Price Per Square Foot – The Most Overrated Metric in Valuing Residential Real Estate
There are a lot of misleading metrics in real estate, but the most misused or irrelevant one that is so commonly referred to when attempting to value a property is price per square foot. Price/sf is only useful in valuation when comparing properties that are apples to apples or when evaluating a large sample size against another large sample size. Looking at a single property and evaluating based on price/sf can and normally does lead to incorrect or misleading conclusions and there are several reasons why.
In commercial real estate, price/sf is typically more relevant than in residential. You pay a price to lease or buy a certain size space to use as a business with very little emotion. Prices/sf will vary within an area for different classes of property, but space can generally be divided and rented/sold to different tenants/owners, which reduces any advantage economies of scale might give. In residential real estate, economies of scale are extremely important. With all things being equal, a 2,000 square foot property is almost always going to have a lower price/sf than a 1,000 square foot property. It will invariably have one kitchen and other expensive set of infrastructure that would reduce the marginal cost when applied to a larger property. Additionally, as the purchase price increases, the number of potential buyers decreases, so normally buyers in a higher price range will have less competition and typically be able to obtain a better relative value.
High land value is another major reason why using price/sf as a valuation metric can be irrelevant or down right laughable. If a small house in a location with high land value sells for a high price/sf, is the price/sf really because of the house? Of course not. How much would the lot have sold for if the house was not there? This leads to extremely misleading figures for certain houses. In condos, where land values matter less, there are fewer anomalies such as this.
While condos are less prone to dramatic and misleading land value price/sf skews, there are many features that attract or repel buyers, resulting in large price differences, that are not related to the square footage itself. Taking land value out of the equation, this is also true for houses. High ceilings are a big one. These are almost universally appealing to buyers and increase volume, but the square footage remains unchanged. Same with views, outdoor space, usable floor plan and specific upgrades and other unique features that increase demand without increasing square footage. On the other hand, there are plenty of large condos and houses with unattractive features, poor layouts, and a lack of natural light that a buyer might not want to live in, thereby reducing the price/sf.
Educating buyers and sellers on price/sf is one of my most frequent jobs. Many online valuation models are strongly based on price/sf, so rebutting this misconception can be challenging. The same is true with appraisers who may use comps with similar price/sf, but different features, undervaluing the emotional appeal or uniqueness of property that has a higher value to buyers and thus a higher price tag. The truth behind the lack of nuance in putting too much emphasis on price/sf (in most circumstances) demonstrates that valuing and selling real estate can be more of an art than a science.