Actual Cash Value v. Functional Replacement Cost Insurance?

Question

Hello everyone,

I am under contract on my first long term buy and hold rental. It is a 4BD/1.5BR SFH in Auburn Maine. I am paying $113,000 and will be replacing the roof on it this spring. Everything is currently functioning in the home but the furnace, roof, hot water heater etc. are beyond their expected life.

When I called Progressive, they were able to offer me coverage from two different underwriters and I'm torn on which to go with.

1. Foremost insurance (Annual Cost: $986): $2500 deductible (will be changing to $1,000 per lender requirments); $180,000 functional replacement cost; $300,000 personal liability; $5,000 Sewer, drain, or mold mitigation ($250 deductible). The original quote with all the bells and whistles was $1,346. My primary home is worth twice this and insures for $614 - so the $1,346 was shocking. I took off everything I could and the $986 was as low as I could get the price.

2. American Modern (Annual Cost: $677); Actual Cash value is market value minus land value; I took my purchase price of $113,000 subtracted the land value of $14,600 and came up with $98,400. $1,000 deductible; mold/remediaton - $5,000; personal liability $300,000; loss of rent - up to $9800.

The main piece I am confused about it is what would I actually get if I went with option 2. If the house burned down then I would get $98,400 minus depreciation. Since houses in this area really don't depreciate, I believe they are talking about the individual components of the property, e.g. If the roof is over 20 years old then its worth $0 because its beyond its expected life?

I would love some clarity on what a home built in 1867 with older but functional components could really get in the event that it was a total loss. Would my $98,400 have $10K taken off for the roof, $10K taken off for the old furnace, $2K taken off for the water heater etc... ? One insurance agent told me a cash value policy is useless while another said its a popular choice for investment properties.

In the event of a total loss, I would really just be concerned with paying off the mortgage and moving on so the actual cash value sounds like it might be a good option if I could understand what I would realistically get considering the "market value minus depreciation" wording of this?

Thank you!

Sarah M

Joe Splitrock · Answer

The risk is you end up with a burned down building and a lot. The insurance money may cover the loan and if you are lucky there is enough money to remove the debris and fill the hole. (You can't just leave a burned down building without cleaning up). I had an 1880 building and I went the cheap route. Definitely some risk, but it is rare for a property to completely burn down, so I rolled the dice. I did have a major fire in that property and it could have burned down. Insurance covered everything minus deductible. Damage was around $10K for a minor grease fire in the kitchen. Fire didn't do much damage, but after the fire department dumped water and took axes to everything, it was pretty bad.

Ryan Thomas · Answer

@Sarah Msuya

Hey Sarah,

I’m a commercial insurance agent with experience selling both. Functional replacement cost is better and will cover the amount to rebuild the structure. ACV will not. The reason it is functional is because the building requiring it are over 100 years old and we can’t indemnify antique wood frame. So we do our best to make it functional*. Sometimes if you provide proof of renovation we can bump it to full replacement cost. Ironically i’m writing this as I’m inputting older rental dwellings in an insurance rater haha

Jason C. · Answer

@Sarah Msuya

I’ve done ok with AM cash value policies. Paid for a couple of roofs but had to come out of pocket about 1500 on the last one I did. It had three layers of shingles and it was at least five years past expected life.

I don’t use insurance except for the big stuff so I enjoy the reduced premiums. And almost all of my properties are so old they cost way more to rebuild than they are worth as is.

Jeremy VanDelinder · Answer

(I own a restoration company and work with depreciation all the time.) Don't think of the house as a single unit but as a bunch of parts. Each element (roof, flooring, paint, cabinets, etc) depreciate at different rates over their expected life (much like cost-segregated depreciation in a multi-family complex if you are familiar with that). So, the only way to answer that question is to do a rather involved analysis or suffer a loss (not recommended (-: ) In the event of the loss, you would get the value of each element at it's current remaining life-- ex. suppose flooring is a 20-year component and it's 10 years old, you would get 50%. If framing is a 100 year element and you are 10 years in, you would get 90%

I think @Ryan Thomas has good advice above. Replacement costs a bit more, but totally worth it in the event of a los.

Tony Wilcox · Answer

Each carrier is a bit different, but if the roof is a 30 year roof and it needs replaced at 20 years, you'd roughly get 2/3 minus your deductible paid out to you.

Tony Wilcox · Answer

I would be careful about the depreciation. Every house will depreciate. It isn't the market value, but mostly goes off the age of the home, and what percent your are insuring it at compared to replacement value.

Josh Cousineau · Answer

Unfortunately I don't know a lot about insurance, but being from Auburn, let me know if you need any renters. I have people reaching out to me all the time looking for good rents. Best of luck on this transaction.

Josh

Bill C. · Answer

@Sarah Msuya

Hi Sarah,

Good question,

First, love love Portland, ME... so excited to visit when this pandemic is over :)

In terms of insurance... yes most banks require replacement value to ensure that their loan doesn’t get wiped out. It’s also good for you so that if there is a fire, you don’t lose your investment.

But I think more importantly, is how you’re thinking about risk.

Insurance is all about evaluating and hedging risk. If you’re trying to be a long term investor then you’re trying to minimize risk to maximize risk-adjusted returns... what I’m trying to say is that the main things that can completely blow up an investment in rental properties are relatively limited if you’ve done good underwriting of the property. Catastrophic damage and liability are the major risks ( I guess maybe a pandemic lol). This is why IMHO paying an extra few hundred dollars annually extra for solid insurance along with high liability coverage and maybe an umbrella policy ( if the property is personally owned or expensive enough to be more than liability limits in LLC) is worth it.

Finally, I also think that a solid insurance agent ( while not as useful for primary residence) is very valuable for rental property... they can inform you about many various options and can offer access to coverage that can truly save you in a pinch such as cyberattack liability coverage.

Just food for thought.

Happy investing !

Carlos Ptriawan · Answer

Realistically, almost everybody uses Replacement cost and not ACV. Many lenders also require RC to protect their investment esp if it's rental. When shopping the insurance I found the total cost actually is not too different between ACV and RV.

Danny Randazzo · Answer

@Sarah Msuya speak to your local insurance agent or broker to understand exactly what you are getting and what you need. Most times insurance only kicks in when damage occurs not normal wear and tear or not working because it’s past it’s useful life

Actual Cash Value v. Functional Replacement Cost Insurance?

Actual Cash Value v. Functional Replacement Cost Insurance?

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@Josh Cousineau