Property Insurance Limits: Market Value vs. Replacement Cost Value

“Why does my building limit differ from the market value price of the property?” is a common question that plenty of commercial property owners frequently ask. After all, when big numbers don’t match, it should raise an eyebrow. Yet, when you see that the limit of insurance for your building isn’t equal to the purchase price of the property, there’s a reasonable explanation. The answer lies in the replacement cost valuation method.

We’ve got the down low on replacement cost. Let’s dive in!

Understanding Valuation Methods

Many people who own or are looking to buy commercial property mistakenly interchange a few terms—market value, assessed value, and replacement cost value. Yet, these terms don’t mean the same thing. To eliminate any future confusion or misunderstanding, let’s sort these out right off the bat.

For starters, the market value of a commercial property is essentially the amount someone will pay for the property. Although several elements influence this particular type of value, insurance companies aren’t jazzed up by it. Really, it’s fairly unimportant to the insurance world.

The assessed value is even less important to insurance companies, but plays an enormous role in measuring applicable dues. In other words, the assessed value is used for tax purposes.

The value that lights up the eyes of insurance folks is the replacement cost. This valuation is reached by calculating the cost to rebuild your property from the ground up with materials of like kind and quality. This value should match your commercial insurance policy’s building limit.

Market Value vs. Replacement Cost

It might come as a surprise that you are not insuring your building for the same cost that you purchased it. After all, many important and relevant variables factor into the market value including:

• Comparable sales
• Income the building generates
• Size and condition of the building (interior and exterior)
• Proximity to cities, employment, popular attractions, etc.
• Size and condition of the lot
• Popularity and demand of the market type
• Amenities on the property

Clearly, these are the sort of elements that matter to you as a business owner. Still, when it comes to your building limits, an insurance company has blinders to most of those factors. Instead, they are laser-focused on how much it will cost to rebuild your property in the event of a total loss; and this value can differ significantly from the market value.

For example, let’s say you are looking for insurance on a property in good condition located in a safe neighborhood of an attractive city. The benefits of the surrounding area may contribute to an increase in the sale price of the property. However, they do not affect the cost to rebuild the building. Thus the replacement value will likely be significantly lower than the market value of the property. If you were to use the market price of the property as your building limit, you would be over-insured.

Conversely, let’s say you are looking for insurance on a property in a dangerous area that is less attractive to real estate buyers. In this case, the negative effects that the surrounding area have on the market value of the property might cause it to dip lower than the replacement cost valuation. If you were to insure at the market value rather than the replacement cost value, you might find yourself under-insured.

The use of the replacement cost as the building limit in property insurance is vital for insurers and insureds alike to ensure sufficient coverage.

How is Replacement Cost Determined?

The replacement cost relies on variables such as:

• Debris removal and demolition . Cleaning up the damaged or destroyed property is often an overlooked cost. And yet, it’s often first on your to-do list after a total loss.
• The cost of the materials to rebuild. Consider that materials when the structure was first built were likely far less expensive than they are today due to inflation.
• The cost of labor to rebuild . The cost to replace your building is not limited to the materials needed; you will also need to pay contractors and workers to complete the work. Similar to the above point, this cost may be affected by inflation.
• The lack of bulk discounts . Depending on your business district, contractors might have constructed multiple projects in your area, granting them discounted prices for bulk materials. This is a discount your total loss won’t likely be given.

Replacement Cost Value (RCV) is the ideal valuation method to determine building limits, but carriers have other limit valuations at their disposal including the following:

• Actual Cash Value (ACV) which is the replacement cost minus depreciation. Claim payments in ACV are less advantageous for insureds than a true replacement cost limit and you should always look to avoid this.
• Agreed Value which is a fixed value agreed upon by the insurer and insured. This is often used when a replacement cost cannot be accurately calculated (think historic buildings where “like kind and quality” is difficult to measure).

How to Find the Replacement Cost of Your Property

“So, how do I find out the true replacement cost value of my property?”

In short, the best way to guarantee your building limit is properly set is to have an appraisal done. Of course getting an appraisal isn’t always a quick and easy process, but it offers many benefits to you as a property owner in addition to finding the replacement cost of your building. The appraisal may help you identify deficiencies in your structure before they lead to disaster.

At ReShield, we believe it’s of the utmost importance for our clients to understand what should be taken into account when setting their policy limits. Though it may not seem important when originally placing insurance, your policy limit can be dire in the event that the unthinkable occurs. It’s always best to be prepared for anything with the correct insurance in place.

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