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

by | Feb 13, 2019 | Blog

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.

The Real Value of an Appraisal

by | Feb 22, 2017 | Blog

 

Appraisals eliminate the guesswork in determining the market value and actually lower your risk before you purchase. In addition to providing you with the after repair value of your property, an appraisal will show you photos of the comps, location of the comps, and how the appraiser arrived at the final number.

The challenge is appraisals can take time to get, and if you are in a competitive situation and need to close quickly (like a week or less), you or your lender will need to find someone who can meet the timeframe.

Three Key Things a Good Appraiser Does

Determines Actual Square Footage

In Texas, most of the county appraisal districts list the square footage of each property on their website, so investors look up the property online and treat that data as fact. Unfortunately, over 25% of tax records are wrong on square footage (some very slightly and some more severely)! Many investors rely on this data too much and end up getting burned.

Recently one of our hard money clients purchased a property where the online county tax roll records said the house was 1800 square feet. When our appraiser measured it, the actual square footage was 1350 square feet, which, as you might imagine, had a tremendous negative impact on the value. The good news is our client was able to renegotiate the purchase price and get it lowered to offset the difference. But if they hadn’t had it measured, they would have overpaid and lost money in the deal! 

The first thing an appraiser does when they get to the property is to measure it. If your lender doesn’t require an appraisal, you may need to order the one yourself, or find another lender who will.

Drives the Sold Comps and Analyzes the Competition

Appraisers will normally drive by the sold comps they are using for the appraisal to see how they physically compare to the subject. Looking online is the starting point. After that, it’s seeing how they look in person that can take on a whole new meaning. Things like the layout of the lot, location on the street, property amenities not seen or discoverable online can all be taken into consideration.

If you are going to be flipping the property, you may want your appraiser to help you analyze the competition (those are the active properties on the market right now) both now and when you get ready to sell the property. Why do this? It’s good to know how many actives versus sold properties there are. This ratio tells you the health of that particular market. For example, if there are five actives and one sold in the last six months, that probably indicates that the market is not very strong in your area and you may want to reconsider this as a flip. If the numbers are reversed and there are five sold properties and one active, that market is probably very strong and you should not have any issue selling it. 

Looks for Obsolescence and External Influences

Things like walking through one bedroom to get to another bedroom, or not enough bathrooms for the number of bedrooms in a house, can create functional obsolescence that otherwise might not be seen or understood by a new investor. External influences such as the property backing to large power lines, commercial/industrial property, a drainage ditch, or other negative influence, can impact the value significantly. A good appraiser is going to catch these things, make the appropriate adjustments to value, and note them in the appraisal.

A while back a friend of mine came to me with a house I told him not to buy. It sided to a busy, four-way through the street, and backed to a power transformer that was the size of a two-car garage, both of which could be seen online. Despite these issues, he insisted the ARV was in line with the rest of the comps in the neighborhood that were not exposed to these influences. I politely disagreed and tried to explain to him that he should absolutely order an appraisal to confirm the value, even though he was paying cash for this deal and not getting a loan. Rejecting that idea, he closed on the purchase and called several months later to tell me he still owned it. He was willing to take a loss and wanted to know if any of our clients would want to buy it as a rental. This is a situation that could have been totally avoided had he ordered an appraisal.

The Bottom Line

As you can see in the stories above, you expose yourself to greater risk when you do not get an appraisal. If your hard money lender is just relying on comps, you might think twice about what I just discussed so you don’t get overexposed in a deal and end up losing money.