Market Value vs. Fair Market Value: What’s the Difference?

(This is the 1st of a 3-part article | Part 2 | Part 3)

(by David Maloney) There seems to always have been confusion regarding the term “market value” and how it relates to “fair market value.” Given the inconsistent manner in which terms are used within the appraisal profession, it is not surprising that such confusion exists. There is “market value” itself, but there are also various “types” of market value such as “fair market value” and “orderly liquidation value.” But there are also types of value that are NOT market value types such as “replacement value” and “forced liquidation value.”

There are many reasons why we need to know whether or not we are developing an opinion of market value or a type of market value, not the least of which is that USPAP requires that, when developing market value or a type of market value, that we do certain things such as:

Ascertain and state if market value is to be the most probable price in terms of cash or otherwise (STD 7-3(c), STD 8-2(a,b)(v))
Analyze and summarize agreements of sale, validated offers or third-party offers to sell, options, listings (STD 7-5(a), STD 8-2(a,b,c)(viii))
Analyze and summarize all prior sales of the object that have occurred within a reasonable time (STD 7-5(b), STD 8-2(a,b,c)(viii))

There is no need to satisfy the above three requirements if one is developing opinions of replacement value or forced liquidation value as neither is a type of market value.

When a client asks what something “is worth,” they are usually asking for its “market value.” A common example is a homeowner wondering what his house is worth. By means of applying proper appraisal techniques and methodology during the appraisal process, an appraiser can answer that question with an opinion of the property’s “market value.” The development of this opinion of market value assumes the existence of certain assignment conditions which are, by definition, associated with “market value.” Such assignment conditions include there being reasonable exposure time, an arms-length transactions, buyers and sellers knowledgeable of the relevant facts, parties are acting in their own interests, price is in terms of cash and is unaffected by creative financing or concessions, etc.

Market value provides a base line for negotiations should the client decide to sell. Depending on many factors, the client might decide to ask more or less than market value when attempting to sell the property. Thus, market value provides a basis for the price the seller is ultimately willing to accept when selling. If the property is particularly rare and in demand, the client might ask for more than its market value. On the other hand, if time is of essence and a quick sale is necessary, the client might ask for less than market value in order to entice a buyer and expedite the sale.

Market Perspective vs. User Perspective

When determining value in general, the appraiser does so from either the “market perspective” or from the “user” prospective. In the market perspective, buyers and sellers assume that normal and typical marketplace conditions exist. e.g., reasonable exposure time and normal marketing process, arms-length transactions, buyers and seller knowledgeable of the relevant facts, parties acting in their own interests, price is in terms of cash, price is unaffected by creative financing or concessions, etc. It is the “market perspective” that appraisers use when determining “market value” or various types of market value such as fair market value or orderly liquidation market value.

Keep in mind that market means just that. Market values are value types used when parties are buying and selling a property within a defined marketplace (such as yard sales, auctions, Craigslist, etc.) under conditions that both parties “expect are typical and normal” for that marketplace. By making use of comparable sales data from only “typical and normal” marketplace transactions when developing their opinions of “market value,” appraisers help ensure that the goal of USPAP is met, i.e., the goal of helping to maintain the public’s trust in the appraisal profession.

The other “perspective” that is used by the appraiser when developing opinions of value is the “user’s perspective,” but it is a perspective that is not used when developing an opinion of “market value.” This is because the user perspective takes into account the user’s objectives which could very well be in variance with the expectations of marketplace participants and with what marketplace participants accept as being “typical and normal.”

