@Lois Stern An excellent question, with a long, complicated answer :-).
First off, before I give a short and long answer, I'll echo what others have already said: FMRs for your area may or may not reflect what you can actually rent your place for. Your own homework or other expert opinions on what your exact place in your exact location are going to be much more valuable than the broad numbers your local PHA uses for a much larger area. That said, here's a short and long version on how they come up with numbers for your area and how they may be helpful to you.
SHORT ANSWER: Your local FMRs are calculated by HUD periodically to reflect the 40th or 50th %ile of rents+utility costs borne by the tenant. In other words, they seek to reflect what HUD would expect a solidly blue collar American renting a foursquare, adequate place to pay in the PHA's area. This can be a helpful # if you want a safe estimate of what a B class property can rent for in an area you're not familiar with, provided comps for the neighborhood aren't way off. As the number includes utilities, you'll need to knock it down $50 to $150 depending on unit size and utility costs in your area to reflect just the rent HUD calculates, minus the utilities.
LONG ANSWER: Your local FMRs are the result of a mindbogglingly complex formula that usually reflects a multi year rolling 40th %ile of rents+utilities borne by the tenants in a PHAs area. If that seems like an overly broad, one size fits all neighborhoods number that could lead to a lot of areas where that number is ether way too high or way too low, that's because it is. If you live in a large city (top 10 type city), your PHA probably uses the 50th %ile to help open up more of the city to Section 8 voucher holders. This helps a bit, but still runs into the same issue of being a one size fits all number. In recent years, about half a dozen PHAs in large urban areas have piloted zip code specific FMRs to tailor rents more specifically to neighborhoods rather than just the whole city. These efforts have shown decent promise, and there is currently a proposal to expand the program to the top 20-40 cities nationwide.
Now, where on earth does HUD get enough info to plug into this formula to spit out the FMRs for an area, and whats a more simple way to explain how they actually get the FMR? HUD uses data from rent surveys for 2 bedroom units, supplemented by general rent trends in smaller areas that may not generate enough data in rent surveys on an annual basis, to calculate the amount of rent paid. HUD then also partners with NOAA and utilities to estimate how much utilities cost and whether weather is a substantial factor in those calculations. They then use set %ages up and down to give you FMRs for other size units. This obviously has the potential limitation of being inaccurate if rents for a particular unit size are skewed high or low in your area, but in general are surprisingly accurate.
But wait! There's more! HUD is the first to raise their hand and admit that a single number isn't a great reflection of rents across all neighborhoods, so they give local PHAs some tools to help ensure they have flexibility to make sure vouchers are able to be used in decent areas of the city, as well as make sure they're not paying 150% market rent for a unit in a war-zone. The first is a broad strokes tool where the PHA can adjust the FMR for the whole area by up to 5-10% up or down. The main purpose of this is usually for small areas to tweak their FMRs to better reflect rents where the lack of data hampered a good initial calculation, to chase a skyrocketing or plunging market more closely (remember the 3 year rolling set of data HUD uses) or to soften big swings in FMR for current tenants. The PHA also can assign FMRs by neighborhood (outside of the pilot program I mentioned), provide exceptions for tenants to rent places above FMR if they require reasonable accommodations, and is required to not spend more than market rent for a unit, even if the unit is under the FMR cap (ie don't pay top dollar for war-zone units). There are other tools as well, but those are the easy to explain ones. PHAs use some or all of them in different ways, sometimes giving the impression to landlords like @Amy E. that inspectors are just taking a guess at things. The bottom line is your local PHA has a lot of leeway to make sure that they have a good process to assess whether a tenant/the gov't is overpaying for a unit.
Now, practically speaking, what are some of the things an inspector might take into account when checking whether you're way above market or not on a unit? Ask your inspector! It really does vary quite a bit locally as to how much your PHA digs to see if your place s above market. In some places, like Baltimore, we have landlords on the boards talking regularly about how they're able to achieve a good premium above market renting to Section 8 tenants. Clearly, those inspectors are choosing housed tenants over worrying about spending too much. Conversely, there are locales which will use sq ft, amenities, neighborhood, comps and condition to see what your place is worth to them, in an effort to save the taxpayers some money.
A few final notes, the HUD website always publishes all of their data and FMRs for all areas here: http://www.huduser.org/portal/datasets/fmr.html
Your local PHA will give you a copy of their FMRs and local utility values if you go into the office and ask. Many also have them on their websites, but not all. Some are still stuck in the Stone Age. They are separate non-profit entities from HUD, so small town PHAs can seem pretty backward sometimes.
You can always calculate what the max someone with X income and a voucher can rent your unit for using the Happy Software rent calculator. Someone posted it in the downloads section of BP. Not the most intuitive to use, so if anyone ever has questons, shoot me a PM and I can walk you through it. Easy once you get the hang of it though.
Final caveat, while FMRs are the max you can charge for rent, and reflect the maximum a PHA is willing to subsidize your unit for rent+utilities, you can usually get closer to that FMR number for your rent due to the "40% rule" and sometimes through some extra, more complicated tricks as well. If any of those last two sentances confused you, forget I mentioned them. They're worth another book length post and math lesson in and of themselves :-).
Hope this helped!
