Geting a proper investment property insurance valuation can be difficult. Add in the idea of a different value for insurance and you have a complicated world.
Demystifying Insurance Valuation
Lessons from Goldilocks
The valuation of any asset can be tricky, and who better to understand that than an investor.
I once approached the owner of a property that I liked. I had heard through a mutual friend, that he was thinking of selling it and I approached him, hoping to close the deal before he put it on the market. The short of it is, I asked him what he wanted for it. His response illustrates the point I am trying to make. “Well…” he said. “I had it appraised, and as an owner-occupied unit, it is valued at $121,000. As a Rental Property, it is valued at $185,000.” Okay…truth is, he never did answer my question.
The “market” value of a home is in the eyes of the beholder, and thus the negotiation. Obviously we try to be objective by looking at comparables and the price per square foot. A home can be appraised, but even that can be subjective (funny how they often come out to the same price as what the seller was asking, right? But I digress). Then you have your finance gurus who talk about valuation models that seek to determine the return, and therefore the value. We hear things like “Cap Rate,” and “Discounted Cash Flow,” which are other ways investors evaluate properties.
For insurance purposes, we care about one thing and one thing only; indemnifying you. We care about what the replacement cost of the home is. What it is going to cost to get you back to where you started. For investors, this means we are going to get the asset back where it was, producing cash flow. Also, we don’t care how much the land cost. The land will still be there to build upon; we only care what it costs us to start installing the walls, roof, floor coverings, deck, etc. We are looking for the replacement cost.
How do you determine that? It could be through appraisal (minus the land value), or through another expert opinion (i.e. a contractor or real estate agent). It could be through a “Cost Estimator Tool” provided by your insurance agent, or a combination of all these sources. The key is to find an accurate valuation and insure the home for 100% of that amount. Not more and not less.
Why? For a couple of reasons:
- This is the amount that the company will pay if there is a loss. You already will be on the hook for a deductible. Let’s not complicate things. Let’s minimize your out-of-pocket expense.
- You don’t want to over-insure it, you will pay too much for premium and the company will raise its eye when you insure, your $125,000 property, for a million dollars. They will be inspecting it and will cancel your policy if it looks like things are not accurate.
- You don’t want to under-insure it. First off, the most the company will pay is their “limit of liability” or the value you have on your policy. So if you under-insure it, you will have your deductible, plus the difference between the replacement cost and what you insured it for, as your out-of-pocket expense. Finally, if you get too low on the valuation, you start getting penalties. Usually this kicks in at lower than 80%. Some companies will penalize you by saying that if you insure the home for less than 80% they take the claim to an actual cash value world. Others start reducing the amount they will pay of the claim, by the same percentage that you have underinsured the property.
So, when it comes to valuation, remember Goldilocks and the Three Bears. You don’t want too hot (over-insuring the property). You don’t want too cold (underinsuring the property). You want 100% of just right (replacement cost). So do some homework, figure out what the home is worth and insure it just right!