important to step back and ask this question: What is similar? Let’s pay attention to PSF, but cannot forget to look to the comps…
Yes, depending on the type of property and reliability of the data, price per square foot can be one of many good indicators of value. When you place all of your eggs in the price per square foot basket, which many agents do, you can get into trouble when attempting to estimate the value of a property.
Good information Tom, as usual. As an appraiser in California, I often hear agents mention price per square foot. The home value is based on more than just the square footage of the home. I explain that in our market, the majority of the value of a home is primarily based on location. The land below the home typically accounts for 70% or more of the value, the percentage gets higher as you get closer to the coast. Views also account for value differences here. Comparables should be from the same area, so the the location will be similar but not all views. I ask the agent how many square feet their own home is, and then I ask if they were to double the square footage of the home-would the value double? The answer is no. If it were yes, I would add 2000 sq ft to my 2000 sq ft home and double my value. There is more to it than the square footage
Great points, Mark. Price per square foot is a good indicator of value in certain situations. Many agents I run into don’t have a full understanding of the law of diminishing returns or they would not apply the price per square foot to the home they are pricing with little regard to the property they derived that price per square foot from.