December 10, 2020
In real estate, there are many different terms you’re likely to run into which you may know off the top of your head. A great example of this is the myriad of ways to communicate the value of a property. Each one has its own context and use that varies from the others.
Let’s take a closer look at one specific type of valuation, fair market value.
What Is Fair Market Value?
According the U.S. Supreme Court ruling in United States vs Cartwright, fair market value is defined as follows:
“The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”
Fair market value is not the same as market value or appraised value. Instead, it’s the value a property would have if a willing buyer wanted to purchase it at a particular moment from a willing seller. A few conditions apply that, namely:
- Neither the buyer nor the seller are pressured to go through with the purchase
- All parties involved are acting in their own interests
- Both buyer and seller know all the facts about the property (nothing is hidden or withheld)
- Time is not a factor in the transaction
- It is operating as an arms-length transaction between unfamiliar people
Obviously, this is not a very realistic scenario. But the purpose of fair market value has less to do with making a realistic sale and more to do with coming up with a definite value for a property. It all comes down to how fair market value is typically used.
When Is Fair Market Used?
The main context where fair market value is used is in legal issues. This covers a broad range of legal processes, including:
- Estate Management
- Insurance Applications & Claims
- Eminent Domain & Related Real Estate Claims
- Taxation by Any Local or Federal Government Body
In all of these legal processes, the actual value of the property is necessary. For example, in a divorce the property value is needed to keep the separation of assets balanced. With insurance matters, property values affect the type of insurance needed and also how much is paid out for a claim. When eminent domain issues come up, proper valuation is needed to ensure the owner gets what they are due.
Fair market value is almost never used as the true sale value when you’re buying or selling a property on your own. There are far more variations in a real market transaction that can change the perceived value of a property and impact the sale in some way.
The purpose of fair market value in legal processes is to provide and unbiased, third-party valuation of a property. That valuation is then taken and used to calculate taxes, insurance claims, divorce settlements, etc.
You can use fair market values for personal or investment use as well. It may help you settle on a good sale price for your home, or you can use it as a factor in negotiating a price for an investment property. It’s not the only number to consider in these cases, but it can be one more useful piece.
How Fair Market Value Is Calculated
For properties, there are usually three ways to get the fair market value. These are:
- Professional Assessment—Third-party property assessment experts are common in CRE deals.
- Comparable Sales—Realtors, brokers, and market analysts can often develop a reasonable fair market value based on sales of similar properties in the local market.
- Automated Valuation Models—Automated systems use pre-programmed algorithms connected to large real estate databases (think Zillow or Realtor.com). This is often the least reliable way of getting a fair market value estimate.
Understanding fair market value is useful when you own or intend to own real estate of any kind. Even if you don’t learn how to calculate it on your own, you should develop some familiarity with it, especially if you to invest in real estate.
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