Why Price-Per-Square-Foot Gets Investors Into Trouble?

One thing that confuses new and seasoned investors is taking the price-per-square-foot approach to determining the value. What does this mean? Let’s take a look at the following comps and analyze them:

• House #1 has 1500 square feet and sold for $145,000 or $96.67/square foot
• House #2 has 1800 square feet and sold for $150,000 or $83.33/square foot
• House #3 has 1600 square feet and sold for $147,000 or $91.88/square foot
• The subject property has 2200 square feet so the ARV should be $199,381, correct?

This is absolutely not correct! How did this happen? This happened because the investor took the selling price and divided it by the gross living area. So in this example, they took the three price-per-square-foot values above and added them together to get $271.88. Then they divided that number by three to get $90.63, which is the average price-per-square-foot of the three comps. When you multiply $90.63 times 2200 you get $199,381. Mathematically, this seems to make sense; however, this is one of the biggest mistakes you can make, and sadly, it happens all the time.

The reason you don’t want to do this is the methodology is flawed. According to Ohio appraiser Mike Armentrout who wrote an article titled “The Reality of Price Per Square Foot”:

“The primary fault with $/SF is that it encompasses every feature of the property and not just gross living area. Only calculating the relationship between size and sales price ignores all the considerations a potential buyer may make. If we were comparing two properties that were identical with the exception of size, then it is rational that the larger of the two may sell for more and thus the $/SF could be an accurate indicator. On the other hand, if we had two identical homes in terms of size but one had a larger wooded lot and sold for more, the equation would not be as reliable. As properties have more dissimilar amenities and features, the less reliable it becomes a function of indicating value. This is simply because other factors are not directly related to the gross living area.” 

I couldn’t agree more with this quote. Also, given a specific market, higher square footage homes generally sell for a lower $/sqft and lower square footage homes sell for a higher $/sqft. Ask yourself the following question: would you pay 33% more (or $50,000 more in the above example) to get 400 additional square feet of living space? Of course, you wouldn’t. Neither would a market buyer. In fact, if there were a buyer like this for some crazy reason, the property would not appraise as the buyer might expect, because there is probably no justification for value this high.

Keep these things in mind when you are evaluating a property. If you need help, just contact us and we will guide you through it. For more detailed information about determining the ARV of a house, read my blog The 12 Steps to Determining the ARV.  And don’t forget oddities like garage conversions! Check out this blog here to determine how they can affect the ARV.