Definition of Replacement Cost

replacement cost
After Hurricane Sandy hit the shore of Lavallette, New Jersey. © Glynnis Jones, Hurricane Sandy New Jersey

Definition: Replacement cost is the amount of money it may require to replace a structure with a similar type of construction, and the expense varies from year to year, especially if you're looking at the cost to replace a home. When real estate markets are appreciating, it can often cost more to buy a resale or used home than to build a new home. But when markets decline, sometimes it is cheaper to buy an existing home than to build new.

Replacement cost is generally part of a homeowner's insurance policy. But you should ask. If it costs more to build a new home than the initial expense of your home, then you will want to make sure the replacement cost coverage of your policy is higher than the price you paid. If prices are appreciating in your neighborhood, you may also want to increase your basic insurance coverage but the replacement cost coverage might go down.

When an appraiser prepares a comprehensive appraisal, replacement cost, i.e. the cost to replace the existing building with a similar building, is calculated but rarely used as a stand-alone appraisal. That's because comparable sales carry more weight in a residential appraisal than replacement cost.

The price of construction materials fluctuate. Labor costs change as well. When my home was built in the 1940s, the homes in my neighborhood sold new for about $10,000.

Ten grand today barely covers putting on a new roof. And a composition roof only at that price. Not a shake or tile roof. It's considered good practice to review your homeowner's policy every couple of years to make sure you have enough replacement cost built in should disaster occur.

Just in case you're thinking that disaster will never happen to you, I would not be so certain about that.

Apart from wildfires and sink holes, flooding is a very real possibility, even if you don't live in a flood zone. You need to make sure you carry flood insurance, too. Water does more damage than just about anything short of an asteroid hitting the Earth.

Replacement Cost Coverage Saved This Woman in Anderson, California

Here is a true story about losing a home. I went to visit a friend in Anderson, California, a few years ago. Her home sits on an area in the mountains called a hogback, so called because it resembles the back of a hog. The land is relatively flat on top but slopes on both sides. My friend enjoys a remarkable view from Mt. Lassen to Mt. Shasta. Unfortunately, she lost her home, along with 1,000 other homeowners in Anderson, all because an arsonist had started a fire.

She showed me photographs of the ashen remains of her home, her recovered childhood possessions like a charred silver spoon lying in the burned out trash. Everything was destroyed. I had no idea how quickly a fire could demolish a home into a heap of blackened soot. Quite a few residents of Anderson, California, did not carry replacement cost coverage, and many other homeowners had no insurance at all. Sometimes people don't spend money to prepare for disaster when other pressing issues dictate.

As is common in these types of instances, volunteers from local churches and nonprofits appeared on the scene to help homeowners sort through the ashes to retrieve items of personal and sentimental value. There was really nothing of tangible value left after the blaze. Within a few weeks, an insurance adjuster came out to assess the damage and arrange for the lot to be razed.

Within a year, my friend had a brand new home. Completely rebuilt from the ground up, made from sturdier materials, supposedly more resistant to forces of nature. Her insurance company paid not only for the complete reconstruction of her home, but offered reimbursement for temporary living expenses and for the loss of her personal property.

Some of her neighbors were less fortunate, especially a few residents who owned a vacation home in Anderson and could not afford to rebuild.

Many of those without insurance for replacement cost had no choice but to write off the loss.

At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.