Risks involved in buying during a strong real estate market


We can all think about the benefits of an increasing market value in your home, investment property, property/plant/equipment or other assets.  The benefits include greater purchasing power, borrowing power, increased net worth, larger balance sheet, etc. The increase in value could be due to inflation, improvements, valuation, supply/demand, etc.  We have discussed understanding how to protect your home in a previous post.  This post is focused around evaluating the net worth exposure of resource inflation and replacement cost inflation.

This growth in replacement cost value can cause uninsured risk to your net worth or the increasing out of pocket costs associated with replacement of your home.  Corporations also experience this risk but tend to not experience this risk as much as individuals.  It depends on how the business is accounting for the value of the real estate asset(s), which is normally carried at purchase price or replacement cost.  Therefore, not carried at market value and less exposure.

Its important to note Replacement cost IS NOT:

  1. The market value of the home.
  2. The home’s purchase price or the cost of the land.
  3. The outstanding amount of any mortgage loan.

In periods of rising home prices, fast inflation or inflation outpacing the Fed 2% inflation target, we would recommend you review your policy limits regularly.  If your real estate asset is mortgaged, most lenders only require policies to cover the banks’ risk plus your coinsurance requirement (typically 80%), so be careful thinking that the amount of insurance the bank requires is enough.  It may cover your mortgage requirement and asset at purchase price but may leave you exposed to net worth decrease in the event of a loss.

For example, if your home or asset is insured for $100,000 and it increases in replacement value to $110,000 over 5 years of living in it, your insurance policy doesn’t automatically cover you for the increased replacement cost.   Creating a $10,000 exposure to your net worth.  Obviously this is an example and the numbers can be greater and move quicker depending on economic conditions.  When you start using $1,000,000 assets and greater increases in replacement cost value, we are talking 6-7 digit exposure.

The good news is there is a solution to solve this gap in coverage. There are endorsements to your insurance policy to add to increase your limit as an automatic inflation adjustment or you can periodically reevaluate your policy limits.  We recommend considering both as a belt and suspenders approach.

With the help of websites like Zillow or Trulia you can keep a update of the regular market price of your home or real estate assets to determine your increase in market value.  To determine your risk or change in market value.  Keep in mind any architectural details or unique building materials that may Affect Your Estimated Replacement Cost, such as:

  • Upgraded bathrooms or kitchens (including cabinets).
  • Finished or partially finished basement.
  • Additional rooms or living space.
  • Custom molding or arched windows.
  • Other unique features
Online Calculators

Then there are other tools to determine replacement value of your home.  But a standard approach would be determine the price per square foot for replacement via an estimate or online calculator.  Keep in mind insurance is only to protect you from loss not to provide any gain after the fact, so your insurance company will not foot the bill and the additional cost replacing your 2,000 sq. foot house to now a 4,000 sq. ft house.  The following calculators should help with estimating replacements costs, zip code is an important factor as labor costs different amounts in New York suburbs, Chicago suburbs, or Washington DC suburbs.

 

https://www.budgetdirect.com.au/home-contents-insurance/replacement-value-calculators.html

http://www.building-cost.net/CornersType.asp

 

Replacement cost estimates are influenced by supply of labor, demand for labor, and the cost of construction materials.

In the event of a catastrophic regional event, be aware resources may be expensive.  For example post hurricane or earthquake, the costs of building materials and home builders pricing may surge due to supply shortages.  This is why careful thought has to go into your limit, anything above your limit you would have exposure to pay.

According to Marketwatch, we found some information around the 10 most expensive places to raise a family and 10 most expensive cities to buy a home, these cities also will be replacement value sensitive.   Many people who bought homes or other assets during the peak of the housing market or low interest rate periods would beg for this risk if they are underwater on their home or asset.  We do not want readers to take this situation as a given and all assets don’t increase in value.  We do not take the financial risks of buying assets for granted and neither should you.

Commercial or Investment property

If you are a big fan of Financial Samurai (similar to us) and spend time focusing on passive income sources, we are here to help protect these income sources and maintain your financial freedom.  If this is an investment property, your loss of rental income should be protected with a policy for landlords, and the inflationary impact of increasing rents should be evaluated every few years.  If you make $20,000 of passive income through a rental property, and the property has a mortgage again the bank will only require you to carry their minimum insurance to protect the banks’ ownership in the asset, not your ownership or the growth in your asset value, replacement value or growth in rental income due to market forces or inflation. Again we recommend insurance endorsement to increase protection regularly or regular review of your exposure.

InsuranceShark

We are big fans of consumers using an educated insurance consultant to help evaluate your risks, but in the event you are a “do it yourself” type of person.  We recommend you carefully evaluate your risk and risk tolerance on an annual basis.  See our deeper discussion on how to buy insurance.   Please note not all assets increase value and not all assets can be protected by insurance protection, insurance protection is designed for hazard risks.  Speculative risks or other  financial assets can be protected via hedges, derivatives or other securities.

Please contact us or comment below with questions.

Comments

comments

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