When you become a real estate investor (or any kind of asset investor, for that matter), understanding calculations, data and information allow you to understand asset performance. This is especially important when it comes to buying and selling those assets.
One important piece of information needed is the fair market value (FMV) of an investment, especially that of real property. Knowing the FMV – and the steps in calculating it – are important when either acquiring an asset, or disposing of it.
What it Is
Google the term “fair market value” and approximately 1.5 billion results will pop up. Delving into Cornell Law School’s Legal Information Institute’s Wex (legal dictionary and encyclopedia), fair market value, or FMV, is
“ . . the value of property as determined by the marketplace (or objective purchasers) rather than as determined by a subjective individual. This is what an informed and unpressured buyer would pay to an informed, unpressured seller in an arm’s length transaction . . .”
In other words:
- If you’re selling investment real estate at an asking price of $2.3 million because it seems like a good price, that IS NOT the fair market value.
- If real estate assets in your neighborhood similar to yours trade for $2.3 million, that IS the fair market value.
Why It’s Important
Cornell’s Wex points out that the FMV can be found in regulations, like those listed in the Internal Revenue Code or bankruptcy law. In fact, the IRS goes into a lot of detail about FMV, property valuation, and all kinds of rulings as it pertains to the fair market value of various assets. And for those who are filing for bankruptcy, the FMV is important because it is a “standard of value” when it comes to such cases, especially involving instances of fraud. This tool is also used when it comes to divorces or eminent domain issues.
But assuming you’re not headed to the courts to figure things out, understanding your real estate’s FMV is important for the following reasons.
Have your property taxes gone up in recent years? While it might be tempting to scream at your city, town, or county assessor, the reason for the increase is likely that the property’s fair market value has gone up. These government agencies assess taxes based on the market approach (involving supply and demand), with a focus on how much money trades hands when similar properties in your neighborhood are bought or sold.
FMV also has an impact on property insurance, especially in the event of damage. Basically, in determining the per-month premium you pay, your friendly insurance agent will figure out the property’s FMV, as well as home liabilities and other factors. Then, in the case of property damage due to a natural disaster or “act of God,” you’ll be recompensed for the property’s actual value.
Acquisition and Disposition
Finally, by knowing your FMV, you determine a realistic price when it’s time to buy or sell. If you’re thinking about investing in an asset, it’s a good idea to understand both the market value and asking price, to be sure you aren’t being ripped off. And when it comes to selling, you have a better idea of a realistic asking price by taking a look at your asset’s fair market value.
How It’s Calculated
There are generally two methods used when figuring out a real asset’s FMV:
- Area comps. Fair market value can be highly dependent on what similar properties in your neighborhood are buying or selling for. These comps are what commercial real estate brokers and residential Realtors examine when helping you price your asset for sale (or advise you when buying).
- Expert appraisals. Property appraisers are highly skilled in determining the fair market value of real property, mainly based on size, age, location, property type, and construction type. And by the way, the assessor will also compare your asset to others in your neighborhood, using the market approach.
If you’re figuring out FMV for other investments (such as stocks), this can be determined through ratios, such as earnings per share, market value per share, and price-earnings ratios.
What You Need to Know
While you might not have to specifically calculate your asset’s specific fair market value, it’s still an important number to know. The FMV will govern many decisions you make when it comes to your financial strategy. It helps you determine whether to challenge a tax increase, how much to price an asset you’re selling, or the overall value of your investment portfolio. Along with other metrics you examine as the basis of your investment decisions, be sure to ensure that fair market value is on that list.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice, meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.