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Replacement cost vs. Market value

I often get asked the difference between replacement cost for insurance and the market value for a home being resold. Since I know this is a question/concern out there I thought that I would write about it. Replacement cost is the cost it is estimated to take to put that house back with like quality features in today's market. Usually this will be a higher value than resale. I will list a couple of reasons for this. Scenario 1) You are selling a home that is a great deal for someone, but needs a little updating. The updating requirements are going to push the market value of the home down. But from an insurance perspective if you have to rebuild that home, the same quality sinks, carpet, paint, roof, etc... have to go back into the building process. These items will be bought at today's prices and today's like quality, not a discounted price because tastes have changed over the years. Scenario 2) You are selling a new tract home in a new neighborhood. The rebuild cost will often come in higher because you are looking at replacing that home without the benefits gained from mass production.

In summary, the goal of the policy is to be there for the insured with the amount of money needed to put them back in like kind and quality of home.

Posted by John Tooley on 09/10/2008 10:05 AM

Comments (12)

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12 Comments on Replacement cost vs. Market value

SEP

2008

Great blog post. This is very valid conern and subject. Think about all the people under insured and then boom!

I have a buyer who is buying a house for $950,000. The land is valued at $600,000. He obviously does not need to buy insurance for over $950,000. To rebuild the house would not cost more than $450,000.

Hi John,

Thanks for the info. I'm in a fairly high cost land area myself. Actually I have one in escrow now, it's over $800 and it's considered a tear down.

But another issue, a question I thought most of today's policies have a "replacement" provision, is that correct?

John excellent explaination that all consumers can understand.

Ellie makes a very valid point, one which many insurers "overlook". In an inflationary market (or one in general that is appreciating), the value of land should not automatically be insured. Most casualties (like fire) may destroy the insured property, but not the land - therefore no need to insure the value of the land. However, if you have septic, buried oil tanks, etc. or if erosion, flooding, landscaping, etc. are of concern, a good insurance agent will counsel you as to how much insurance cover you really need.

Mortgage loan officers and underwriters often need to be reminded of this too. I can't tell you how many times I've received a call personally or received a call from a client saying that the lender wants updated coverage on the total value of the house and land each year. As long as the home has replacement value coverage, many lenders will back off when "re educated".

There is replacement and there is reproduction! Can you expand on that so everybody out there in real estate land understands the difference. Please also explain the cost factor variations for deductions as well as touching base on having a home video of your property in a safe deposit box.

Great post. Good reminder!

Ellie - You bring up a good question regarding land vs. structure. When insuring you are insuring structures, not land. In a case where the land holds the vast majority of the selling price then the question may not even come up. If it does I ususually reconcile against the structure value as split out on the appraisal.

Lynda - Great point, and you are correct in taking into consideration that on some properties the "dirt" value becomes greater than the value of the home. Bottom line is homeowners need to be sure that they will get back what they lose.

Regarding the "Replacement" clause that you are refering to. Be really careful here. The devil is in the details. I have had customers approach me with policies that listed their home as vastly under what it would cost to rebuild, but assured me that the agent had told them they would replace the home if something happened to it. Never once has one of those policies been without a "limits of liability" The limit of liability is the maximum the policy issuer is on the hook for.

Consider this; can you ever imagine a company of any kind writing a completely blank check for services to be rendered with no consideration of the premium? Any policy on a home will somewhere in it have a description of the home, and a maximum they will pay to reconstruct that home, and this will affect the premium. The description has to be accurate, and consequently the coverage should be correct.

A great resource for this topic is the online documentary that PBS did regarding the California forest fires. This article has numerous testimonies from people that bought policies they expected to replace homes, even though the liability limits were too low.

Barb - I believe you are referring to homes that contain features which are no longer common place. A good example of this would be an old home with hardwood or exotic wood furnishings that may require artisan crafting to replace. If the decor was standard practice for the time period some replacement cost calculators will calculate those features in for the sake of determining replacement value. If these features are one of a kind features you go down a completely different path all together.

The video taping of your property is something I really encourage my clients to do. Many policies seek to replace personal property at replacement value up to the limits of the policy. This means that your television may have been 5 years old at the time of a fire, but the policy intends to replace it with like make and model on todays market (this is good, the way you want it). But before anything can be replaced at all you have to know what you owned that needs replaced. Very few of us could sit down and write out a list of all we owned today including make and model. Certainly we can't imagine being able to do this shortly after a catastrophic event. So in order to be prepared have a record of it. An inventory list or even easier a video tape diary of sorts. Either of these need to be kept in a secure location.

John you are awesome! Thanks for explaining as many do not know and it was a refresher for me as well.

Great explanations John. I appreciate your insight and understanding. The PBS video of the California fires was very helpful.

MAR

I was researching this topic for a speaking engagement to a group of real estate agents later this week. I am an insurance agent by profession. I like to use appraisals to explain replacement cost to real estate agents. There are 2 approaches in an appraisal: market value approach which is useless to us for the most part and the cost approach which we use the estimated duplication cost new as a guide. That being said we determine replacement costs on our local experience and use the appraisal duplication cost figure as a cross check. With the market values slumping I have noticed that cost approaches have decreased as well. An insurance agent should never "copy someone's paper" when practicing their profession and should accurately determine their own RC values without the bias of market conditions on appraisals. For everyone that has a replacement cost policy and have chosen to insure it for less than the true replacement cost I would recommend looking into a nasty little clause called the coinsurance clause in most policies. One should never dictate to an agent how much they would like to be covered for rather they should allow their agent to pick the amount of coverage that is appropriate and lower the premium through self insuring with a higher deductible. Hope this helps some readers.

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