What is the Fair Market Value of a home?

Many buyers want to know how to figure out the Fair Market Value (FMV) of a home. Is it the value assigned by the tax assessor? Nope. Is it determined by an appraiser? No again. Maybe you can look it up in on website like Zillow? That’s not it either.

real estate prices chartThe Fair Market Value of a home is defined as the price that a willing and knowledgeable buyer would pay to a seller, subject to the following conditions:

  1. The parties are behaving in their own best interests. (Buyer wants the lowest price. Seller wants the highest price.) For example, a parent selling to their child at an artificially low price does not determine an FMV.
  2. The parties are free of any undue pressure to complete the transaction.
  3. The property is on the open market for a reasonable amount of time to allow the transaction to be completed. For example, a property marketed and sold to only one buyer, without marketing it to the broader market, may not sell for the highest and best price that the market will bear.

The tax assessor says the home is worth $XX

County tax assessors use value estimates to determine property tax rates for each house. In Washington State, they do this every year, but it is done in an automated way using statistics based on recent sales in the neighborhood. The assessor has not seen the inside of the home and has no idea of the condition and finishes. They may also not be aware of inaccuracies in square footage introduced by additions or remodels over the years. The older the home, the more likely that inaccuracies in tax data have been introduced. Remember that home owners have NO incentive to fix this, as it usually would increase their property taxes.

I’ve compared tax assessed values to sale prices thousands of times. Sometimes the value is close and other times it is wildly different than reality. I’ve seen assessed values off by $200-$400k in some instances. Also, there is a huge lag in the time frame for assessed values in Washington State. If you look up the assessed value of a property for the 2013 tax year, that value is based on the assessed value issued in July 2012. However, the value issued in July of the previous year is based on data analysis conducted as of January of that year. Said another way, looking up the taxable value in December 2013 gives you a number that they calculated from data on January 1, 2012, a full two years earlier.

The appraiser says the home is worth $YY

An appraiser estimates the value of a home by comparing it to recent similar sales in the neighborhood. They usually conduct appraisals on behalf of a bank that is extending a mortgage on the home. Their primary role in that case is to protect the bank from over-lending on a property. They are NOT protecting or advising the buyer on what they should or shouldn’t pay for a home, though obviously it can serve as a check and balance for a buyer’s purchase decision.

Appraisers are not omniscient, nor are their value estimates of a home authoritative. If you got three appraisals, you’d get three different price estimates. Appraisers can be wrong when calculating their estimate. Maybe they are not familiar with the local market, or maybe they aren’t fully aware of the supply and demand at that particular moment in time. They are also human and subject to their own biases on what a particular view, location or amenity may be worth.

Zillow says the home is worth $ZZ

There are a variety of websites that offer a value estimate for homes, with sites like Zillow being quite popular. Remember that these are computer-generated models that use recent sales nearby to try and calculate a value by using homes with similar year built, size and room counts. These computer models are based on publicly-accessible data from county tax records and other data, so they are subject to the same inaccuracies as tax-assessed value described above. A computer isn’t aware of a view, nor is it aware of the condition or finish level of a home, so it is a very rough guide to the price. Sometimes it is fairly accurate, and other times it is not.

Online home value estimates are simply a starting point to estimating the value of a home. You need to understand the statistical confidence level in such numbers. For example, Zillow has a Data Coverage and Zestimate Accuracy table that compares actual sales to the previously estimated price. As of February 2013 in Seattle, they have 1.2M homes with Zestimates. 36.1% of the Zestimates were within 5% of actual sale prices. 62.5% were within 10% of actual sale prices, and 85.8% were within 20% of actual sale prices. The median error for our market is 7.3%. What that means to the home buyer is that you need to look at the value range, not the Zestimate to give a better guide to market value.

Can’t I just use the average $/sq ft for the neighborhood?

Buyers often fixate on the average $/sq ft for a particular neighborhood and try to multiply that number times the size of the home they are buying. The real estate market doesn’t function that way.

$/sq ft can be misleading. What if some other homes inflated their sq ft by including a garage? What % of the square footage is below or above grade? (Below grade living areas are worth less than above grade ones.) Does the home you’re comparing have a better location, floor plan or view? A 2000 sq ft home with a stunning view that is right down the street from a 3000 sq ft home with no view is likely worth considerably more, despite its smaller size. What about new homes in an older neighborhood? Obviously the average $/sq ft for that neighborhood is going to be driven lower by the older homes, so it needs to be adjusted for things like year built and quality of finishes.

If you are going to use $/sq ft as a guide to a home’s value, you must adjust those values for differences in utility, quality, room count, age and location.

Home values are different for everyone

Everyone will have a different opinion of value for a home, based on the home’s utility to them. A buyer who wants a pool is willing to pay more for a home that has one, while a pool is a nuisance to buyers who don’t want to maintain it. A stunning view may be worth $100k to one party and $50k to another. Same thing goes for exotic finishes in the home. Someone who highly values a $50,000 home theater will certainly pay more than someone who wouldn’t get use out of it.

A home’s value is determined in the present, not the past

Market conditions change constantly and the fair market value is determined by what someone is willing to pay at this moment in time. This can be measurably different than just a couple of months ago if there is more or less buyer demand in the market. For example, you may find a home in a fairly homogeneous neighborhood where there are three sales in the last six months that tell you that $500k is a fair price for the home. However, there are 10 bidders on the home who drive up the price today to $525k. Is the home $25k over market value? No, that is the current market value based on buyer demand at this point in time. Obviously buyers make decisions on how they will bid based on recent sales in the neighborhood, but if they face ever increasing competition and really want the home, they will pay more and prices will appreciate. The same concept applies when prices are declining.

Determine your own market value

Bidding on a home is nerve-wracking, particularly in the face of lots of competition from other buyers. Work with your real estate agent to analyze the data yourself and come to your own conclusions on what you are willing to pay. Recognize the current market conditions and weigh that against your desire and budget to buy this particular home. Don’t lose sight of the big picture. You are buying a home for a long-term residence and while no one wants to overpay, worrying about price differences of 1-2% on such a large long-term investment isn’t going to be very relevant to owning a home that is a match for your long-term housing needs.