New Niche: Understanding Replacement Cost

Editor’s Note: At a recent conference, Fannie Mae’s Mark Simpson, Director Property Standards, Single-Family Credit, shared how insurance industry changes offer appraisers a new opportunity to provide lenders with an additional service: replacement cost data.

The data is used to determine an appropriate level of hazard insurance for Fannie loans. Fannie requires hazard insurance that settles on a replacement cost basis. For the most part, insurers are not providing this information any longer, leaving appraisers an opportunity to furnish the data to lenders using the Cost Approach. The definition of “replacement cost” is not the same for appraisal and insurance purposes, however. Below is a replacement cost “primer” from Marshall & Swift that details the differences.

A recent Q&A issued by Fannie Mae offers the following guidance to lenders and helps explain why the expert hand of appraisers is still needed: “It is not appropriate for the lender simply to subtract the reported site or land value from the appraised value of the property to make that determination because that result is an estimate of the depreciated value of the improvements, not an estimate of their replacement cost.”

You’ll find the complete Fannie Mae Q&A at OREP members and WRE subscribers enjoy 10 percent off their first replacement cost report from Marshall and Swift using their new (source code MAGWREAU06)  

New Niche: Understanding Replacement Cost

By Gretchen Gary

Both cost approach appraisals and insurance policies use the term “replacement cost.” While the term is the same what they define is quite different.

When using the cost approach, the appraiser must first identify the appropriate cost basis for the assignment and determine if the opinion of value would be represented best by the replacement cost or the reproduction cost.

While replacement cost details the cost to replace the existing structure with a substitute of “like kind” or “equal utility,” using current standards of materials and design, reproduction cost is the cost to construct an exact replica in all salient characteristics of the subject property.

In general, most every cost approach appraisal features the property’s estimated replacement cost new, which is adjusted to account for depreciation and land value. The common appraisal equation is as follows: replacement cost of building and other improvements minus depreciation plus land value equals replacement cost new.

Reproduction cost, far less common in modern appraisal, is closer in definition to the replacement cost represented on the insurance policy.

Insurance Replacement Cost
What is replacement cost as it applies to the insurance policy? Recommended over actual cash value, replacement cost coverage insures a home for the estimated cost to reconstruct an exact duplicate or replica of the building at current prices. The costs assume use of like kind and quality materials, construction standards, design, layout and quality of workmanship.

To clarify what the cost implies, the insurable replacement cost is better explained as reconstruction cost. Also worth mentioning, the replacement cost on an insurance policy need not account for depreciation or land value, as does the replacement cost estimate of a cost approach appraisal. After all, in the event of a total loss, depreciation and land value have no influence on the cost to reconstruct a replica of the lost structure. And depending on the local market, reconstruction cost could be more or less than the current market value of the structure.

The following are included in replacement cost new (as defined in the appraisal):
Plans, specifications, surveys and building permits; material and labor costs, including all appropriate local, provincial and federal sales taxes; normal site preparation, including finish, grading and excavation for foundation and backfill for the structures only; utilities from structure to lot line figured for typical setback (not included with mobile or manufactured homes); contractors’ overhead and profit; depreciation; estimated land value.

The following are included in replacement/reconstruction cost (as defined in the insurance policy): All the above mentioned inclusive of replacement cost new, except for depreciation and land value; current building codes; reuse of building components or mechanical systems below grade level; loss of economies of scale associated with new construction; extra costs due to site accessibility; higher labor costs and premium prices for materials; extraordinary fees and other contingencies.

Authror’s Bio
Gretchen Gary is the Copywriter with Marshall & Swift, the leading provider of building cost data and widely recognized authority on the cost approach.

Tags: , , , , , , , , , ,