Is Price Per Square Foot the Best Way to Value a Home?
How Do You Determine the Value of a Home?
Home buyers and sellers face a real challenge when attempting to place a value on a home. There is not one exact perfect value for home because so many factors contribute to value. For one, buyers and sellers both will filter value through their personal tastes and wants and needs, and this can cause wide swings in the value that someone will place on a particular home. In addition, there are many different ways to measure value in a home and therefore convert that to a reasonable price for the home.
You can compare the average sold prices of homes in a neighborhood and you can compare the price per square foot of those homes as well. There are other ways to measure value that include a more in-depth analysis and comparison of homes to calculate replacement costs should you have to recreate the same home using modern materials and values. This type of valuation is one that you will typically find used by home appraisers.
Given the variety of methods used to price a home and the abundance of possible opinions on value for a particular home, I want to focus in on price per square foot as a tool to value a home. Is price per square foot the best way to value a home that you are considering purchasing or selling?
How Do You Calculate Price Per Square Foot?
First, let's define the method for calculating price per square foot to begin our discussion. Price per square foot is calculated by dividing the price of the home by the square footage of the home to come up with a price per square foot number. For example, if the price of the home is $100,000 and it is 1,000 square feet, the price per square foot is $100. You can calculate the price of a home in reverse by multiplying the price per square foot by the square footage of the home to get the price. For example, a 1,000 square foot home with a $100 price per square foot has a price of $100,000.
Right away, there are several issues that are raised by this calculation and they need to be addressed to ensure integrity with the resulting value. There are three numbers involved in these calculations, the price per square foot, the square footage of the home and the price of the home, and each of them are subject to extreme error. For example, what method was used to measure the square footage of the subject home? Was it measured to ANSI standards, or did the homeowner go out and walk off the perimeter to estimate the size? Do you even know which method was used?
Whatever method was used to calculate the square footage of the home, it has to be very accurate and consistent with the method used to measure comparable properties. If it is not, then one of the variables in the price per square foot calculation can be significantly inaccurate.
How can these errors affect the price of the home? Here is an example to see how large the error can become.
If you have a home that was measured by one person to be 1,500 square feet and you use a price per square foot of $150, the price of the home is $225,000. If another person measured the home at 1,550 square feet, then using the $150 price per square foot gives you a price of $232,500 - a difference of $7,500!
If you think that making a 50 square foot error in calculating the total square footage of a home is hard to do, then I suggest running several calculations yourself to see how easy it is to make such a large error. You only need to make a mistake of a few inches here and a few inches there to end up with a significantly different total square footage when talking about an object as large as a house. Even if the error is innocent or a product of differing styles of measurement, using the incorrect total square footage in your calculation can result in many thousands of dollars of difference in price that can work against you when pricing a home.
Which Price Per Square Foot Should You Use?
Another variable to consider in the calculation is the price per square foot itself. Where did this number come from for your calculations? If you looked at comparable sales around the subject home, you can come up with a list of neighborhood prices per square foot. However, all of these numbers will be different and some will vary significantly from each other. How do you know which of these numbers to pick to use in your calculations? Obviously, most home buyers would want to pick the lowest number and most home sellers would want to pick the highest. If you are a buyer and you pick the wrong number, it can cause significant errors in your calculations of price.
Here is another example to show how this type of error can affect pricing.
If you have a home that measures 2,000 square feet and you choose to use the neighborhood average of $125 per square foot, the home price is $250,000. If you were to decide to compare to a home with a price per square foot of $127, then the subject home price becomes $254,000. A $2 change in price per square foot resulted in a price difference of $4,000 in our example! Imagine if you were a buyer and incorrectly chose to use $129 or $132 per square foot, you could end up spending many thousands of dollars more for a home by picking the wrong number.
The final variable is the price of the home itself used to calculate the price per square foot. If you are comparing a subject home to homes that have sold in the area, then you can use the prices of the sold homes to calculate a price per square foot for each. Again, as we have seen above, any errors in the pricing that you use for comparison can greatly affect the value of the subject property in a negative manner.
Here is an example of how this type of error can affect the price of the subject home.
If you have two homes that you are using as comparison properties for pricing that are the same square footage, then any difference in the price of those two homes can change the calculated price per square foot. If one home sold for $175,000 and it is 1,350 square feet, then the price per square foot is $130. If the other home was just a little more desirable to the buyer because they liked the paint colors better and it sold for $178,000 with 1,350 square feet, then the price per square foot of that home is $132.
In this example, a home that sold for a higher price because of a personal decision by a home buyer raised the price per square foot by $2. As we have seen above, such a difference in price per square foot can have a significant affect on pricing for the subject home and that can negatively affect a home buyer.
Should You Use Price Per Square Foot to Value a Home?
So what does all of this mean for valuing a home using price per square foot? In my opinion, it means that you have to be extremely careful when pricing a home using price per square foot because of the inherent possibility for errors in the calculations. An error in measuring the subject home or in the measurement of the comparison homes can lead to a significant change in price per square foot. How can you verify that all of the square footages of all of the comparison homes are correct? I do not believe that you can.
In addition, how do you decide which price per square foot to choose from the list of comparable property sales when deciding on a price for the subject home? Do you guess? Do you just always pick the lowest number, or choose the average number? As we have seen, picking the wrong number with which to make your calculations can have a significant affect on pricing, potentially in a very negative manner for a home buyer.
In fact, I am of the opinion that you should avoid using price per square foot calculations when valuing a home in most situations. I do not think that it is the best way to value a home. It can function as a check and balance against neighborhood comparable sales, but using it as your primary method of computing price can cause you to make a major error in pricing that can equate to thousands of dollars.
I guess you are now wondering what my suggestion is for determining the value and pricing of a home for both home buyers and home sellers. It is going to be the subject of another article, but here are a few hints - I believe that the key to accurate pricing is to compare the actual sale prices, and not the price per square foot, of homes of similar sizes, styles, finishes, location, etc.
You have to consider both buyer and seller motivation and you have to make reasonable allowances for condition. The reason that I believe that this is a better way to price a home from a buyer and seller perspective is because the actual sales price of a home is a factual number. It includes all of the variables within it such as location, condition, desirability, etc. Using a factual number as the basis of your pricing of a home will go a long way towards negating errors in pricing that can cost you a significant amount of money.
I hope that you have found this article thought-provoking and educational. This is of course a topic open for debate and I would love to get your feedback. Thanks for reading and be on the lookout for the next article on pricing.
About the Author: Joe Hayden is the Team Owner and Manager of the Joe Hayden Real Estate Team - Your Louisville Real Estate Experts!