Replacement Cost Article

One of the craziest results of our recent economic malaise has to do with the replacement cost of private homes.  For the past 50 years, the actual replacement cost of a home was less than the market value of the home.  After all, you weren’t covering the land, landscaping, etc.  As everyone knows, market values have taken a dive over the past two to three years.  Replacement costs have not.  In fact, replacement costs have steadily risen over the same period.  Why is this the case?  The answer lies in the fact that the determination of a replacement cost and a market value are based on substantially different criteria.

How is replacement cost developed?  There are three primary criteria used by insurance companies to determine the replacement cost of a home, square footage of the “finished area” of the home, the location of the home and building quality of the home.

Finished area means the actual square footage of the livable area of a home, excluding any basements or crawl spaces.  The location of the home is used to develop the general construction costs of material and labor.  These costs can vary significantly in different geographical areas.  The quality of the home means the type of upgrades contained in the home (such as designer counter tops vs. builders grade, etc.) and the architectural complexity of the home.

There are several “secondary “ criteria used in developing the replacement cost of the home as well, these include things such as the number of bathrooms, the size and type of garages, fireplaces, etc.

The size of a home and the quality of it’s upgrades play an important rule in creating market value however much of the market value of a home is based on demand for the location and how desirable the area is (schools, shopping, security, convenience, etc.).  In essence, there are many more criteria used to create market value than replacement cost and market value can change on a whim whereas replacement cost is more stable.

Many people who have some knowledge of the building industry feel that, in general, replacement costs of existing homes as determined by insurance companies are significantly higher than they believe it would take to replace the home.  They are basing this belief on the actual costs they have witnessed when building new homes.  It does cost substantially more to replace an existing home than build new and here’s why. 

Economy of scale:

When a contractor is building many homes at once, materials are purchased in large quantities hence the price is lower.  Delivery costs of materials decrease as well. 

“Top-Down” vs. “Bottom-Up”
New construction starts at the foundation and is built “up”.  Repairing a significantly damaged home usually requires repair from the top down which is far more expensive and time consuming.

Demolition and Debris removal: 
This is an additional and substantial cost not present in new construction.

Use of labor:
When several homes are being built, even if not in the same area, a builder is able to schedule sub-contractors efficiently and less expensively.

 Access to the worksite:
New homes normally do not have impediments to the work site such as landscaping, other homes etc.  When working around these impediments, the cost of transportation and labor increases.

Undamaged parts of the home and the contents of the home must be protected.
Rain damage, looting, etc. are all exposures that must be protected from causing further damage to contents remaining in the house or undamaged parts of the home.  New homes normally do not have these security issues, especially for contents.


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