by Sandra Hou, Director of Appraisal Services — West
In the insurance industry, replacement cost value (often referred to simply as “replacement cost”) is one of the most common and acceptable values used to insure properties. In my line of work, we are often hired by risk pools to value their members’ properties for replacement values, in order to make sure the members are properly insured in the event of a loss, such as a fire or a natural disaster.
So What Is a Replacement Cost?
A replacement cost is the cost to construct — at current prices, as of the effective appraisal date — a substitute for the building being appraised, using modern materials and current standards, design, and layout.1
When it comes to insurance appraisals, the replacement cost value generally includes, but is not limited to:
- Material and labor costs
- Normal site preparation
- Utilities from structure to lot line
- Standard architectural and engineering costs
- Contractor overhead and insurance
- Unique building features
- Permitting and/or inspection fees
Common Misconceptions About Replacement Cost Values
Interestingly, when I discuss replacement cost values with my clients during a project engagement, I’ve noticed that they often hold some common misconceptions about just what these values include.
For instance, many believe they should insure a building at the same cost they paid to construct the building. But this cost — often known as the “project cost” — includes many variables that aren’t insurable and, therefore, shouldn’t be included in the replacement cost value at all. Common examples of these are: land acquisition, demolition of previous structures, and site and land improvements.
Typically, the project cost is about 20-30% higher than the replacement cost. So, if the client were to insure the building at the project cost, they would be significantly over-insuring the building. And that would mean they’d also be paying a higher cost of insurance.
This can be an issue for renovations to existing buildings, as well. Clients who have done major renovations — for example, adding a new roof, new windows or redoing plumbing — often want to add the renovation costs to their replacement costs. But replacement costs already are the cost to construct new — so they automatically factor in the cost of a new roof, windows, and plumbing, etc. Similarly, building addition costs also should not be added to the replacement costs, because the replacement costs are for the complete building, if replaced new. By adding project costs into the total, it only serves to increase insurance costs and over-insure the property.
Another misconception I run into sometimes when working with clients is when property managers believe they should insure a building at the same cost they paid to acquire the building. (This cost is known as the “fair market value.”) The fair market value tends to be higher than the replacement cost value of the building. Why? Because the fair market value includes factors that aren’t considered in the replacement cost value, such as the land that the building sits on, site improvements that surround the building, surrounding properties, and the going rate for recently sold properties in the area.
If the client were to insure the building at the fair market value, instead of the replacement cost value, once again they would be significantly over-insuring the building, and once again, would be unnecessarily paying a higher cost of insurance.
Multiply this issue over many properties, and you can see how these kinds of misconceptions can seriously affect your organization’s bottom line.
How to Right-Size Your Replacement Costs and Your Coverage
So how do you avoid making costly mistakes when it comes to calculating the replacement cost value of your properties?
Generally, I advise clients to reach out to AssetWorks for guidance. Our valuation specialists understand the nuances of property valuations and we can help determine appropriate replacement costs for buildings, new and old. By getting a stronger handle on your property replacement costs, you can avoid over-insuring your property and lower your costs for coverage. In this age of tightening budgets and skyrocketing costs, what wise property manager wouldn’t want that?
- Appraisal Institute, The Dictionary of Real Estate Appraisal, 5th ed. (Chicago: Appraisal Institute, 2010).
About the Author
Sandra Hou resides in Los Angeles, CA, with her husband Steve. When she’s not acting as Director for Risk Management at AssetWorks, she spends her free time exploring hiking trails with her husband and rescue pups, Meatball and Spaghetti.