Whether you’re an investor, a broker, or someone who wants to buy a home for personal use, buying a house is a long process. That means you need to do as much due diligence as possible to ensure that you’re making a sound investment — rather than one that will bleed you dry and leave you worse off than when you started.
That’s why knowing what to look for in a home is essential. Knowing a home’s fair market value is even more critical to ensure you’re not overpaying. So what is the fair market value (FMV) and how do you calculate it?
What is Fair Market Value (FMV)?
Fair market value is the value of a property as determined by the marketplace as opposed to being determined by an individual.
The technical definition, according to the Internal Revenue Service (IRS), 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 sell and both having reasonable knowledge of relevant facts.”
Four basic components go into determining fair market value:
- Cost or selling price – The price a buyer and seller agree upon based on their reasonable knowledge of the property and current market trends.
- Sales of comparable assets – Typically called a comparative market analysis, this is an analysis of similar properties in the area.
- Appraisal (or expert opinion) – The fair market value of the property (FMV) according to an appraisal report.
- Replacement cost – The cost to buy or build a similar property or asset.
Once you have these four components, you can determine the fair market value of your home or property. By doing this, you can identify the most profitable neighborhoods to invest in over time.
What Is Fair Market Value Used For?
Fair market value is used to determine the price or price range at which a home will sell when working with a buyer or seller. This is done to devise a listing or offer strategy.
Appraisers also use fair market value estimates in appraisal reports when a homeowner wants to refinance. It’s completed during the home-buying process when the financing process begins. The appraisal report is the most common way to find the fair market value of a home or property.
But it’s not only real estate agents and appraisers that use fair market value estimates. Attorneys, insurance companies, and government officials use fair market value estimates in various scenarios, including death, divorce, loss from a natural disaster, and eminent domain.
Agents and appraisers typically narrow their list of comps by researching active, under contract, and sold properties similar in age and size, from the previous 90 days to 180 days. Once the most relevant homes are selected, they usually make adjustments for several factors, such as some of the following:
- Number of bathrooms
- Square footage
- Fireplace vs. no fireplace
- Pool vs. no pool
- Type of garage
- Type of lot (privacy, proximity, view)
Typically, CoreLogic’s Marshall & Swift Residential Cost Handbook is used for looking up the generally accepted range of values for these adjustments.
How Do I Calculate Fair Market Value?
Fair market value can be calculated using a comparative market analysis (CMA) or predictive market analysis (PDA). The CMA is determined by the average value of three or more homes within a certain region. An appraiser might approach determining fair market value by examining a group of homes and factors in any positives or negatives about each property. Doing this helps give a more truthful picture of what the home or property is worth.
Another way to determine the fair market value of a home or property is by using the cost approach. The cost approach It’s typically used when a home is unique and there are not a ton of comps weighing against it.
The cost approach calls for the appraiser to consider the previous sale price of the lot and estimate the cost of construction to replace the home on the property. They usually factor in depreciation and subtract it from the value.
Income Capitalization Approach (IRV)
Another way to calculate fair market value is called the income capitalization approach or, income approach. This approach is typically only used for income or rental properties. This is because it’s based on how much income can be generated from a home or property.
The income capitalization approach uses the income the property generates to determine its market value. The more income a property can generate, the higher its value.
The income approach is usually used in commercial real estate to determine the value of apartment buildings, office buildings, and retail shopping centers.
The income capitalization (IRV) formula is:
Net Operating Income (I) / Capitalization Rate (R) = Property Market Value (V)
Before you can get the value, though, you first have to do three things:
- Estimate the net operating income
- Determine the capitalization rate
- Apply the IRV formula
After you do these, you’ll be able to determine the property’s market value.
Estimating the Net Operating Income
The net operating income is the amount a property generates after all operating expenses are paid.
To get an accurate estimate, you’ll need to get the NOI from the monthly cash flow statement of the property you’re trying to acquire. The appraiser is required to have access to the income and expense statements for the property, which will provide a more accurate calculation.
The formula might look something like this:
Rental Revenue – Rental Property Operating Expenses (mortgage, repairs, insurance, property management, etc.) = Monthly Cash Flow
You can even take it a step further and break the formula for net operating income (NOI) into four stages:
- estimate potential gross income
- Estimate operating expenses
- Subtract vacancy and collection loss
- Subtract all expenses
Estimate Potential Gross Income
The potential gross income is the income you expect from a fully occupied property (100 percent occupancy) in a building that offers market rent or lease (or a combination).
- Market rent – the average rent charged for a particular area in the marketplace
- Lease rent – scheduled or contract rent
The potential gross income should include every income source, including income from rented parking spaces, vending machines, laundry rooms, etc.
Estimate Operating Expenses
Estimating operating expenses means looking at three different types of building expenses:
- Fixed expenses — Expenses that are not affected by a building’s occupancy (such as insurance and property taxes).
- Variable expenses — Expenses that are affected by a building’s occupancy (maintenance fees, management fees, etc).
- Reserves — Used for things on the property that will need to be replaced periodically (such as built-in appliances).
Things like mortgage payments and building depreciation are not included in operating expenses.
Subtract Vacancy and Collection Loss
An appraiser usually estimates the nonpayment of rent and periodic vacancies based on the market and local area of the property. Once you subtract the loss of income from the potential gross income, you’ll have your gross income – one you can work with.
Once you have an accurate estimate of your operating expenses, you can subtract them from the expenses you previously calculated for gross income.
Determining the Capitalization Rate
The capitalization rate (also known as the cap rate) is essentially the return on investment you’ll get. There are a few ways to calculate the cap rate, and you can usually find it in market surveys. The CBRE analyzes average cap rates for certain types of properties. They release a Cap Rate Survey twice per year.
But you can also ask your real estate broker for guidance on how to calculate the cap rate because they’ve likely worked with investors before who’ve had to do the same thing.
The capitalization rate estimates the expected returns based on the property’s market price. It excludes investment property financing methods, such as hard money loans and mortgages. While there is no definitive way to get the exact cap rate for a property, you can get pretty close by using the following formula:
Net Operating Income (I) / Sales Price (V) = Cap Rate (R)
This formula can be applied using the NOI and the sales prices calculated when comparing similar property values.
Applying the IRV Formula
Now it’s time to apply the IRV formula to solve the income approach formula:
Net Operating Income (I) / Capitalization Rate (R) = Property Market Value (V)
Challenges of Calculating Fair Market Value
Some people find it difficult to calculate the fair market value of their property on their own because so many factors go into it, especially since homes are selling above fair market value thanks to the seller’s market we’re currently in. That can make it challenging to know the fair market value of your home.
If you’re struggling with determining the fair market value of your home, ask your real estate broker or an appraiser for help.
Cons of Using the Income Capitalization Approach
The income capitalization approach can be an issue for several reasons, one being that maintenance costs can be unpredictable, which means it’s harder to consider events like fires that can increase it.
Cap rates are only estimates, so the actual numbers can vary once you see them. The numbers are based on average market numbers and don’t usually consider the subject property’s variables, making it hard to get an accurate estimate.
Calculating Fair Market Value Accurately
Determining the fair market value of your home might seem daunting, but it can be done with the right tools and guidance. Using technology to your advantage that can calculate fair market value for you can help you get the most accurate calculation of your property’s fair market value quickly and efficiently.
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