The cost to replace a home is usually different from the cost to purchase it. When those values differ too much, homeowners can be caught with insufficient coverage.
What’s the value of a specific house? That depends on whom you ask. Real estate agents, mortgage lenders, and home sellers or buyers will answer with the house’s market value (or resale value). Insurers will answer with the house’s replacement cost estimate (RCE). And homeowners will often be confused as to the difference between the two.
The costs of selling vs. the cost of replacing
A house’s RCE is generally defined as the cost to rebuild a structure with the same kind and quality of materials on the original site. It doesn’t include the value of land or other intangibles (such as nearby school quality) that are often included in a selling price. In many areas of the country, such as the Northeast and large metropolitan areas, land value can be 50 percent or more of the total market value of a home.
The two values are based on independent concepts, used for different purposes, and subject to different market forces. While both market value and reconstruction costs fluctuate, their movements don’t usually occur at the same time, speed, or amount. When the real estate market is trending upward, market value of a property inclusive of land, home, and additional improvements is typically higher than the cost to rebuild only the home. Whereas when real estate is trending downward, market value may be less than the cost to rebuild just the home.
Inflation and the housing market: A tale of two trends
Inflation has been the leading economic news story of the past two years. In summer 2022, the consumer price index reached an 8.5% year-over-year increase, its highest point since 1981. Reconstruction costs have been hit harder than many categories: Average year-over-year reconstruction costs have increased by 11% per year since 2021, compared to a historical average of less than 4%. This may reflect specific pressures on the construction market; extreme weather events, supply chain challenges, labor strains, and other factors have resulted in unusual volatility.
Until March of 2023, existing home sales prices had increased year-over-year for 131 consecutive months, a record streak of nearly 11 years. However, both March and April 2023 saw year-over-year decreases, and home prices are currently around 13% lower than their record high in June 2022.
According to Verisk research using both Homeowner Data and 360Value, the average market value of a house in the United States in 2023 was $397,624, while the average RCE was $454,860, meaning that the average property’s market value was 13% below its estimated replacement cost. In some states, the discrepancy was startling:
The top 5 jurisdictions, in order, with market value lower than RCE by percentage are South Carolina, Alaska, Washington D.C., West Virginia, and North Dakota, all ranging from 47% to 78% lower. In contrast, the top five states with market value higher than RCE are California, Washington, Hawaii, Massachusetts, and Utah, ranging from 17% to 52% higher.
How insurers can help close the coverage gap
Market value/RCE differences can compound year over year. Verisk’s latest research revealed that RCE valuations were off by an average of nearly 4% just three years from the original calculation, and that discrepancy grew to 7% by the fourth year and almost 11% at five years. A property that starts with a 13% gap between market value and RCE can have an even bigger shortfall as time goes by.
Insurers need to be both understanding of the policyholder’s concerns regarding coverage and cautious when they explain the differences between market value and reconstruction costs. While some may write coverage at a lesser amount, or market value, it may be wise to consider whether the resulting coverage will result in the home being underinsured in the event of a total loss. Estimation tools that calculate based on construction costs can help point to a more accurate cost basis.