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Market Value vs. Replacement Cost

How to understand the difference between these two value approaches

James Siebers    |    Property Valuation

The market value and replacement cost of a building are not the same thing. They are distinctly different concepts which are estimated using different criteria. It is not necessary that the market value and replacement cost of a building are identical. They are two distinctly different approaches to valuing a property.

Market value is the estimated price at which your property would be sold on the open market between a willing buyer and a willing seller under all conditions for a fair sale. Replacement cost is the estimated cost to construct, at current prices, a building with equal utility to the building being appraised.

When comparing market value to replacement cost, it is important to understand what both represent and what factors are considered in each circumstance. Otherwise, a meaningful comparison cannot be made.

Market value represents the agreement between buyer and seller of what property is worth. In real estate, it often includes the value of land, site improvements to the land, buildings, and sometimes personal property and intangible assets. In order to compare market value to replacement cost, adjustments must be made for such factors.

Replacement cost is the cost to construct or replace at a given time, an entire building of equal quality and utility, using prices for labor, materials, overhead, profit and fees in effect at the time of the appraisal. The construction or replacement of the building uses modern materials and current methods, designs, and layouts. Replacement cost does not take into consideration improvements necessary to conform to change building codes, demolition, debris removal, site accessibility, reuse of building components or services, overtime, bonuses for labor, abnormal soft costs, extraordinary fees, premiums for materials, and other various contingencies.

In addition to material and labor costs, CoreLogic cost data includes:  consideration of permits, surveys, builders risk insurance, sales taxes, built-ins and other costs that would typically be paid for by a consumer in a particular market, for example, an electrical or plumbing allowance.

Unless specifically added to your cost estimate, the CoreLogic costs do not include real estate commissions, land, landscaping, sidewalks, driveways, patios, well and septic systems, sewer and water systems, and other land improvements.

Although the concepts of market value and reconstruction cost are different, both are affected by economic conditions. The supply and demand for housing also impact the fair market value. The supply and demand for labor and materials affect replacement cost. When situations arise where supply does not equal demand, market value, as well as replacement cost can change quickly. These conditions can be short term or temporary. At CoreLogic we continually monitor changing market conditions throughout the United States and Canada and make adjustments for these situations where and when appropriate.

It is important to note that the fair market value and replacement cost for a building may not be the same. The reason that they could be different is because they are different concepts. Market value is in the eye of the buyers and sellers, while replacement cost is the sum of all elements brought together to produce a physical property. In the example above, we have made the two total valuations identical, which is the ideal. Overhead and profit component is just one of a number of variables that can change the total a cost approach valuation.

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