Replacement Cost Valuation method (opposed to the conventional cost approach) is used to determine the cost to rebuild properties in the case it gets completely destroyed by a fire, hurricane or other disaster.
The Replacement Cost (in conventional appraisal theory) is defined as
“The estimated cost to construct, at current prices as of the effective appraisal date, a building with utility equivalent to the building being appraised, using modern materials and current standards, design, and layout”.
However, the definition of insurance replacement value is different:
"The cost of replacement of all improvements to a property which could conceivably be destroyed."
In summary, Replacement Cost is the actual cost to replace an item or structure at its pre-loss condition.
Relevant cases for Replacement Cost:
1. For insurance coverage purposes, the insurable value of the property is the replacement cost new of the building improvements only, with no land value, depreciation or site improvements. Developer's profit is not considered.
2. HOA requirements - Homeowners' Association for condominium, townhouses, planned unit development must be re-evaluated within certain interval period.
3. Value of the improvements for certain renovations - Many jurisdictions state that new renovation improvements to a total property cannot be made beyond 50% of the actual value of the improvements.
1. Obtain a complete working drawings or perform the inspection of the property taking measurements, photos and notes on the major components that make up the property.
2. Utilize the professional commonly recognized software that calculates the building cost based on condition, quality, and zip code.
3. In addition to the building cost estimates, other site improvements including parking and landscaping are added if they are required.
4. If necessary, tenant-interior improvements that is permanently fixed to the building (specific to the special use such as the lodging, medical, office) is estimated.
5. Once all calculations and findings are compiled, the professional replacement cost appraisal report can be presented.
The Replacement Cost does not count any land value. The purpose of replacement cost is for the use for insurance coverage. The replacement cost is not same as the market value.
When the Cost Approach is utilized to arrive the market value indication, the concept of accrued depreciation (not accounting concept, rather value loss) must be analyzed.
Accrued depreciation is then subtracted from the cost new estimate to quantify the contributory value of the subject improvements.
Accrued depreciation is defined as:
“the difference between an improvement’s reproduction or replacement cost and it’s market value of the date of appraisal”
Accrued depreciation can be caused from physical, functional or economic sources. Physical depreciation is basically the diminished utility of the physical components of the structure. In other words, the older the improvements, the less remaining life the improvements have. Functional obsolescence is a loss in value due to a poor design, over-improvement or outdated structural components. Functional obsolescence can be either curable or incurable. An item of depreciation is considered to be curable if it is economically feasible to correct as of the date of appraisal. If the item is not economically feasible to correct, it is considered to be incurable depreciation. Economic obsolescence is a loss in value to the subject’s improvements that are caused by factors outside of the subject’s boundaries.
The scope of work is to appraise the improvements "as-is" without the underlying land value.
Flood Value - includes foundation
Casualty Value (Fire, Wind) - excludes foundation and about 15% of plumbing and electric.
In most cases, the following are not part of the scope of work: Demolition, Debris Removal, Depreciation
- The application of depreciation is an insurance internal decision applied by the insurance carrier in a payout scenario (Actual Cash Value vs. Replacement Cost Value).
- The difference between new construction and reconstruction is approximately 15% of an industry standard.
- "Up to code" is the replacement of the structure under consideration of current building codes in the local jurisdiction.
- The scope does not consider any market forces of Highest and Best Use.
- Conventional cost approach deducts depreciation and includes the site.
- An insurance appraisal requests the reconstruction value of the improvements as-is with like-kind material, no consideration of depreciation and the exclusion of the underlying land value.
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