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Market Value & Replacement Cost - What's the Difference?
Jun 29, 2015

 

Market Value and Replacement Cost

If you own commercial property, choosing a property insurance policy that fits your specific needs is important. A wide variety of policy options are available at different prices that cover an assortment of reimbursement options. Although there are policies that offer a large amount of financial coverage, depending on the type of property that will be insured, it may make more financial sense to pick a policy that still offers adequate coverage while having lower premiums.

Commercial properties can be valued in a variety of ways, and a number of factors can determine whether your property’s value goes up or down each year. Knowing how much your property is worth and obtaining the insurance policy that both protects you and suits your financial needs is important. The following are descriptions of common types of policies and valuation, and the costs that they generally cover.

Market Value

Simply put, market value describes the estimated amount that a property would sell for on the date of valuation. Any land included in a commercial property is also a part of the market value of the property. The term market value can be used interchangeably with open market value, fair market value or fair value.

A number of factors are considered when a property’s market value is appraised, some of which cannot be influenced by the buyer, seller or appraiser. These include the location of the property, capitalization rates, rent growth rate and the general state of the real estate economy.

A market value is most often used when buying or selling a property, though the market value may be examined when determining the replacement cost or actual cash value of a building.

Replacement Cost

The replacement or reconstruction cost is a type of valuation that covers the cost to replace or repair a property with materials of the same or comparable quality. Unlike market value, the replacement cost of a commercial property does not include the value of any land and is determined based on the amount needed to hire contractors and purchase building materials to construct a replacement.

The replacement cost of a commercial property will almost always be lower than its market value, as the replacement cost only has to take building materials and labor into consideration when determining compensation.

Although a replacement cost policy offers a large amount of financial protection in the case of a loss, it is usually more expensive than other types of coverage and, as a result, may not make sense for every property. Without continuous maintenance and renovations to a property, the value of a building will generally depreciate over time. However, the cost of construction and labor to replace a lost property is usually a fixed amount. As a result, it may be better to opt for a less expensive plan that still protects the operations of your business.

Actual Cash Value

Actual cash value functions in a similar way to replacement cost in that it covers the cost to replace or repair a property. However, under an actual cash value policy there is a deduction in coverage to account for the depreciated value of the original property.

A property covered under an actual cash value policy will be rebuilt or repaired using modern construction techniques and materials. The difference between this cost and the depreciated value of the original property is only covered under a replacement cost policy and not actual cash value.

Actual cash value policies generally have lower premiums than replacement cost plans, and they may make more sense for particular types of properties. For example, a store located in a very old building in a popular urban environment will not depreciate as quickly as a new office building located in a business park. The store is more location-sensitive and does not require a modern building to operate, so an actual cash value plan and its lower premiums may make more financial sense than a replacement cost plan.

Functional Replacement Cost

Another less expensive option for property coverage is functional replacement cost. This type of policy is used when a functionally equivalent building can be found to replace the original property at a lower cost than building a replacement. A building’s functional replacement cost is lower than the replacement valuation, which results in a reduction in the amount of coverage and correspondingly smaller premiums.

Functional replacement cost coverage can also be used to repair a partially damaged property with less expensive materials, such as replacing a wall with drywall instead of plaster.

The main reason for using functional replacement cost coverage would be to save money with lower premiums, so it may be a good option for properties that use expensive materials that are not necessary to the function of the property or for buildings with intangible value that is not relevant to their commercial functions.

Which Type of Coverage Best Fits Your Needs?

The value of any piece of commercial property changes constantly. Knowing your property’s value and obtaining the policy that best suits your needs will safeguard your current and future assets. Contact Tanner, Ballew and Maloof, Inc. today to appraise your property’s value and learn more about which type of policy is best for you.