21 Aug Fair Market Value Myth
One of the most valuable investments you can make is the investment in yourself and your knowledge. If you are able to familiarize yourself with insurance terms you will be able to have a better understanding of the coverage’s you may or may not need as suggested by your insurance agent. At a minimum, it will help you better understand the terminology that is being used to describe your insurance options and will help you make an educated decision as to whether or not you are properly insured.
Some of today’s most misused phrases are current market value and Fair Market Value. While you can read in a previous article about how Fair Market Value is not associated with the level of insurance you carry I wanted to provide some more in depth examples on what the term really means to us as investors and owners.
Fair Market Value is the price at which a willing and knowledgeable seller that is not under duress would sell a property to a willing and knowledgeable buyer that is not under duress. Foreclosures and short-sales are not indicative of Fair Market Value. The seller, whether it’s a bank or an individual, is under duress. They simply do not meet the guidelines of the definition. Fair Market Value must be kept separate from purchase price, asking price, or any other price except when it involves the exact two parties listed in the definition.
Fair Market Value has numerous factors with the most important being location. A Commercial Retail Store Front in a high crime area of a big city is not going to sell for the same price as Commercial Retail Store Front in a wealthy end of the neighborhood. But the cost of supplies such as wood, bricks, and electric wiring to replace the building in the event of a complete loss from a fire would be about the same.
Current Market Value does include issues of duress such as short sales and foreclosures from the surrounding area. Wherein Fair Market Value would be used in a regular retail setting where a buyer is working with a seller and neither is motivated by undue stimulus; current market value is found in a setting where surrounding foreclosures and threats of short-sales would be taken into consideration. Simply stated, the definition of current market value is found in the title. It is the current price for which the house will sell today.
However, neither of these two have anything to do with the level of insurance that you should have on your investment properties. Let’s look at an example with current market value. In this illustration, you are a buyer in a depressed area. You wish to purchase a property for $100,000 from a person that going through the short-sale process. After looking at comparable sales in the area, it appears that this house, which is in great condition, would sell for $250,000 if many other neighbors were not in the same situation. You figure you can rent it and then wait for it to recover to its Fair Market Value. In this situation, the Fair Market Value would be $250,000; the Current Market Value was $100,000. So where does this leave us in regards to insurance? Insurance has nothing to do with these two prices because it has everything to do with how much it would cost to replace the building in the event of a complete and total loss. Remember, inside of the Fair Market Value is the value of land and the foundation which isn’t covered in most policies. In a vague sense, insurance is worried about putting the walls and the roof back up on the existing foundation and the land does not have to be repurchased.
In our example, the investor might discover that it takes $175,000 to repair the house back to its current condition. You can see that if the investor only insures it for what he paid for it ($100,000) he would be out $75,000 and he can’t insure it for Fair Market Value ($250,000) because that’s not what it would cost to make the house whole again.
So why can’t this investor in our example insure his property up to $250,000 (FMV)? There are a couple reasons for this. First, insurance is only allowed to make you whole. You cannot profit from insurance. Our investor would have profited by $75,000 in our example. Second, this would be like insuring an investment. That also is not allowed in an insurance contract. Insurance contracts can only insure situations that can be accurately measured (i.e. how much it costs to rebuild a house). The cost of wood is known, the cost of a brick is known. The Fair Market Value is not a fact. It is an appraisers very professional estimate under non-stimulated conditions.
Bottom line learning objective from this article is simply this. Do not confuse current market value or fair market value with replacement cost. These are all different. When it comes to insurance make sure your agent is helping you become properly insured and not over or under insured.