Why Larger Homes Sell for Less per Square Foot

In the popular understanding of Bay Area real estate valuation, the concept of price per square foot plays an outsize role in the public’s perception of value. But its interpretation and application are often replete with misconceptions and misinterpretations. If you want to really understand why larger homes sell less per square foot, read this article and you will learn the whole story of why this is true in the Bay Area – and coast to coast.

The Square Foot Pricing Puzzle

Before delving into the depths of square foot pricing, it’s crucial to comprehend what it represents. The price per square foot is a common measure in the Bay Area real estate market used to compare the value of different (but perhaps otherwise similar) properties. However, its application is far from straightforward and often leads to skewed perceptions about property value. In fact, the square footage of a home is only one of a number of factors that appraisers use to value properties – and it is far from the most important.

Prices per Square Foot are Not Linear

A common error lies in the simplification of the price per square foot equation. It’s often misconstrued that a larger property will naturally fetch a linearly higher price. However, the reality is far from this misapprehension. A larger home does not usually equate to the same price per-square-foot as an otherwise comparable but smaller home.  In fact, in many cases, homes with a larger square footage sell for significantly less on a per-square-foot basis than “average” sized homes in the Bay Area real estate market.  That’s because the law of diminishing returns will dictate how much you’ll be able to get for the additional square footage.

Factors that Truly Drive Bay Area Home Prices

A prevalent misconception is the belief in a uniform price per square foot across a neighborhood. However, real estate markets are dynamic, and property prices can vary widely even within the same locality. Factors such as specific location, property condition, upgrade quality, floor plan, views, economic obsolescence, and lot size, among others, will in all cases significantly influence the price per square foot of any property.

Your Neighbor Sold their House too Cheap!

The Paradox of Larger Homes: Decreasing Value per Square Foot

An intriguing aspect of the price per square foot calculation is the apparent paradox that emerges with larger properties. Perhaps surprisingly to some, as the size of a property increases, the price per square foot tends to decrease. This decrease is a classic example of the law of diminishing returns or economy of scale. When you’re building a house – or adding on to an existing house – the first square foot is the most expensive.  Building a 100 square foot house would be almost the exact same coast as building a 110 square foot house; a 1,100 square foot house costs nearly the same to build as a 1,000 square foot house.

Here are a number of other reasons why and how the price per square foot decreases as the total square footage increases:

Small, High Cost Rooms

There are some components of a house that are really expensive and have a higher price-per-square-foot than most other parts of the house.  Notably, the kitchen and bathrooms are the most expensive rooms in the house, but typically occupy a small percentage of the overall square footage.  These expensive rooms boost the average price per square foot of a home considerably – but as the home increases in size, the percentage of the home which these rooms occupy decreases, which further lowers the cost per square foot of the house.

Second Stories Cost Less

Second stories are substantially less expensive to build than first stories.  The foundation is one of the most expensive components of your home, and adding on a second story does not materially impact the cost of the foundation.  At the same time, the roof and roof framing is also expensive, but this does not increase either by adding a second story.

Adding a second story will require an expensive staircase, and some additional framing in the first story to support the second story’s weight.  Numbers vary considerably depending on the design, materials, and labor costs but a good rule of thumb is that the second floor will cost about 20% less per square foot to build than the first floor.

The Land-Structure Value Ratio

Understanding the decline in value per square foot with larger properties requires a comprehension of the land-structure value ratio. A property’s value is the sum of the land value and the structure value. When a structure is enlarged, the land value remains fixed, resulting in a slower rate of value increase for the property compared to the rate of size increase. Consequently, the price per square foot must decrease as size increases.

In the Bay Area, at least 50% of the price that you pay for any house is the value of the land that it sits on – for some properties, it is as high as 60% or 70% of the total value of the property.  This is a really important to understand when considering the “price per square foot” of any home.

What the Studies Show

Empirical evidence demonstrates that as property size increases, the price per square foot often decreases. This inverse relationship is observed across various real estate markets and is supported by various studies:

• Cost to Build a House Study: Research indicates that as the size of a house increases, the cost per square foot decreases. This is because certain fixed costs, such as land development and foundational work, are spread over a larger square footage, reducing the average cost per unit area.
• Value vs. Size Analysis: A study published in the “Right of Way” magazine found a downward-sloping curvilinear relationship between property size and value per square foot. As the size of a property increases, the value per square foot tends to decrease, and vice versa.

