The economic goods approach to replacement costs

The economic goods approach to replacement costs

Here is a story about Sam and Sally, who are twins and homeowners living near each other but with very different homes. Let’s compare the replacement costs for their homes by the old-fashioned multiplier versus the economic goods approach, which uses patented, modern technologies.

Sam lives in the house that he grew up in. It is an average construction quality, 2,500 sq. ft. ranch style home with a two-car garage. There are 2.5 bathrooms. The kitchen has been updated so it is newer, but it is still an average kitchen. The replacement cost for his home has been estimated at $326,000.

Sally chose to have a custom, 5,000 sq. ft. home built in the same city but in a more exclusive zip code. The architect that she hired designed a European Influenced style home with a mix of a French mansard roof, Tuscan balconies and arched windows. Sally chose a builder that her neighbor recommended who works regularly in that section of town. Many of the homes on her street were built by this construction firm and if her home needed to be rebuilt, she would hope that they would be employed again. If not, there are a few other high-value home builders that are just as good. To balance with the size of the house, instead of a 2-car garage, she has a 4-car garage. Sally also has a covered porch.

“The description of each home’s exterior paints a picture of what’s inside the home.”

The idea of assigning a cost for a building component and then using a multiplier based on the quantity of the component has been around since the 1950s. Since Sally’s home is twice the size of Sam’s home, plus a larger garage and a porch, would you expect it to be at least twice the cost of Sam’s? If the replacement cost for Sally’s home was around twice Sam’s, would it be at least $660,000 to say $700,000?

That’s the downside of adding just the materials, labor and a multiplier. Sally’s home is actually $1,484,000.

Why is it more than four times the replacement cost for Sam’s house? Multipliers—and counting only materials and labor—don’t take into account that the size of a structure is not the only factor. If we look at homes as we do other economic goods, this will make more sense. Just as a forest is made up of more than just trees, a luxury home is more than a multiple of a smaller home. Our world is three dimensional and any valuation tool in a three-dimensional world needs to be as well.

The description of each home’s exterior paints a picture of what’s inside the home. The 2,500 sq. ft. ranch style describes a home with an average kitchen and perhaps 2.5 baths. The features and finishes are average. There are many contractors who have the skills and experience to build this home. Plans for the home and the materials to build it are readily available.

In the case of the 5,000 sq. ft. European Influenced style home, this description paints a picture of a home with one kitchen and 4-5 baths. More lead time would typically be needed to purchase the materials and custom order items for the home. The features and finishes are not merely more of the same items in Sam’s house, there are different features and different finishes—higher quality, more expensive and probably more numerous types of each. Fewer builders have the experience and financial capabilities to build this type of home. Further, additional skills—at higher hourly costs—are needed by the trades to complete it. Custom builders that have excellent reputations and are recommended by others can, and will, charge more. Think about other economic goods, for example a polo shirt that is purchased at the Gap versus one purchased at Ralph Lauren. Compare a gallon of milk at Safeway versus Whole Foods. The same items are being purchased but the costs can vary based on where it’s purchased.

“Multipliers don’t take into account that the size of a structure is not the only factor.”

Builders who can replace the ranch style home are more plentiful than those who have the experience and skills to replace the European Influenced style home, which means a reduced supply of builders for the larger home. It is easier (and therefore less expensive) to find builders to replace small homes with simple floor plans, using materials that are easily obtained at any building supply center. Conversely, it is more difficult (and therefore more expensive) to find builders with the building knowledge, access to materials and financial stability to replace large or specialized homes.

We mentioned Sam recently updated his kitchen so let’s look at just the kitchens in these homes.

Sam went to the nearby home improvement store and picked out the cabinet style he liked, granite countertops and new stainless steel appliances. They were able to schedule the installation within 6 weeks of purchase. The total cost of the new kitchen was $35,000. Sally’s home is almost 15 years old and she is considering an update to her kitchen. She visited a custom kitchen design center near her home. After selecting her new kitchen’s custom cabinets, marble slab countertops and built-in appliances, the cost came to about $110,000 and could be scheduled for completion in 6 months. Her home has more cabinetry and appliances in the upstairs family room and rear porch, but she will leave those as is, for now. Lastly, Sally and Sam met at the home improvement store near Sam to pick out a few cabinets to replace what they have in their small family cabin at the lake. This cabin is only 1,000 square feet, with a small kitchen. The cost to replace the few cabinets, laminate counters, stove and fridge was $6,000. So, similar to the home values, the kitchens costs are not mere multiples of each other. All values depend on the location, amount and quality.

Sally and Sam are both happy with their homes and, in the event that something unfortunate occurs, would like them replaced fully. In order to provide an accurate replacement cost for both homes, their insurance carrier should use an estimating tool that is able to compensate for very different homes. The result will provide the homeowners with the ability to rebuild what they have now and will help the insurance carrier to better align premium and risk.