Market value and replacement cost are two important concepts in the world of insurance. Both terms are used to calculate the coverage that policyholders receive for their assets or properties, but they represent different approaches to valuation
Market Value and Replacement Cost of a Building Are Not the Same Thing
They are distinctly different concepts which are estimated using different criteria. It is not necessary that the market value and replacement cost of a building are identical. They are two distinctly different approaches to valuing a property.
Market value is the estimated price at which your property would be sold on the open market between a willing buyer and a willing seller under all conditions for a fair sale. Replacement cost is the estimated cost to construct, at current prices, a building with equal utility to the building being appraised.
Market value represents the agreement between buyer and seller of what property is worth. In real estate, it often includes the value of land, site improvements to the land, buildings, and sometimes personal property and intangible assets. In order to compare market value to replacement cost, adjustments must be made for such factors.
Replacement cost is the cost to construct or replace at a given time, an entire building of equal quality and utility, using prices for labor, materials, overhead, profit and fees in effect at the time of the appraisal. The construction or replacement of the building uses modern materials and current methods, designs, and layouts. Replacement cost does not take into consideration improvements necessary to conform to change building codes, demolition, debris removal, site accessibility, reuse of building components or services, overtime, bonuses for labor, abnormal soft costs, extraordinary fees, premiums for materials, and other various contingencies.
Although the concepts of market value and reconstruction cost are different, both are affected by economic conditions. The supply and demand for housing also impact the fair market value. The supply and demand for labor and materials affect replacement cost. When situations arise where supply does not equal demand, market value, as well as replacement cost can change quickly. These conditions can be short term or temporary.
It is important to note that the fair market value and replacement cost for a building may not be the same. The reason that they could be different is because they are different concepts. Market value is in the eye of the buyers and sellers, while replacement cost is the sum of all elements brought together to produce a physical property.
The Colorado DOI (Department of Insurance) is engaged in an ongoing analysis of losses from the fire versus insurance coverage.
“According to the department: “Of the 951 total loss claims analyzed, 76 homes had guaranteed replacement coverage, meaning that the insurance policy on these homes provides coverage for replacement of the home with similar quality, square footage, finishes, etc., without a cap, meaning underinsurance is not a problem for these homes. These 76 homes represent 8% of the homes in the analysis.”