Unexpected inflation and rising replacement costs could combine to present an unpleasant surprise to your expectations of property insurance coverage should the need arise. Many tend to think of real estate as stable assets, well positioned against many risks. However, for upgraded properties covered by replacement cost policies, an important question to ask and answer is whether your property has a insurance limits in an environment of increased construction costs?
Inflation in construction costs of single-family homes
Construction costs for single-family homes have recently seen significant increases nationwide. The national median price per square foot for single-family homes began in 2021 increased by 21% according to the National Association of Home Builders (NAHB) in its review of the recent construction data survey. According to the NAHB:
“Median selling and contract prices per square foot of floor space have undoubtedly increased in all regions of the United States, reflecting soaring building material prices and rapidly rising labor costs. that hit homebuilding in 2021.”
This data suggests that there may be a significant discrepancy between market values or purchase prices, even for homes built within the last two years, and replacement cost values used for insurance purposes.
Trade cost inflation is not going away
Commercial construction costs also increased significantly, but to a lesser extent. Turner Construction Company Third Quarter 2022 Building cost index reports an 8.62% increase in non-residential construction costs compared to the third quarter of 2021. Inflation in the construction sector is not in the rearview mirror of an asset manager. Construction cost increases may moderate in the near term, but the data suggests that inflationary pressures are not dissipating anytime soon. Labor and supply chain issues are still present. According Dodge Data & Analytics, the number of non-residential projects in the planning stage is up 28% from October 2021 despite the Federal Reserve’s 2022 forecast interest rate hike campaign.
Beware of discrepancies between value and replacement cost
Replacement cost analysis for insurance is especially critical in an era of declining property values, as the potential for significant discrepancies between commercial property market values and replacement cost values emerges. Despite today’s significant construction cost inflation, commercial property values have fallen 13% since the start of 2022, according to Green Street Advisors Commercial Property Price Index. Despite national trends, the answer to the market value question can vary widely from market to market, neighborhood to neighborhood, and property to property depending on many factors. Still, the mismatch between insurance coverage limits and property valuations is a huge problem, according to Oswald Companies Vice President Bryan Williams. In the current environment, commercial builders’ risk insurers are focusing more on coverage specifications and insuring contingencies, as well as the fixed costs of new construction. In addition, indexation clauses ranging from 5% to 10% are incorporated into the policies.
Providing information is key to properly sizing coverage
In working with insurers to determine the best coverage on the most competitive terms, information is key. Working with a checklist tailored to the particular circumstances of a property can be beneficial for both the insured and the insurer. Below is a checklist of underwriting information requirements for commercial builder risk coverage, courtesy of Oswald Companies:
SUBSCRIPTION INFORMATION REQUIREMENTS – WHAT DOES THE CUSTOMER NEED TO PROVIDE?
- An application – New construction or Renovation/Rehabilitation (sometimes both)
- Construction budget(s)
- Construction schedule, with milestone dates for each building/fire division (ideally in the form of a Gantt chart)
- Geotech project report (new construction)
- Engineering report on the condition of existing buildings/structures (if applicable – If insurance on an existing building is desired or if structural work is to be carried out on an existing building)
- Renderings of completed buildings/structures
- Plot plan showing distances between buildings, with the occasional need to show equipment/material drop-off areas
- Planned protection measures (fencing, lighting, electronic surveillance, security service, hot work permit system, water damage control plan, etc.)
- Insurance requirements from lenders, if any, if known
IF BUSINESS INTERRUPTION (DELAYED START-UP) COVERAGE IS DESIRED, ALSO ASK FOR THE FOLLOWING:
- Pro forma income statement for loss of income or rent – Ideally for the period of time it would take to clean up the site and rebuild from scratch following a late event – APPLIES ONLY TO OWNERS OF PROJECT.
- Documentation for the estimated “soft costs” of the project, which refers to additional expenses that may be incurred if the completion of the project is delayed due to a covered cause of loss and most commonly includes the following:
- Accounting fees
- Advertising and promotion costs
- Engineering and/or architectural costs
- Extended Terms & Conditions Fee
- Insurance premiums
- Interest on money borrowed to finance contract work
- Legal fees
- Fees and loan fees
- Municipal permits and fees
- Project administration expenses
- Property taxes
- Security fees