These findings highlight the limitations of using price per square foot as the sole metric for property valuation. While it can provide a general sense of value, it’s essential to consider other factors such as location, amenities, and overall design to gain a comprehensive understanding of a property’s worth.

For Best Results

The Principal of Regression

The principle of regression in real estate refers to the tendency of the price per square foot of larger-than-average homes to be lower than that of smaller or average-sized homes in the same neighborhood. Larger homes often appeal to a smaller buyer pool due to their higher overall cost, and the incremental value of added space decreases.  Thus, while the total price of a larger home is generally higher, the cost per square foot will not usually scale up linearly, leading to a lower price per square foot compared to smaller homes. This principle is important for understanding market dynamics, especially in areas like the Bay Area and Silicon Valley where property values and buyer preferences can vary widely.

The Cost of Updating a Larger Home

Older, larger homes often face challenges in commanding a high price per square foot, primarily due to the increased costs associated with updating and maintaining them. These homes, while spacious and potentially rich in character, often require significant investment to bring them up to modern standards, both in terms of aesthetics and functionality.

For instance, updating an older, larger home may involve extensive electrical, plumbing, and structural work, which can be disproportionately expensive compared to smaller homes. Additionally, the cost of modernizing finishes, fixtures, and appliances in a larger space adds up quickly.

Buyers considering these properties are likely to factor in these potential renovation costs, which will usually lead them to offer a much lower price per square foot compared to smaller, more recently updated homes. This is particularly relevant in areas like the Bay Area and Silicon Valley, where the real estate market is competitive and buyer expectations are high.

How Appraisers Adjust for Price per Square Foot in the Bay Area

Many homeowners use the size of their home versus the size of recently sold, smaller properties in the neighborhood to claim that their homes must be worth substantially more than these recent, smaller, but otherwise comparable sales.  To better understand the way that appraisers look at this question, it is helpful to examine the sales comparison grid that appraisers use when determining fair market value for a home.  An example of the sales comparison grid is below:

Appraisal Adjustments URAR Form 1004

In this appraisal, the subject property is 1,264 square feet, and in the upper left corner of the grid you can see that the appraiser notes the sale price per gross square foot of living area is $703.13. The price-per-square-foot of the comparables is $703.70, $577.70, and $714.29 respectively.

Here are the comparable properties their difference in square footage, the total adjustment made for that square footage, and the total price per square foot of each adjustment:

• Comparable 1:  Difference in Square Footage: 86 / Total Adjustment: $10,500 / Adjusted Price per Sq. Ft. : $122.09
• Comparable 2:  Difference in Square Footage: 216 / Total Adjustment: $26,000 / Adjusted Price per Sq. Ft. : $120.37
• Comparable 2:  Difference in Square Footage: 144 / Total Adjustment: $17,500 / Adjusted Price per Sq. Ft. : $121.52

As you can see, the average adjustment made per square foot in this example is nowhere near the average price per square foot of either the subject property or the comparables.  The average price per square foot of the comparables is $665, but the average price per square foot of the adjustments is only about $121 – or only about 18% of the price per square foot for the property as a whole.  That is far less than most homeowners expect their “extra” square footage may be worth.

The Art of Pricing: Beyond Square Footage

Given the complexities and paradoxes surrounding square foot pricing, it’s essential to adopt a holistic approach when valuing properties.

The “Apples to Apples” Approach

Instead of using the price per square foot as the primary determinant of property value, it’s advisable to adopt an “apples to apples” approach. This method involves comparing similar properties based on size, location, condition, and other relevant factors. It allows for a more accurate and realistic valuation of a property.  This is also called the “sales comparison” approach to home appraisal, and is the most common method of appraisal in the Bay Area.

The Importance of Trends

While average or median per-square-foot costs may not provide an accurate measure of a property’s value, they can offer valuable insights into overall market trends. By comparing the average price per square foot over time, we can discern whether property values are rising or falling.

I find that looking at the average price per square foot of zip codes, for example, is more useful than looking at the average sale price in a zip code.  It’s even better to track the average price per square foot for homes in zip code within a certain square footage range (e.g. 1,500-2,000 square foot homes) on similar sized lots.  By looking at the data this way, the rise or fall of average price per square foot can be instructive to spot home value trends in a given area.

The Bottom Line

In the intricate world of Bay Area real estate, the price per square foot serves as a helpful tool but not a definitive guide. It’s a metric that demands careful interpretation and cautious application. Understanding its limitations and fallacies can help property buyers, sellers, and appraisers navigate the real estate market more effectively and make informed decisions.

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