If the market value of my real estate is low, should I still pay for replacement cost?

There exist many ways to calculate the value of your real property. When it comes to an insurance value, several stakeholders have some skin in the game.

The lender wants a value greater than the financed amount even though the insurance company is under no obligation to pay an amount greater than replacement cost. So what happens in a down real estate market when the best business decision might be to buy a low priced replacement building rather than face the relatively high cost of rebuilding the old one?

If a decent replacement is on the market, the business could buy, move and reopen sooner and suffer lower collateral losses, like lost sales.

So here's the problem. If you claim the loss with the intention of buying a building with the proceeds rather than fixing the old one, the insurance company is only obligated to reimburse the "actual cash value" of the building.

Actual cash value (ACV) is the replacement cost less depreciation. With older buildings and other add-on coverage, the difference can be significant. And ACV valuation may work for you; don't discard it out of hand.

The add-on coverage defrays costs associated with upgrading due to building codes, replacing obsolete building materials, extra demolition required by the authorities, or upgrading life, fire and access codes.

So under replacement cost valuation, the insurance company pays for your old building to be replaced with the modern, up to code version. Depending on the age difference, these costs can be significant.

With an ACV claim, the insurance company cuts you a check for that amount less what the lender got. The advantage, in down real estate markets, is if you can buy a reasonable, usable replacement location for the cash proceeds and the same loan amount, you end up with a different location and the land from the first location. You may need to demolish the balance of the building though.

Back to the lender: unless you negotiated an agreed value to a total loss, the insurance company does not look at the financed amount as relevant to the claim. Some specialty coverage can be bought to cover that shortfall, but it is not yet standard.

We suggest thinking about the contingencies and planning for them in advance. Is it more important to reopen and save the sales, or is it wiser to build an inventory stored elsewhere? How about your suppliers? Can you replace them quickly in event of a fire at their facility? A good crisis plan is common sense for risk management. Then, your selection of economic valuations of your building will be appropriate.

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Further Reading
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