For instance, replacement value (which is NOT a type of market value) makes use of the user perspective and measures value based on what it would cost the insured (i.e., the “user”) to replace a property within a reasonable amount of time from within the marketplace in which the insured customarily or most conveniently shops. This is antithetical to market value which requires open, competitive markets and reasonable exposure time.
Another example of using the user perspective would be for an assignment in which a client needs to sell a property at “forced liquidation value” over an upcoming weekend yard sale—a property that would normally and typically require 30 to 60 days to sell if the seller hoped to achieve its full “market value.” Once again, the forced nature of this example does not satisfy market value’s requirement for reasonable exposure time.
Another example of employing the user’s perspective might be a plaintiff suing his landlord for wrongful conversion after his property was placed on the sidewalk and stolen as a result of being evicted from his apartment. Now the plaintiff is suing not only for the replacement value of the stolen property but also for its “value to owner” or for its “sentimental” value in order to be “made whole” by the courts. In this scenario, while market value or fair market value might be a starting point, the additive elements relating to developing an opinion of “value to owner” relegate this scenario to a category involving assignments which are anything but “typical and normal.”

All of the above three scenarios impose “user” conditions that are not consistent with what marketplace participants expect and consider to be typical and normal. As a result, none of these scenarios are candidates for developing “market value” or any market value “type” for that matter. Instead, one requires the development of replacement value, one requires the development of an opinion of forced liquidation value, and the third requires an opinion of “value to owner” which will require input from economists and behavioral psychologists, by the way, not to mention possible consideration of the “endowment effect”!

Market Value Requires Normal and Typical Marketplace Conditions

What does all this mean? It means that market value must reflect what is normal and typical within the marketplace that is geographically relevant to the subject property. If the conditions of your particular market value assignment are not normal and typical (for instance if there is an urgency to sell, or if the seller is not a “willing” seller, or if the buyer is desperate and feels an urgency to buy), do not use the term “market value”. Use some other value term and define it, but do not use market value because market value pertains only to values developed from the market perspective when assignment conditions are normal and typical. Note that in AO-22 USPAP states that one should not use the term “market value” alone if the definition of the type of value being developed by the appraiser includes conditions that are not normal and typical.

But what is normal and typical? I allude to the answer above (reasonable exposure time, arms-length transactions, buyers and seller knowledgeable of the relevant facts, parties acting in their own interests, price is in terms of cash, price is unaffected by creative financing or concessions, etc.) See this article for a somewhat detailed discussion of Market Value, market value types and what is normal and typical.

What’s the Difference Between Market Value and Fair Market Value?

Market value is an opinion of the most probable buy-sell price. It reflects the probable amount of money a buyer would pay and a seller would accept for an item of property under specific conditions as noted in the following definition:

“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. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby: the buyer and seller are typically motivated; both parties are well informed or well advised, and acting in what they consider their best interests; a reasonable time is allowed for exposure in the open market; payment is made in terms of cash in United States dollars or in terms of financial arrangements comparable thereto; and the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.” (Federal Register Vol. 55, No. 163, August 22, 1990. This definition has also been adopted by the International Association of Assessing Officials for tax assessment purposes.)

Market value presumes the transfer of property as of a certain date and under the above noted typical and normal assignment conditions. An example of an supplementary “assignment condition” that might be included in the appraiser’s definition of market value to make the report more understandable might be that for this assignment market value assumes a reasonable exposure time of between 30 and 60 days. Having made that part of his value definition, the appraiser would then research the appropriate market such as a regional auction house (which can properly advertise and sell the property within 30 to 60 days) for recent sales on which to base an opinion of market value. The appraiser would make a mistake if, instead, he researched the yard sale market (which typically has an exposure time of only 2-3 days) or the consignment shop market (where exposure time might be 6 months or longer!) for comparable market data since those markets would not be consistent with his definition of market value which assumes 30 to 60 day exposure time.

Fair market value is a specific type of market value. It is defined by a legal or regulatory jurisdiction and varies with individual jurisdictions. For federal uses such as estate and gift tax or charitable contributions, fair market value is defined by Treasury Regulation §1.170A-1(c)(2) as:

“…The price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts.”

