Ryan Lundquist of Sacramento Appraisal Group wrote a great post explaining economies of scale and how we run into instances all the time in our lives of something small costing more than a larger amount of the same thing. The Starbucks coffee analogy he employs is such a great illustration and I highly recommend checking his article out here (http://sacramentoappraisalblog.com/2016/04/18/starbucks-cups-and-price-per-sq-ft/)
The surprising thing Ryan pointed out, though, is that we often ignore these economies of scale when we make assumptions about the price per square foot of residential property. You might automatically think that a larger house costs more per square foot than a smaller one. As it turns out, when Ryan analyzed the Sacramento County (California) residential market he found that “the larger the house, the less you tend to pay for each square foot.” That’s a very interesting observation but I wanted to add a few of my thoughts on the nuances that can complicate this explanation of economies of scale and the law of diminishing returns.
Three key points:
- Ryan’s illustration assumes you are comparing two homes of equal quality. In our Chicago market (as well as many others), the larger homes tend to have higher-end finishes and therefore, higher construction costs. You wouldn’t want to compare a 4500 sq ft newly-constructed home to a basic 1950’s 1200 sq ft ranch or that ranch to a 2000 sq ft 1930’s English Tudor style home with architecturally significant details. Those are not the same apples! To see the true relationship of cost per square feet from property to property, the properties should be a similar to each other as possible (location, quality, lot size, functional utility, etc).
- Also, we must consider the Fixed costs. For example, let’s say we are comparing two new construction homes in the same development in the suburbs (this is based on actual numbers). Both are of similar quality and style, with 4 bedrooms and 2.1 baths. One model is 2500 sq ft and is selling for $250,000 ($100 per sf) and the other is 3100 sq ft and is selling for $275,000. The construction costs for both of these homes include certain fixed costs. Each has one kitchen, 2.1 baths, one HVAC system, etc. The additional 500 sf most likely is attributed to larger rooms, maybe a larger kitchen, larger master bath, a living room and family room both. After those first 2500 sq ft are built out and the fixed components are in, the price for the additional square footage costs less to build. In this case each additional sf over the 2500 is priced/valued at $41 per sf. ($275,000 – $250,000 = $25,000. Then take $25,000 / 600 sf = $41/sf). This is significantly less than the $100/sf the 2500 sf home is selling for. If we applied the $100/sf to try to value the 3100 sf home, we would think it is worth $310,000, when it is actually being sold for $275,000.
- What else is included in price per sf? Land! That itself may be just as important as the improvements when considering price per sf. When I take the sales price of a home and divide it by the gross living area (GLA), the resulting price per square foot isn’t solely attributed to the property itself but also to the site it sits on (which in many cases can be over 30% of the property’s value). But the value of the lot is not all: the price per square foot also includes the condition, quality, beneficial location (across from a park, golf course, walking distance to restaurants or train stops) or adverse location (busy street, adjacent to commercial buildings, etc). All which basically brings us back to point #1.
That’s what can make appraising so challenging and interesting! Rarely am I presented with a bushel of organic Gala apples to chose my comps from, all the same size and perfectly speckled. Nope! Sometimes there are tart Granny Smiths and sweet, small Red Delicious apples in the mix. It’s my job, as an appraiser, to consider the hard facts and attempt to measure market reaction to the subjective attributes of each when arriving at an opinion of value (and also to make sure I’m not throwing an orange or banana in the comparison mix). Price per square foot can sometimes be a good indicator or at least a piece of the market value puzzle, but will usually not tell the whole story.
Tom Horn also has a great take on some of these same issues regarding agent’s pricing properties based only on Price Per Square Foot (http://birminghamappraisalblog.com/appraisal/price-per-square-foot-agents-worst-enemy-pricing-home/)