I think you always need to be careful to avoid overbuilding for your neighborhood, at least from an investment perpective. People have always done it though and I’m sure they always will. Some will regret it, some couldn’t be happier.

“Is this the type of market that you would recommend adding on to your home?”
As sdcellar inferred it depends on your reasoning. Maybe grandma is coming to live with the family, something like that? If they are doing it themselves it doesn’t cost much compared to buying a bigger house some other place.
Obviously in economic terms it makes more sense to buy the worst house in the best neighborhood during a favorable time in the market cycle and bring it up.

It’s been my experience that the additional value that’s attributable to the extra living area is virtually never equal to the cost of building that area.

There can be some extenuating circumstances that would economically justify a room addition. For instance, if you have a great loan on the property and don’t want to reset the clock with a new loan on a new property; or if you or your family can do the consturction yourselves; of if you have a personal attachment to that location and can’t necessarily find the larger house in that neighborhood; etc., etc.

Other than that, if you need the larger house you’re usually better off going and buying it. For one thing, adding second floor additions to a structure that was designed and engineered as a 1-story structure can cause problems. Extending outward on a ground floor eats up usable lot area, which can be a problem on the smaller subdivision lots. If you add too much living area relative to the other properties in your neighborhood you’re getting into an overimprovement situation. The value of those projects never comes close to their costs – we’re talking $.25 on the dollar in many cases.

Also, a lot of room addition and remodeling projects turn out nice but do so at the expense of the marriage. I’ve seen a lot of couples get divorced because of the additional stress it places on a relationship to live in a construction zone or incur cost overruns. The reliability and honesty of these home improvement contractors is variable and you are usually rolling the dice when dealing with someone you don’t know well.

Without those connections I wouldn’t even consider it.