Many parts of the real estate world run on the concept of "fair market value." When an assessor determines your property's value for real estate taxes, he frequently starts the process by identifying the fair market value. Appraisals attempt to estimate fair market values, and lenders use them to decide what to lend. When you sell real estate, you typically want to get at least fair market value, and when you buy it you typically want to pay no more than fair market value.
Defining Fair Market Value
A property's fair market value is the price that a buyer that could buy the property would pay for the property, assuming that it was offered for sale in an open market. Because markets change, a determination of fair market value is only accurate for a specific point in time. It's also just an estimate, as the only way to be sure of anything's fair market value is to sell it.
Problems with Fair Market Value
Estimating fair market value for a gallon of regular unleaded gasoline is easy -- it's the price that people pay in a given area. If two stations are selling gas at $3.35 and a third prices it at $4.00 and has no customers, the fair market value is $3.35. Since one gallon of gas is the same as any other, it's easy to extrapolate that the $3.35 price also applies to gas that hasn't been sold yet.
Real estate is different. Even given two essentially identical houses sitting next to each other on identically sized lots, there's a good chance that there are differences in the way that they've been maintained or decorated on the interior. The sun may strike them differently, making them more or less expensive to cool or heat or affecting the owners' success growing fruits or vegetables. Furthermore, it's unlikely that the two houses would sell on the same day. With this in mind, fair market values are usually opinions based on adjusting data from other transactions.
Creating Fair Market Value
Given one house with 2,000 square feet of floor space and valued at $200,000 and another with 1,900 square feet of floor space and valued at $190,000, you could adjust the two values into a fair market value of $195,000 for a 1,950-square-foot house that was also essentially identical. Most fair market values are derived using a process like this. Assessors, appraisers or real estate agents look at current sales data and adjust what they see to estimate what another property might be worth.
Appraisers use a process called paired sales analysis to make these adjustments. In this process, they take two seemingly identical houses but with one difference -- for example, the presence of a fireplace in only one of them. They then assume that the difference in price corresponds to value of the added feature. When they do this over enough analyses, they get the data necessary to calculate values.
Adjusting Tax Assessed Values
Tax assessors also adjust fair market values to come up with taxable values for property taxes. The methods they use are usually defined by state law. Some states use only a flat percentage of the property's fair market value for taxes. Others may take money off the top for certain exemptions. In other states, changes in the fair market value are used to reduce a property's value, but any increases are tied to a fixed or variable percentage relative to the preceding year.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.