There are a lot of numbers and statistics commonly thrown around in real estate, but none is more commonly used than price per square foot.
It’s one of the main numbers used by real estate agents, investors, and even the general public when talking about property valuation.
But what if I told you that price per square foot might actually be extremely inaccurate?
Even worse… What if it was actually misleading?
That’s what we are going to talk about in this post!
We are going to break down how price per square foot is commonly used, why it is misleading, and how to better use it to get a better understanding of property valuation.
Why is it so commonly used?
The most basic reason it is used is due to the fact that every single property has square footage. Many people believe that by breaking each property down into a price per square foot you now have a similar unit of comparison to be able to compare properties to one another, even if they are in fact not similar properties.
Another reason it is used so often is due to the fact that it is the easiest stat to calculate in real estate.
All you have to do to complete a price per square foot analysis, is to simply divide the sale price of a property by its total number of square feet and you have the resulting price per square foot.
Lastly, it is commonly used by many people because of the fact that it is already used by so many people.
Since it is a statistic that is commonly published on large sites like Zillow, Realtor.com, Trulia, and others, many agents feel the need to also share the statistic since they believe it is a statistic that people are looking for.
The Main Issue with Price per Square Foot
The main problem with price per square foot is not with the calculation itself, but rather with the way that the calculation is used to compare properties.
When you break a property down into a price per square foot it is only valid when you are comparing it with other properties that are extremely similar.
However, this is not how it’s commonly used.
Most times when people are quoting price per square foot it is because they are using properties that are significantly different from their subject property and they are using the price per square foot as a comparison metric.
For example, let’s say that a comparable property sold for $250 per square foot but it was 800 sq ft smaller than the subject property. If you use the price per square foot method, you would think that you need to adjust this property to $250 x 800 sqft, right?
This adjustment would most likely be way off!
The price per square foot of a property encompasses everything included in the property such as the land, the foundation, the square footage (both above grade and below grade), and the amenities such as granite countertops, stainless steel appliances, etc.
Simply gaining more square footage of the house may or may not add any additional value of these other categories.
If you used the entire price per square foot as your adjustment you would likely massively overestimate the value of that additional square footage.
Depending on whether the comparable is larger or smaller than your property you could end up grossly over or under valuing the comp, and therefore over or under pricing your property.
In reality, the only time price per square foot can be used, without it being potentially misleading, is if you are comparing two extremely similar homes.
For example, if you have two properties that are in the same neighborhood, with extremely similar lots and views, and are the same floor plan, but one has upgrades more similar to your subject property and the other features less upgrades, you could use the price per square foot difference to estimate the approximate value of those upgrades, and then apply it to other comparables that also lack those upgrades.
However, in this case the price per square foot isn’t even needed. You could just use the additional value as a percent of sale price to determine the value increase for those amenities instead.
Using the price per square foot in this case wouldn’t be misleading, but it is most likely an unnecessary step.
The Better Way to Use Price per Square Foot
Now that we’ve covered all the reasons that the standard methodology of using price per square foot is invalid, or needed, let’s talk about how you can use it successfully.
While we still believe there is a place for price per square foot, there are some additional calculations that need to be done before you can make your adjustments.
Break the price per square foot down further
As we mentioned above, the biggest problem with price per square foot is that it encompasses every aspect of the property, but is generally only used to adjust for size differences.
To truly determine the value we need for square footage adjustments, we need to break the price per square foot down further.
We recommend breaking it into the following six categories:
- Unfinished basement/foundation
- Finished basement
- Above grade square footage
- Miscellaneous amenities
Breaking it down this way also helps you use the value associated with each of these categories to better estimate the value of the land, the garage, and the amenities.
Every market, and even individual properties within each market, will be different so the value to assign to each of these six categories will vary, but in this post we break down each category and some guidelines on how to estimate the contributory percentage to use for it.
Use the Market Price Per Square Foot
Any time you calculate the price per square foot on a single property there is the potential that the property itself is an outlier for some reason and therefore the price per square foot can be affected by the outlying factors.
By breaking down the price per square foot for the market, rather than just for a single property, and using the average or median price per square foot, you will have a lot more support for your adjustment as many of the outliers will be smoothed out by all the data.
How do you do this?
Step 1: Calculate the price per square foot for each comp in your market (Sale Price/Total Square Footage)
Step 2: Find the median or the average of the data
Step 3: Break the resulting price per square foot down into the six categories mentioned above
You can easily do this in Excel or in a tool like Comp Adjuster.
The resulting value will be more supportable for the entire market area, which makes it easier to apply to all your comparables. Additional adjustments can be made for time, location, quality, and condition to help bring superior properties down and inferior properties up in value if needed.
If you have ever used the price per square foot to estimate the value of a property, you aren’t alone. Lots of people use this method.
But just because everyone else uses it, doesn’t mean you should too.
The fact is, it’s not a good method!
Hopefully the information we covered in this post will help you take the smarter approach moving forward so that you can have a better view of value, and have a more supportable method to back it up!