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By STEVEN GOTTLIEB, MAI, MRICS, senior manager, Deloitte Financial Advisory Services LLP; NATHAN FLORIO, senior manager; and THOMAS HOFFMAN, manager

The attacks of Sept. 11, 2001, hurricanes Katrina and Ike, and other recent events provided valuable lessons regarding the process of obtaining and maintaining adequate insurance coverage and the need to properly estimate insurable values for real property assets. Although many in the commercial real estate industry have taken notice of recent large-scale events, many still underinsure their most valuable assets.

Policyholders that don't understand the parameters used in calculating insurable value, or simply misinterpret their policy, are often at a disadvantage when collecting on a claim from their insurance carriers.

Consider this insurable value definition from a typical property insurance policy: it provides for "the cost to repair or replace damaged property with property of like kind and quality." This may sound all-encompassing, giving policyholders assurance that they will recover the "value" of their property following a loss.

But which "value" will actually be recovered?Are we talking about actual cash value? Or fair market value? Or even insurable value?

The term "value" may have different meanings in different contexts and can even be defined differently by different parties; policyholders should understand which definition is applicable. (Find a list of such definitions in Table 1.)

INSURABLE VALUE COMPONENTS

Often insurers and policyholders will have different views about what the insured is entitled to in case of a loss. Policyholders should understand the difference between actual cash value and replacement cost value.

ACV is typically understood to mean the depreciated asset value, while RCV is the current dollar cost to replace the asset new. In addition to hard construction costs, indirect costs such as insurance during construction and legal and architects fees are also a factor.

All costs incurred when constructing a building should be included when estimating insurable value, via either the ACV or RCV methodology. Policyholders must interpret their policy as it relates to insurable value at the time they negotiate coverage, not after a loss.

Policy exclusions can also be a source of confusion. Exclusions, or items which are not covered in the event of a loss, include building elements that are expected to survive a destructive event such as foundations and underground utilities, and may include certain soft costs and developer's profit.

It is the policyholders' responsibility to understand the policy so that the scope of the valuation meets the policyholders' needs. A third-party appraiser, if used, also needs to understand these issues.

METHODOLOGY

The cost approach is typically the appropriate valuation methodology to use when preparing an insurable value estimate. It measures property value by estimating the cost to construct a reproduction of, or replacement for, the existing structure, including entrepreneurial incentive, and then deducting depreciation from the total cost. (See Figure 1 for a diagram of the cost approach.)

Note that the "insurable replacement cost new" equals the "replacement cost new" less exclusions referenced in the policy. The three forms of depreciation--physical deterioration, functional obsolescence, and economic obsolescence--are typically deducted in the order shown to arrive at an estimate of fair market value.

Also, the presumption in the market that ACV is the equivalent of fair market value is not always true. According to Mark Davidson, senior counsel at Proskauer Rose LLP, when valuing "buildings with iconic value, there can be the possibility of discrepancy between market value and ACV."

Davidson explains that "certain states have defined ACV to be equal to market value. If the policy defines ACV, however, that controls" the determination of the basis for repayment.

For example, one of the World Trade Center policies contained language referring to ACV as being equal to replacement cost less physical depreciation. This underscores the need for the policyholder to understand the valuation context contained or implied within their insurance policy.

Unfortunately, in calculating insurable value, there are no standard rules or valuation methodologies. The methodology used to estimate insurable value must be consistent with the parameters of the insurance policy.

LINKING INSURABLE VALUE TO MARKET VALUE

Another prevalent practice within the real estate industry is the inappropriate use of the insurable value estimate performed as part of a financing or mortgage appraisal as the basis of an asset's insurable value to be used in the policy.

These estimates are prepared for a lender that wants to confirm that the value of a mortgaged property is higher than that of the mortgage. In short, the lender is concerned with having enough insurance to cover the loan, not necessarily the full asset value.

These insurable value estimates are often performed as an afterthought by the appraiser at the lender's request, using generic data and policy exclusions based on assumptions rather than policy specifics, by professionals with limited construction or insurance expertise.

Owners often assume that because they received their loan, in part because the appraisal supported the loan amount, the insurable value estimate contained in the report is appropriate. The problem is compounded by using this estimate as a basis for the insurable value of their assets.

The appropriateness of the insurable value in relation to the property's market value may also be overlooked. Although appraisers typically consider three methods (sales comparison, income, and cost approach) when estimating market value, many rely on only the first two when preparing mortgage appraisals; the cost approach is often "considered but not developed" into a market value estimate by the appraiser. Why?

Perhaps the appraiser is unfamiliar with the mechanics of, and detail required for, the approach, especially when estimating depreciation. Or, perhaps by not developing the cost approach, the appraiser can avoid the need to estimate land value. Or, perhaps the lack of focus on the cost approach is based on the misperception that the cost approach doesn't reflect the motivations of investors.

The point is that market value appraisals and insurable value estimates are different. Often, a bank appraisal estimates the market value of the property via reconciliation of the sales comparison and income approaches (and without developing a cost approach), yet also includes an insurable value estimate via the cost approach.

However, without developing the cost approach into an estimate of market value that reconciles with the other approaches, how can the appraiser be certain that the insurable value estimate is reasonable?

(Editor's note: Part 2 of this piece will look at an example of an insurable value estimate of a suburban office building, as well as delve into rebuild considerations. The story will be posted online as a Web extra in the May issue.)

April 1, 2009

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