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 an existing home. The value of an existing home is negotiable and buyers and sellers both will filter value through their personal tastes, wants and needs. 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 this popular 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 standard (an industry standard used by some appraisers), did the data come from the PVA or did the homeowner go out and walk off the perimeter to estimate the size? Do you even know which method was used and the inherent errors in each method? It might be surprising to learn that 2 skilled persons measuring a home frequently end up with different results.
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.
Suppose you have two different people measure the same home, one at 1,500 sq.ft. and the other at 1,550 sq.ft. A difference of 50 sq.ft. is not unheard of and in fact I have observed differences much higher than this number - 100, 200, 500, or more, sq.ft. Using a price per square foot of $150, the home measured at 1,500 sq.ft. would be priced at $225,000 and the home measured at 1,550 sq.ft. would be $232,500 - a difference of $7,500! Depending on which side of the transaction you are on, this could be a costly mistake.
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 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 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.
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 a buyer because they liked the paint colors better or they were highly-motivated to buy, 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 use when deciding on a price for the subject home? Do you guess? Do you always pick the lowest number, the highest 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 or seller.
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. To learn more on that topic, read this article on the 5 Factors of Value to Price a Home.
I hope that you have found this post 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!