We are doing a haunt this year in just over 1000 square feet. I think it is possible to go small, and while there are quite a few disadvantages, there are some advantages as well.
The obvious disadvantage is that you will be quite limited on the number of rooms that you will be able to produce. If people pay $15 to walk through a very small haunt in about two minutes, they are probably going to feel ripped off, even if everything in it is high quality and the scares are awesome. So, you have two options. First, lower your price. Secondly, create a show that requires people to spend some time in each room. A theatrical, story-telling type haunt can easily keep people in each room for several minutes. The problem becomes that to make a successful show, you will probably have to do both. That means not only a lower price per person, but a lower throughput as well.
On the plus side, it takes less money to build and requires a much lower number of actors each night. It can be done, but only you can determine if you can make the economics of it work.
Lords of Chaos, LLC
House of Chaos Haunted Attraction