Establishing Fair Market Value for Rent
Recently, we discussed establishing fair market value for physician compensation. But physician compensation is not the only item requiring establishment of fair market value. Hospital-owned entities require any real estate lease to be at fair market value when it involves a referral source: in other words, rent that reflects fair market value.
The market value (synonymous with fair market value) is the most probable price which a property should bring in a competitive and open market. Fair market value assumes the following:
- The buyers 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 Stated dollars or in terms of financial arrangement comparable thereto
- 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
Fair market rent is the rent a typical market participant would pay based on market metrics. This can be calculated multiple ways:
- Cost approach, which estimates rent by determining the annual return to the land based on its fair market value plus the annual return on the depreciated replacement cost of the improvements (building and site) over the remaining life of those improvements. This can also include furniture, fixtures and equipment if included in the lease. Expense structure also needs to be considered.
- Market approach, which estimates rent based on what other comparable properties in the market have rented for.
- Income approach, which estimates the rent based on the income that can be produced by the space and what other similar tenants have paid in rent for similar space, typically based on a percentage of net operating income.
These three approaches (or less depending on relevance) would then be reconciled to determine the fair market rent for the leased space.
When having a fair market rent analysis performed for your entity, make sure the following steps are included:
- Discussions with senior management and advisors about the prospective business operation and markets served
- An analysis of local demographic trends
- A review of local and national healthcare trends and transactions
- Conversations with commercial real estate brokers to better understand the local market and confirm land sales
Thomas J (TJ) Griffith is Vice President and Seniors Housing Practice Director at Principle Valuation. Contact him at TGriffith@PrincipleValuation.com