Market Value vs. Replacement Cost
The U.S. residential real estate slump has been widely publicized. However, the market values of homes have declined more rapidly than their corresponding replacement costs. In many cases, replacement costs are still increasing — just at a slower rate.
It’s valuable to differentiate market value from replacement cost in your discussions with clients and prospects:
- Market value — the price a property can realistically sell for, based upon other property sales in the same area
- Replacement cost — the cost to reconstruct a home with all of its unique features in today’s marketplace, using materials and craftsmanship of similar quality
Most frequently we see the greatest differential between replacement cost and market value in historic homes. However, we also see it with custom homes in suburban neighborhoods and homes that are not easily accessible. Some examples:
Historic Homes
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A homeowner purchased his historic residence for $1.7 million. It contained unique architectural features that would require various skilled craftsmen to reproduce. It was built using materials that are no longer available and, if rebuilt, the home also would have to be brought up to current building codes. All of these factors resulted in the home’s replacement cost value of $9 million. |
Custom Homes in Suburban Neighborhoods
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A homeowner purchased a 30,000 square foot home for $7 million.
The house featured sophisticated audio, video, lighting and house management systems. It was decorated with imported designer wallpaper and a variety of custom paint finishes. In addition, the grounds featured a custom granite swimming pool, an elaborate English garden and a greenhouse. Other homes in the neighborhood were basic, suburban wood frame homes; nothing comparable to the residence. The replacement cost for the home was determined to be $21 million. |
Inaccessible Homes
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A homeowner purchased 60 acres of remote land to build a custom winter retreat. During the building process, temporary housing for the workers had to be erected; the closest town was 60 miles away. In addition, due to inaccessibility during winter months, construction could only occur between April and October — resulting in a three-year project overall. The market value of the home was appraised at $2.6 million, but due to the construction restrictions and inaccessibility, the home’s replacement cost was upwards of $8 million.
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When consulting prospects — especially those who have been under-insured with direct writers — there are a range of replacement cost drivers to explain. Future bulletins will highlight factors such as:
- Guaranteed Rebuilding Cost vs. Extended Rebuilding Cost
- Exchange Rates and Raw Materials
- Building Material and Labor Costs
- Professional Services and Fees
- New Construction vs. Reconstruction
- Condo/Co-Op Valuation
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