Thursday, April 28, 2011

Market Value vs Replacement Costs

Market Value vs. Replacement Cost is something that we in the insurance business discuss a lot with property owners. Depending on the economic conditions there can be a variation between Market Value and Replacement cost. Since the current economic conditions have caused such a discrepancy we at Fey Insurance thought it might be a good time to explain the difference between the two terms.

Market Value is the amount that a house is worth on the real estate market. It is what you can buy or sell the house for. As we sit in the middle of a depressed real estate market, the value of homes is down from years past. When you hear a mortgage company or title company talk about getting an appraisal they are always talking about Market Value because the lending institution is mainly concerned with what they could sell the asset (building) for.

Replacement Cost is concerned with a different valuation of a building. Replacement cost deals with the amount of money it would take to rebuild a structure using the same materials at the same location with the same style of construction. Because this is based on building materials and cost of labor it doesn’t have the large swings that Market Value has. For example, in today’s poor economic conditions, material costs have stayed pretty level meaning the Replacement Cost of a building has stayed relatively flat.

So how do these two forms of valuations play out in numbers? Let’s take an example home that is a brick structure, has four bedrooms/ two baths and is about 2000 square feet. A house like this in our area may be listed on the real estate market for about $250,000 (depending on the school district, location to town, etc) and will probably sell for about $235,000 (which would then be the Market Value). This same structure would have a different value if we used Replacement Cost. In our area the same structure just mentioned would cost about $135.00 per square foot to rebuild if a fire or tornado totally destroyed it. Take the $135.00 per square foot and multiply that by the 2000 square feet and you come up with a value of $270,000 (which would then be the Replacement Cost).

When it comes to banks and lenders they care about Market Value ($235,000 in our example) where the insurance companies, since they will have to pay to have the home rebuilt after a fire or tornado, cares about the Replacement Costs ($270,000 in our example).

So next time you see your homeowner policy or commercial building policy and look at what they are insuring your structure for don’t say to yourself, “I couldn’t sell my building for that” because the amount you are thinking of is the Market Value. Insurance companies are only interested in the Replacement Cost because they want to make sure they are able to rebuild your property and make you just as you were prior to the fire or tornado.