Replacement Cost vs Actual Cash Value

As a real estate investor you should become familiar with these two terms, replacement cost and actual cash value.  This is very important for you to understand when looking at insurance.  Insurance companies value property several different ways but these are the most abundant in the investing world.

Generally speaking, insurance companies prefer to pay out on an ACV policy over a RC policy.  This is because ACV policies deduct for depreciation of the property while RC policies do not.

A RC policy pays for any damage to be replaced with new materials of comparable quality.  An ACV policy is based off of replacement cost but it then deducts for depreciation (ACV = RC – Depreciation).  Depending on your property this could be a substantial difference.

For instance, a property has a roof with a 20-year life expectancy destroyed by hail 5 years after its installation and the cost to replace the roof is $10,000.  The current replacement value of $10,000 less depreciation of $2,500 (25%) equals the actual cash value of $7,500.  Under this same scenario a replacement cost policy would pay the full $10,000 to replace the roof.

When I had my house broken into and several items stolen I was glad I had a replacement cost policy.  The carrier took a list of damaged property and stolen property (which included a tv, laptop, camera, ipod, and several other small items) and wrote me a check to replace everything with its brand new equivalent.  Had my policy been an ACV policy they would’ve seen that the camera is a couple of years old, it was a second generation ipod, and my laptop was almost worthless because it was 5 years old.  If depreciation would’ve been taken into consideration I probably would’ve only received about 75% of what it actually cost me to replace those items.  However, since we had RC coverage we received a new door, tv, laptop, ipod, and camera for free!

Because replacement cost does not account for depreciation it is generally a little more expensive than actual cash value.  On occasion that difference may be enough that it makes sense for you to go with an ACV policy.  If you purchase a property for $10,000 it’s not going to be worth you insuring it for replacement cost.

As a general rule of thumb you can bet that replacement cost will be a better coverage but that doesn’t necessarily mean it will be a better policy for your property.  On the other hand, an actual cash value policy is generally cheaper but you may be sacrificing more in coverage than it’s worth.  Be sure you work with an experienced insurance advisor that knows the real estate investing business well.