Declining Residential Market Values Spur Customer Service Concerns for Insurers

By Scott Amussen

Upside-down mortgages have become a hallmark of the current housing crisis. The downward trend in the value of residential real estate has resulted in countless instances of homeowners owing more on their mortgage than the house is currently worth. These conditions have affected not only the housing industry but the insurance industry as well.

The cost to rebuild a home now exceeds its market value in many parts of the United States. In some cases, the disparity has grown to overwhelming levels. Most homeowners expect insurance coverage amounts to decrease in line with deflating home values and are disappointed when they find out otherwise.

The downward trend in the value of residential real estate has resulted in countless instances of homeowners owing more on their mortgage than the house is currently worth. These conditions have affected not only the housing industry but the insurance industry as well.

While discussing the results of the J.D. Power and Associates 2010 U.S. National Homeowners Insurance Study, senior director Jeremy Bowler said, "Approximately 50 percent of customers…have erroneously expected their premiums to decrease just as home values have declined since 2008. As a result, many customers believe their policies are not aligned with their property values and express dissatisfaction."

Xactware recently conducted an analysis to understand and ultimately explain the differences between market value and replacement-cost estimates. Using data from the fourth quarter of 2010, Xactware selected several metropolitan areas to compare median home sale prices reported by the National Association of Realtors with replacement-cost estimates calculated using 360Value®, Xactware's replacement-cost estimation solution.

The results revealed large disparities between market value and replacement value in many markets, particularly across the Sunbelt, where real estate prices have taken the biggest hit. The most extreme example is Fort Myers, Florida, where the median replacement-cost estimate was 159 percent higher than the median home sale price in the fourth quarter of 2010.

In southwest Florida, it's easy to find homes priced to sell in the range of $40–$50 per square foot, including the home and surrounding land. But reconstruction costs quoted by local contractors can start at $70–$80 per square foot, without including land.

Figure 1
Metropolitan Areas Where Median Replacement-Cost Estimate
Exceeded Median Sale Price in Fourth-Quarter 2010


Metropolitan
Area
Sale
Price
Replacement Cost Percent Difference
Cape Coral – Fort Myers, FL $ 86,000 $222,800 159.1%
Orlando, FL 128,400 213,100 66.0
Phoenix – Mesa – Scottsdale,AZ 132,300 207,200 56.6
Las Vegas – Paradise,NV 134,200 202,400 50.8
Sacramento – Arden – Arcade – Roseville, CA 177,800 252,600 42.1
Riverside – San Bernardino – Ontario, CA 186,300 258,800 38.9
Reno – Sparks,NV 176,000 206,000 17.0

The table shows the difference between median home sale prices reported by the National Association of Realtors (NAR) with replacement-cost estimates calculated using 360Value, Xactware's replacement-cost estimation solution. Results are from the fourth quarter of 2010. The NAR data represents single-family homes. The 360Value data — based on an average of almost 19,000 estimates per metropolitan area — represents one- to four-family homes, the majority of which are single-family.

A Point of Confusion
Often, property owners are not aware of the relationship, or lack thereof, between market value and replacement-cost estimates. Both pertain to the owned property, but the two values are disparate, independent concepts applied to different uses.

Most property owners are familiar with the concept of market value, the current price at which a property can be bought or sold. Market value includes the land on which a house stands and all related structures, including landscaping, fencing, detached garages, sheds, and swimming pools, among others. Market value varies based on supply and demand of real estate in the local area.

But many property owners do not correctly understand the replacement-cost estimate. Xactware defines it as the approximate cost to rebuild a structure with materials of like kind and quality on the original site. A replacement-cost estimate does not include the value of the land or any detached structures on the property. The estimate will vary based on fluctuations of local material, labor, and equipment costs used in reconstruction.

While both market value and replacement-cost estimates fluctuate, changes may not occur at the same time, speed, or amount. The current housing downturn illustrates this concept perfectly because market value has fallen at a much faster pace than reconstruction costs.

Figure 2
Market Value vs. Reconstruction Cost (U.S. Average)

market value vs. reconstruction cost


As market values plummeted in 2008, reconstruction costs — the underlying data behind replacement-cost estimates — continued a slow but steady increase during 2008 and 2009. Different factors influence changes in market value and reconstruction costs, which contribute to the current disparity between market values and replacement-cost estimates.

Educating Policyholders
Education is essential in overcoming potential customer dissatisfaction when a policy includes a replacement-cost estimate that greatly exceeds the market value of the home. To help insurers and agents answer policyholder questions about the difference between market value and replacement-cost estimates, Xactware has created a web page — www.xactware.com/marketvalue — that provides an overview and educational information on the topic.

Scott Amussen is Xactware's assistant vice president responsible for its property valuation and other underwriting solutions.