Before you sign off on a new building property insurance policy, it's important to know the differences between replacement cost and market value.

Building property insurance: Replacement cost vs. market value

Amy MitchellBusiness Insurance, Insurance

One of the biggest challenges you’re bound to face when insuring a building is determining the amount of insurance, or limit, to place on the structure. What someone “paid” for a building or what a building is “worth” on the open market, versus how much the building should be “insured” for on an insurance policy are NOT the same thing. It’s important to work with a knowledgeable insurance partner to avoid confusing a building’s “market value” versus its “replacement cost”.  Read on for helpful information regarding the differences between these two concepts.

Market Value
Market value is a real estate or financial term, and is not a substitute for replacement cost. Also called fair market value, it is just what it sounds like: the value your property would be appraised at if you were to put it up for sale and subsequently what someone is willing to pay. This value is usually what owners and managers feel their property is worth.

Market value is based on the building and other factors, such as supply and demand, location, area crime statistics, parking availability, local real estate climate and the amount and quality of land on which your structure is located. Because real estate values constantly fluctuate, this number is likely to change over time.

Sometimes the factors listed above combine to generate a market value that is higher than the replacement cost. This can be confusing and prompt questions such as, “If I paid $7,500,000 for a building, why am I only insuring it for $6,000,000?” Perhaps the owner entered into a bidding war with other buyers and drove the price up because of the property’s prime location with excellent access to interstates and other related businesses, or the price of steel and concrete are low because of too much supply and not enough demand, thus driving replacement costs down.

Before committing to an insurance policy, determine if a market value- or replacement cost-based plan is right for you.Determining the amount of insurance, or limit, to place on a building can be challenging.

Replacement Cost
Replacement cost is what an insurer agrees to pay for the materials and labor needed, at an estimation of today’s cost, to repair or replace only a structure with like kind and quality as it was before damage occurred. The term “replacement cost” is usually associated with insurance and should not be used as a substitute for market value – they are not interchangeable.

Replacement cost is generally calculated using two main factors: the cost of building materials and the cost of reconstruction labor. These numbers are based on the building’s location, size, use, and quality at the time of damage. Replacement cost does not take into account factors that impact market value such as crime statistics, comparable property sales, and amount of land. It is focused on the costs associated with repairing and replacing a building or structure. Other expenses you may face when dealing with a damaged building, such as destroyed land or upgrades you decide to make when rebuilding are not part of the replacement cost consideration.

There are times when the replacement cost is higher than the market value. If an owner paid only $5,000,000 for a building, why insure it for $6,000,000? Perhaps the property is in a less than desirable area with limited interstate access, high crime rates, and other comparable buildings are selling below expected market value. However, at the same time, steel and concrete prices are up because of a building boom across the country, thus driving the replacement cost higher.

Remember – market value is how much someone is willing to pay for a property, while replacement cost is how much an insurance company will need to pay to have a structure repaired or replaced based on current material and labor cost trends. The two values should not be expected to be the same because they are two different methods of valuing property. There are times when the market value is higher than the replacement cost and vice versa. Each circumstances creates unique risks for an owner or manager.

To make sure your company’s interests are best protected, work with an insurance partner well versed in property coverage. Our experts can help you understand the differences between these two often confusing terms.

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