Market Value is one of the most misunderstood words used on a day-to-day basis by real estate agents, investors, and others within the industry. Often times you’ll see the word used interchangeable for “price,” “cost,” “listing price,” or “selling price” but in fact – market value is none of these things. This article is going to focus on what market value is, what it’s not, and how it’s found in both residential and commercial real estate.
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What is Market Value?
The standard definition of “Market Value” is:
“The most probable price (in terms of money) which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.” (source: Federal Register Federal Register Vol. 55, No. 163, August 22, 1990 )
Clearly, that definition was written by someone a lot smarter and probably a lot older than me. I want “plain english” – not lawyer language, so I’m going to break that definition up into it’s three main parts:
- “probable price” – market value is simply an estimate. It’s not a concrete number – simply an estimated guess.
- “competitive and open market” – if there is no competition, there is no way to decide value. Market value is determined when there is an open option to purchase from multiple parties.
- “undue stimuli” – in other words, there can’t be any coercion force, or trickery, or other forms of influence on the decision of the buyer or seller.
In other words, market value is simply an estimate of what a property would sell for in a competitive market with no extreme outside factors influencing it.
How is Market Value Used?
Market value is most commonly used by appraisers. The job of an appraiser is to simply determine what the market value of a property is. In most cases, the appraiser is hired by a bank to ensure that the loan amount being made is relative to the market value.
For example, if a bank is willing to loan up to 80% loan to value, and the market value is determined by the appraiser to be $100,000.00 – the bank knows that it can lend up to $80,000 to the borrower.
How to Determine Market Value of Real Estate
There are primarily three ways that market value is decided by an appraiser, though each of the three is primarily used for a certain type of investment.
Comparable Sales-Price Approach
The comparable sales approach is the most commonly used method to determine market value – and probably the method you are most familiar with. The appraiser will compare the property they are trying to determine value by looking at what other properties nearby have sold for. The appraiser will look for homes that have similar:
- square footage
- number of bedrooms
- number of bathrooms
- distance from the property being appraised
- quality of the property
Obviously no two properties are the exact same, so once the appraiser finds several properties that have recently sold (in the previous six months, ideally) the appraiser will add or subtract value based on the differences. For example, if the appraiser is trying to determine the value of House A, which has a swimming pool – he will look at Property B which sold recently but did not have a swimming pool. He will then determine the cost of the swimming pool and add it the amount that Property B sold for – in order to better compare “apples to apples.”
Rental Income Approach
While finding similar properties in the residential marketplace can be difficult -finding them in the commercial marketplace can be next to impossible due to the huge variety in different types. For example, trying to compare a 4560 sq foot retail store to another recently sold retail store of that size would be almost impossible. Instead, appraisers use the “Rental income approach” which bases the value of the property off the income it produces from fair market rent. This method utilizes a percentage known as a Cap Rate to determine value, which is the relation between income and market value. Essentially the cap rate is the return on investment a person would achieve if they paid all cash for a deal. Rather than comparing square footage or the number of bedrooms, the appraiser compares the return on investment between one property to another. Using our example from above – an appraiser could determine that the retail store is worth exactly ten times more than the amount of net income it made since a nearby other retail store recently also sold for ten-times the net income.
Replacement Cost Approach
The third, and least common, approach to value is the replacement-cost approach, which as the name suggests, is simply the appraisers estimate of value based on what it would cost to re-build the property from scratch. This type of approach is most commonly used when the subject property is extremely unique and the other two methods don’t adequately provide an estimate for market value.