What is Replacement Cost?

Understanding replacement cost starts with noticing what other models are out there.

In real estate, market value is essential in comparing properties. Financial institutions look at the equitable value while insurance companies use replacement cost. Each of these models are unique to their industry and represent varying valuations based on industry specific variables.

The real estate industry bases a property’s value on current market conditions. Market value is the price point at which a buyer is ready and willing to buy and a seller is ready and willing to sell. Market value is in essence a number determined by a number of variables which include the location, land value, acreage, what people are willing to pay, and quality of materials used in construction. These variables all have a profound effect on the value of a structure.

In the financial field, equity is the star. To determine equity in a property, a financial institution divides the loans against a property by the market value. The resulting ratio reflects the percentage of owned property and is used determine loan-to-value (LTV) calculations and whether or not additional products like mortgage insurance are necessary.

The goal of property insurance is to “return you to your pre-loss state.” Replacement cost is simply a valuation that represents what it would cost to rebuild a structure as it originally was. This cost can vary significantly from the other models as it often has fixed costs which do not necessarily vary with the market. Often these fixed costs are not contemplated in a property’s market or equitable value.

Replacement Cost includes:

1. Demolition and removal of the damaged or destroyed structure. When a loss occurs, the damaged part must be removed. If a total loss occurs, an average home can easily cost $10,000 for these services.
   
2. Increased cost of construction. New construction must be built to current building codes rather than the codes the house was originally built to.
   
3. Architect Fees & Other Trades Fees. Damage to or destruction of property will require that an architect prepare a new plan for reconstruction. In addition, it’s often necessary to bring in an engineer to substantiate whether damage can successfully be repaired, or, must be replaced.

Replacement Cost excludes:

1. Land.The insurance company is not responsible for paying for damage that may have resulted from the covered loss to your property. While land is not covered, often there will be nominal coverage for trees, plants, and landscaping that need to be fixed as a result of a loss.

A two bedroom, two bath condo in Manhattan, New York:

Market Value $1,400,000

Equitable Value $610,000

Replacement Cost $390,000

Due to the affluence of the area and demand, the market value is substantially higher than the replacement cost. The owner has nearly 50% equity stake in the property.

A two story, four bedroom, two and a half bath home in Dallas, Texas:

Market Value $199,000

Equitable Value $209,000

Replacement Cost $241,000

An overabundance of properties for sale drive the market value down below the cost to replace it and causes the owner’s equity in the home to be negative.

(E)valution

When considering insurance providers, your focus should be on the cost to replace your property at current market costs. Many insurance carriers impose a penalty for neglecting to carrying 80% of the home’s replacement cost which they will determine after a loss has occurred. If your limit is not sufficient, you may receive a claim payment to settle your loss that does not cover your actual costs to repair or replace your damaged property.