Treasury Regulation §20.2031-1 elaborates on this federal definition by stating:

“The fair market value of a particular item of property includible in the decedent’s gross estate is not to be determined by a forced sale price. Nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate. Thus, in the case of an item of property includible in the decedent’s gross estate, which is generally obtained by the public in the retail market, the fair market value of such an item of property is the price at which the item or a comparable item would be sold at retail…”

The IRS/Treasury definition of fair market value assumes a hypothetical sale between hypothetical parties and that a sale does not, in fact, take place. Since there are no expenses associated with a “hypothetical sale,” fair market value reflects the gross amount that would be obtained if the property were to be sold and not the net amount that would be retained.

Note that the term “market value” is often used interchangeably with “fair market value,” although these terms have distinct definitions in different standards and may differ in some circumstances.

I often end up making use of the IRS/Treasury definition of Fair Market Value even for non-tax liability assignment but only after consulting with the client. At times, local jurisdictions will make use of a similar yet different definition of fair market value, so be sure to check with the client and his or her attorney to ensure that you are using the proper value type and definition.

Below is a comparison between market value and fair market value when using the IRS/Treasury definition of fair market value for tax liability appraisals (which is most often the case).

With market value:

There is an actual, bona-fide buyer and seller
A transfer of title will take place
The title to the property will transfer as of date certain
There are certain “market perspective” assignment conditions that are assumed to apply to the assignment in order to help preserve the public’s trust in the appraisal profession. These assignment conditions include those conditions that marketplace participants consider normal and typical (e.g., reasonable exposure time and normal marketing process, arms-length transactions, buyers and seller knowledgeable of the relevant facts, parties acting in their own interests, price is in terms of cash, price is unaffected by creative financing or concessions, etc.)
Market value reflects the gross amount that would be obtained and not the net amount (i.e., after expenses are deducted) that would be retained.

With fair market value (when using the IRS/Treasury definition of fair market value for intended uses of federal tax liability):

There is no actual buyer or seller. They are hypothetical parties.
There is no transfer of title. The sale is hypothetical.
There is no date certain as of which title changes hands because the sale is hypothetical and does not take place.
There are certain “market perspective” assignment conditions that apply to the assignment (willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts). But in addition, the Federal definition of fair market value requires the use of the “most common” market and reflects the price for which the subject property would sell at retail, i.e., to the end consumer and not to a dealer or wholesaler intent on reselling.
Market value reflects the gross amount that would be obtained (with any applicable buyer’s premium being additive) and not the net amount (i.e., after expenses are deducted) that would be retained.

Sometimes market value will equal fair market value. In the above example, when juxtaposing market value with fair market value for federal tax-liability assignments, there could very well be no difference between an item’s market value and its fair market value. But in the case of a local jurisdiction that defines fair market value as “actual cash value,” “replacement cost new (depreciated),” “value to owner,” etc., there could be a significant difference between an item’s market value and its fair market value.

Identify Value Type, Definition, Source

So, as in all assignments, during the first step of the Appraisal Process (i.e., during the problem identification phase of the assignment) ensure that there is a clear understanding between you and the client as to:

The type of value to be developed, and
The definition of that value type, and
A citation for the source of that value type definition.

Examples

Appraisals having as their objective the development of fair market value typically have as their intended use:

Non-cash charitable donations
Estate settlement
Gift taxes
Litigation

Appraisals having as their objective the development of market value or a market value type (other than fair market value) typically have as their intended use:

Client wants peace of mind that he is not paying too much when buying a property (client can use market value as a benchmark when deciding on how much to pay for an item)
Client wants to sell an item (client can use market value as a benchmark when deciding on how much to ask for an item)
Pricing services: client wants you to set asking prices for items commonly sold at a yard sale (use orderly liquidation value)
Divorce or equitable distribution (depends on the needs of the client but often use orderly liquidation value and subtract associated expenses to arrive at marketable cash value)

See this article for a somewhat detailed discussion of Market Value, market value types and what is normal and typical.

See this article for a detailed discussion of Fair Market Value.