A buoyant property market has resulted in vast increases in building costs in the last few years – and these need to be taken into account when calculating the insurance replacement costs on all properties. 

Barry Kaganson, MD of national valuation firm Valuation Alliance explains:

“In the last few months, we have seen a rapid and firm increase in demand for insurance replacement cost valuations on all types of properties.  Clients from all sectors are realising that insurance risk is a manageable one, and are being proactive in ensuring that their properties are correctly covered”.

Often, a replacement cost valuation is carried out by the buyer on purchase of a property, and this insured value is then increased each year based on inflation-linked parameters. 

Kaganson cautions against this approach:

“While this may seem reasonable on paper, investors should be aware that often an inverse relationship may exist between inflation and building costs.  With low inflation keeping interest rates in check, this fuels a property boom as has happened in SA, which in turn places strong upward pressure on building costs.  Therefore, applying such a traditional inflation-linked parameter to an historic replacement cost figure, could result in an insured value which is vastly understated.”

In addition, such parameters and indices are tied to national or regional trends, and may not reflect specific properties or areas. Accordingly, Kaganson recommends periodic independent assessment of replacement costs on all properties.  “Many of our clients, particularly those with larger commercial and industrial portfolios are revaluing for insurance purposes on a cyclical basis, valuing a certain percentage of their portfolio each year.  This makes the process cost effective, and achieves a sensible balance of expenditure to risk”.

Jeremy Chetty, Commercial Director of Valuation Alliance, and a veteran of replacement cost calculations, stresses the importance of a holistic approach to such valuations.

“A truly accurate replacement cost valuation must provide cost to construct, at current prices, an exact duplicate or replica of the building, using like kind and quality materials, construction standards, design, layout and quality of workmanship.  Because it might be impossible, impractical or unacceptable to use the materials or methods used in the original construction, “equal quality and utility” may be substituted where necessary for “like kind and quality.”  Such a valuation should also take into account current building standards and technology, re-use of building components where possible, loss of economies of scale associated with new construction, extra costs due to site accessibility, as well as professional fees and other contingencies.”

Whilst general investor perception may be that the difference between a replacement cost estimate and a full blown valuation may be minor, Kaganson stresses the impact such a “minor” difference may have, and the importance of such revaluations with respect to corporate governance issues:

“Consider the situation of an owner-occupied industrial property.  In the event of a major catastrophe and insurance claim, the recoverable amount is a key determinant to reinstate the building to its original condition, hence shortening the business interruption.  At a time like this when cash flow becomes key, the ability of the business to continue as a going concern may well be dependant on the outcome of the insurance claim for reconstruction. Hence the importance of such valuations, especially seen in the context of directors corporate governance responsibilities.”