Market Value and Replacement Cost Valuation
Understanding the Differences Will be Key for Success Moving Forward
By Alexandra Glickman and Robby Kunz
The U.S. Federal government declared an end to the COIVD-19 Public Health Emergency on May 11th, 2023. While the pandemic might be “over,” the lingering effects are something the real estate industry will be dealing with for years to come.
The market value of assets and their replacement cost valuation are both being challenged by persistently high inflation and increasing interest rates. Both have been influenced by the post-pandemic economic era. Asset owners trying to pencil out their deals should take note of the differences between an asset’s market value and its replacement cost value. Understanding the differences and the resulting impact on financials will be key to sailing through the rough waters ahead.
Market Value vs. Replacement Cost Value
The market value of an asset is fairly easy to grasp for anyone in the real estate industry. The market value refers to the price that potential buyers and sellers could expect the asset to fetch in the marketplace. It includes things like the value of the land, the current condition of the asset, and many other intangible characteristics like demand and scarcity of supply.
On the other hand, the replacement cost value of an asset is much more formulaic. A replacement cost valuation is used for insurance purposes to determine the cost to repair or replace a physical structure and its contents with materials of like kind and quality. An insurance-based property valuation may also include business interruption values. This refers to potential income generated by a property that is at risk in the wake of a loss.
The key takeaway here is that these valuation methods are affected by inflation and interest rates in very different ways. Persistently high inflation has contributed to elevated costs for labor, fuel, and materials. This means that the replacement cost values of assets in a portfolio are continuing to rise year after year at a faster pace than usual. To combat inflation, central banks around the world are increasing interest rates. This has the effect of increasing borrowing costs for real estate organizations while simultaneously decreasing the market value of their assets. This inverse relationship has resulted in a scenario where some real estate organizations are insuring assets for values greater than they can sell them for. This is a complicated problem for CFOs and risk managers alike.
Real estate organizations that do not have a firm grasp of their assets’ replacement cost values will encounter a greater deal of volatility in their insurance costs. They may also run into unwelcome financial surprises when trying to rebuild in the aftermath of a loss. First, we will define the problem with inaccurate replacement cost values and their resulting financial impact. Second, we will address ways to verify the replacement cost values with defensible data.
The Chief Concern of Property Underwriters
The Council of Insurance Agents & Brokers noted that Q1 2023 was the 22nd consecutive quarter that premiums increased for accounts of all sizes, regardless of geography, industry, or asset class. The most difficult pocket of the marketplace is property insurance, a major line item for real estate organizations. Insureds should expect premiums to go up for the remainder of 2023. The key will be to secure the best achievable results in the marketplace, and property valuation is front and center in this conversation. The chief concern of property underwriters is true and accurate replacement cost values submitted to them during the underwriting process.
An underwriter who perceives that valuations may not be in line with accurate replacement costs has a number of strategies available to underwrite defensively and ensure the profitability of their book. All of these strategies will have a financial impact on the asset owner. An underwriter might choose to:
» Accept the lower values, but charge higher rates/premiums that they feel are in line with the true exposure they are taking on. They will always err on the side of caution and this could result in drastically higher costs for the same coverage limits, deductibles, terms, and conditions.
» Offer less limit capacity and decrease coverage. In this scenario, an asset owner may need to enlist multiple insurers to achieve the same level of coverage which typically comes at a higher cost.
» Require that insureds take on more risk in the form of increased deductibles.
» Change the terms and conditions under which a policy would pay for a loss. This could be in the form of Margin Clauses or Occurrence Limit of Liability Endorsements.
Any combination of these strategies could be enacted at renewal. Real estate organizations will have to evaluate how these changes impact the terms of the loan covenants they agreed to, in addition to increasing the cost of risk transfer.
What to Do?
Real estate organizations that can provide data-backed, defensible replacement cost valuations to underwriters will have less difficulty negotiating their renewals. The first and most reliable way to confirm an asset’s replacement cost value is to enlist a 3rd party appraisal and valuation services firm. Many firms that operate all over the U.S. also have capabilities to conduct international valuations. Once a professional valuation has been completed or if an asset owner already has one on hand, insurance industry-accepted cost indices can be used to trend the values through time. This helps minimize the cost associated with confirming an adequate valuation. It is important to note, that if you cannot verify the starting value that you plan to trend, then you cannot rely on the resulting value from the index.
Real estate finance can be complicated, especially in times of economic turmoil. By making a conscious effort to maintain adequate replacement cost values, real estate organizations can minimize some of the volatility associated with penciling out deals in a high-interest rate and high-inflationary environment. The cost of insurance will become more predictable and will provide an easier path to determining the net operating income associated with a property after expenses such as insurance.
