How Agents Can Use The Law of Diminishing Return When Pricing a Listing
As a real estate appraiser with over 30 years of experience, I have witnessed firsthand the critical role that accurate pricing plays in the success of real estate transactions. Pricing a property correctly from the outset is crucial for attracting potential buyers and maximizing the seller’s return on investment. In this blog post, we will delve into the concept of the Law of Diminishing Returns and explore how real estate agents can utilize this knowledge to effectively price their listings.
Understanding the Law of Diminishing Returns
The Law of Diminishing Returns is an economic principle that states that as one input or factor of production is increased, while all other inputs remain constant, the resulting output will eventually decrease, thus resulting in diminishing returns. In the context of real estate, this principle suggests that there is a point at which additional square footage will not add the same amount of value per square foot as it does in smaller homes.
This is important to remember when pricing a home because you cannot take the price per square foot of only smaller homes and apply it to a larger home to arrive at an estimated value or list price.
Factors Influencing Diminishing Returns in Real Estate
Property Size:
One of the key factors affecting diminishing returns is property size. While larger homes often command higher prices, there is a limit to how much value additional square footage adds. As the property size increases, the incremental increase in value tends to diminish. For instance, a 2,000-square-foot home may be more valuable than a 1,500-square-foot home, but the difference in value between a 3,000-square-foot home and a 2,500-square-foot home may be relatively small.
Upgrades and Renovations:
Improvements made to a property can increase its value, but there is a point at which further upgrades result in diminishing returns. For example, upgrading a kitchen with modern appliances and high-end finishes may significantly increase its value. However, adding additional expensive features beyond what the market demands may not yield a proportional increase in value.
Neighborhood:
The neighborhood in which a property is located plays a crucial role in determining its value. While upgrading a property to match the standard of a neighborhood can boost its value, over-improving a property may result in diminishing returns. Buyers are often reluctant to pay a premium for features that significantly exceed the norm in their area.
Applying the Law of Diminishing Returns in Pricing
Real estate agents can leverage the Law of Diminishing Returns to accurately price their listings by considering the following strategies:
Comparative Market Analysis (CMA):
Performing a thorough CMA is essential in understanding the local market dynamics and pricing trends. Analyzing recent sales of comparable properties, taking into account their size, upgrades, and location, will help identify the upper limit of value. By comparing the prices of recently sold properties with similar characteristics, agents can determine the point at which additional features or upgrades yield diminishing returns.
Market Research:
Conducting comprehensive market research is vital for staying informed about current trends and buyer preferences in a specific area. Understanding the buyer’s mindset and their willingness to pay for certain features or amenities will help agents gauge the potential impact of specific improvements on a property’s value. Agents should focus on features that align with market demands to ensure that improvements contribute to value rather than lead to diminishing returns.
Consult with Appraisers:
Collaborating with experienced real estate appraisers can provide invaluable insights into the factors influencing value in a given market. Appraisers possess the expertise to analyze the impact of various features and upgrades on property value. Engaging with appraisers during the listing process can help agents make informed decisions regarding pricing, avoiding overpricing due to over-improvement.
Seller Education:
Real estate agents play a crucial role in educating sellers about the Law of Diminishing Returns and its implications for pricing. It is important to help sellers understand that excessive improvements or upgrades may not yield a commensurate increase in value. Educating sellers about the market dynamics and providing data-driven insights will help manage their expectations and set realistic pricing goals.
Elaborating on Pricing by Comparing Homes of Similar Sizes
When it comes to pricing a home, comparing it to other similar-sized homes in the market is a fundamental aspect of the pricing and appraisal process. It allows real estate agents to gauge the value of a property by considering factors such as square footage, features, location, and other physical attributes. One critical observation that arises from comparing properties is the concept that smaller homes tend to sell for more per square foot, while larger homes sell for less per square foot, all else being equal. This insight highlights the importance of using the bracketing method and including both larger and smaller comparables in the pricing process.
The Importance of the Bracketing Method:
To accurately price a home, it is crucial to utilize the bracketing method, which involves selecting comparable properties that encompass a range of sizes, including both larger and smaller homes. By doing so, real estate agents can gain a comprehensive understanding of the market’s response to various sizes and accurately assess a property’s value within that context.
Using smaller homes as comparables for a larger property can help identify the premium buyers are willing to pay for additional square footage and features. Conversely, comparing a larger home to smaller properties can provide insights into the diminishing returns associated with size. By analyzing the range of prices per square foot for properties of varying sizes, real estate agents can establish a more accurate pricing range for the subject property.
Conclusion
Accurately pricing a property is a delicate balance that requires a comprehensive understanding of the Law of Diminishing Returns. By recognizing the factors that influence diminishing returns in real estate, such as property size, upgrades, and neighborhood, real estate agents can make informed pricing decisions that align with market demands. Utilizing comparative market analysis, conducting market research, consulting with appraisers, and educating sellers are essential strategies that empower agents to accurately price their listings.
In the process of pricing a home, comparing it to other similar-sized properties is essential. Real estate agents must be aware of the trend where smaller homes tend to sell for more per square foot, while larger homes sell for less per square foot, all else being equal. Understanding this dynamic helps agents accurately assess a property’s value in relation to its size and the market demand for that particular area. By utilizing the bracketing method and including both larger and smaller comparables, agents can gain a deeper understanding of the market’s response to size, ultimately facilitating a more accurate pricing strategy for their clients.
If you have any questions regarding pricing, including the bracketing method, feel free to contact me. As always, thanks for reading.
Bingo. This is such an important thing to grasp. We can get into quick valuation trouble when we hijack a price per sq ft from a dissimilar house that is much different in size. Ironically, I find abusing PSF often leads to a higher value, and it’s rare to see someone come up with a lower value….
Very good point, Ryan. Seems most people only use the price per square foot that is beneficial to them and provides the highest value indication for their home. I guess it could go the other way if the situation was a divorce case and the person wanted the value to be as low as possible to buy out their partner.