Determining the fair market value of a property is an important process for various reasons. Buyers need to assess fair market value to determine a fair offer price. Sellers need to price their property appropriately based on market value. Lenders need to understand the fair market value to approve financing. By learning what fair market value is and how to properly assess it, you can make informed real estate decisions.
How to Assess the Fair Market Value of a Property
How to Find the Market Fair Value
Fair market value is the estimated price a property would sell for in a competitive market between a willing buyer and seller. The key factors that influence fair market value include:
- Recent comparable sales - Looking at what similar homes have recently sold for in the same area is one of the best ways to gauge fair market value. The more comparable the properties in size, condition, location, etc. the better indication of value for the subject property.
- Supply and demand - If demand is high and supply is low in a given area, fair market values will likely be higher. Looking at housing inventory statistics helps assess supply and demand conditions.
- Property improvements - Upgrades like renovations and additions can increase property value, while deferred maintenance may decrease value. Compare against other homes with similar improvements.
- Location - Certain neighborhoods, school districts, proximity to amenities, etc. impact fair market value. Compare similar locations.
- Market conditions - A hot real estate market may inflate property values above recent comparables, while a cool market may deflate values. Adjust appropriately based on current conditions.
- Appraisals - Licensed appraisers use comparable sales and other valuation methods to estimate fair market value. Their appraisal offers an independent, expert opinion.
What is the Fair Market Value of the Property Received?
Fair market value is typically defined as the sale price that would be agreed upon between a willing buyer and willing seller, with both parties having reasonable knowledge of all relevant facts and neither under pressure to buy or sell.
For a property received as a gift or inheritance, the fair market value is the estimated price it would sell for on the open market. This helps determine gift or estate taxes. If the property has not been appraised recently, one may need to be obtained to properly establish fair market value at the time of transfer.
In real estate transactions, the purchase price itself may be presumed to be fair market value. However, adjustments may be required if additional value was added with personal property items or if the transaction was not at arm's length.
What is the Market Value of a Property?
Market value and fair market value are often used interchangeably, but there are some subtle differences.
The market value of a property is defined as the most probable price it would sell for in a competitive market under normal sale conditions. Market value looks at the value on the open market under typical circumstances for that type of transaction.
Fair market value is based on the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. Fair market value requires all parties to have knowledge of the relevant facts and neither are under pressure or obligation to buy or sell.
Since true fair market value is difficult to establish definitively, the term market value is often used as a reasonable estimate for what fair value would be based on normal market conditions. While not exactly the same, market value and fair market value are highly correlated.
What Does Fair Market Value Mean in Valuation?
Fair market value has some specific implications in the valuation process:
- It represents the hypothetical, arm's length open market price.
- It assumes both buyer and seller are knowledgeable and willing (not forced or distressed).
- It assumes a normal marketing period (not rushed or extended).
- It accounts for the highest and best use of the asset.
- It relies on comparable asset sales and arm's length transactions as references.
- It excludes any special value attributes due to the specific parties involved.
- It reflects the most probable price reasonably obtainable in the market.
So in valuation, the fair market value really aims to estimate what an asset would be worth on the open market based on what typical buyers would pay and what typical sellers would seek to obtain. It provides an objective reference point for the value of an asset.
Is There a Difference Between Market Value and Fair Market Value?
As mentioned, market value and fair market value are very similar, but there are some subtle differences:
- Market value is the estimated amount an asset would sell for in a competitive market under normal conditions.
- Fair market value is the estimated price an asset would sell for between a willing buyer and seller with reasonable knowledge, not under any pressure, and having normal exposure to the market.
The key difference is fair market value implies an idealized, hypothetical transaction not influenced by any unusual motivations of the parties. Market value just assumes normal market conditions, even if one party may have greater pressure or urgency to buy/sell.
In practice though, market value is often used interchangeably with fair market value, assuming it approximates what fair value would be under normal circumstances. But theoretically, the fair market value represents a purely impartial value estimate.
What is the Difference Between Fair Market Value and Valuation?
Fair market value is an estimate of price, while valuation refers to the actual process used to reach that estimate.
- Fair market value is the end result - the estimated hypothetical selling price of an asset on the open market.
- Valuation is the methodology used to determine fair value - looking at comparable sales, discounted cash flows, replacement costs, etc.
For example, a real estate appraiser would use methods like comparing recent sales of similar homes (valuation) in order to estimate the fair market value of the subject property.
So fair market value is the goal, while valuation encompasses the techniques, models, and procedures used to analyze the asset and arrive at the fair value estimate. Valuation aims to determine what the fair market value of an asset is.
What is the Difference Between Fair Value and Market Value IFRS?
Under IFRS accounting standards, fair value, and market value have distinct definitions:
- Fair value is the price that would be received to sell an asset in an orderly transaction between market participants on the measurement date.
