Understanding replacement cost starts with noticing what other models are out there.
In real estate, market value is essential in comparing properties. Financial institutions look at the equitable value while insurance companies use replacement cost. Each of these models are unique to their industry and represent varying valuations based on industry specific variables.
The real estate industry bases a property’s value on current market conditions. Market value is the price point at which a buyer is ready and willing to buy and a seller is ready and willing to sell. Market value is in essence a number determined by a number of variables which include the location, land value, acreage, what people are willing to pay, and quality of materials used in construction. These variables all have a profound effect on the value of a structure.
In the financial field, equity is the star. To determine equity in a property, a financial institution divides the loans against a property by the market value. The resulting ratio reflects the percentage of owned property and is used determine loan-to-value (LTV) calculations and whether or not additional products like mortgage insurance are necessary.
The goal of property insurance is to “return you to your pre-loss state.” Replacement cost is simply a valuation that represents what it would cost to rebuild a structure as it originally was. This cost can vary significantly from the other models as it often has fixed costs which do not necessarily vary with the market. Often these fixed costs are not contemplated in a property’s market or equitable value.