- Market value is the estimated amount obtainable from the sale of an asset on the measurement date between a willing buyer and seller in an arm’s length transaction after proper marketing where parties acted knowledgeably and prudently.
The key difference is fair value under IFRS does not assume a hypothetical arm's length transaction, but rather considers value based on actual marketplace participants and conditions on the measurement date.
Market value is based on an assumed arm's length exchange, while fair value looks at a value within the actual market context, which may include distressed or pressured transactions.
So fair value per IFRS aims to determine value within the real-world market setting that exists on the measurement date, rather than a theoretical ideal market.
What is the Best Evidence of Fair Value?
The best evidence of a property's fair market value comes from:
- Recent sales of comparable properties - Similar nearby homes that have sold within the past 6 months provide excellent value benchmarks when adjusted for differences.
- Professional appraisal - An appraiser will consider comparable sales, replacement value, income potential, and overall market conditions to estimate fair value.
- Multiple listing service (MLS) - The MLS aggregates listing prices for active comparable properties on the market, providing data points for value.
- Competitive market analysis (CMA) - Real estate agents run CMAs to gauge listing price recommendations based on comparable active and sold listings.
- The assessed value for property taxes - Local tax assessments often approximate fair market value but may be based on stale data.
- Third-party real estate databases - Sites like Zillow and Redfin estimate home values via proprietary algorithms, providing additional market perspective.
Ideally, use 2 or more of these sources to triangulate an accurate opinion of fair market value for a property.
What is an Example of Fair Value Measurement?
Here is an example of how fair value measurement might work for a commercial property:
- First, a licensed commercial appraiser is hired to assess fair market value.
- The appraiser looks for recent sales of comparable commercial buildings in the area - selling price, property size, condition, amenities, etc.
- Adjustments are made to the comparable sales prices to account for differences compared to the subject property.
- Overall market conditions are reviewed for factors like supply/demand that may impact value.
- An income valuation approach estimates value based on market rents and capitalization rates.
- A cost approach looks at the estimated replacement cost for a similar building.
- The appraiser considers the most relevant approaches and inputs to estimate a fair market value of $4.1 million for the subject property based on the current real estate market climate.
- Supporting details on the comparable data, adjustments, and valuation methods used are provided in the appraisal report.
How Does IFRS 13 Measure Fair Value?
IFRS 13 provides guidance on measuring fair value under the IFRS accounting standards. The main principles are:
- Exit price - Fair value aims to estimate the price that would be received selling an asset on the measurement date.
- Market participants - Fair value assumes a transaction between hypothetical market participants, not the specific reporting entity.
- Principal market - Fair value assumes the asset would be sold in the principal market, or most advantageous market, for that asset.
- Highest and best use - Fair value assumes the asset would be used to maximize value based on market participant capabilities.
- Nonperformance risk - Fair value excludes entity-specific risks not relevant to market participants.
- Fair value hierarchy - Inputs used are categorized into three levels - Level 1 market quotes being the most observable.
By following these and other guidelines in IFRS 13, companies can measure fair value in a consistent, comparable way.
Does IFRS Allow Fair Value?
Yes, IFRS accounting standards do allow certain assets and liabilities to be measured at fair value:
- Financial instruments - IFRS 9 requires derivative assets and liabilities, as well as other financial assets like stocks and bonds, to be measured at fair value. This captures current market values on the balance sheet.
- Investment property - IAS 40 allows investment property, defined as land and buildings held for capital appreciation or rentals, to be measured at fair value optionally. This avoids outdated costs.
- Biological assets - IAS 41 requires biological assets related to agricultural activity to be measured at fair value less costs to sell. This reflects productive value.
- Assets held for sale - IFRS 5 requires assets classified as held for sale to be valued at the lower of carrying amount or fair value less costs to sell. This avoids overstatement.
While not required for all assets, IFRS does permit fair value in many circumstances when it is the most meaningful valuation method. Fair value aims to reflect current market realities.
What are Level 3 Inputs for Fair Value?
Under IFRS 13, inputs used for fair value measurement are categorized into three levels:
- Level 1 - Unadjusted quoted prices in active markets for identical assets, like stocks. Most observable.
- Level 2 - Inputs derived from market data, such as quoted prices for similar assets. Observable.
- Level 3 - Unobservable inputs reflecting entity assumptions and best estimate when external data is limited. Least observable.
Level 3 inputs would be used to estimate fair value when relevant market data is not available. Examples may include:
- Internally developed intangible assets
- Impaired property, plant, and equipment
- Complex derivatives without a market
- Certain illiquid debt securities
Level 3 inputs involve greater subjectivity. Still, they aim to estimate fair value based on the best information available when active markets do not exist for the asset.
Determining fair market value for real estate or other property can be complicated, but following valuation best practices helps reach a reasonable estimate. Keeping fair market value's specific definition in mind and utilizing available market data provides a strong foundation for valuation. With sound methodology, buyers, sellers, and lenders alike can feel confident they are transacting at fair market value.
