Construction Costs Versus Market Value

Published in the ECHO Journal, November 2011

Reconstruction Costs for Condominium Associations Edge Higher, But Our Homes Are Worth Less

In the present economy, condominium associations’ boards of directors are faced with some real financial challenges. Having a multi-year struggle with rising delinquencies and foreclosures, how does the board maintain the common area in the best condition possible and still manage costs? Some boards, wanting to eliminate unnecessary expenses, are putting pressure on service providers to simply provide the same service or materials for less money. Whether it’s landscaping, pest control, elevator services, janitorial or pool services – many service providers are small business owners who are, like the board, feeling the pinch in this slowly recovering, post-recession economy. Not wanting to lose the business, they are reluctantly yielding to the board’s demands.

Understandably, the placement of insurance coverage is another area where board’s would like to find “maximum value” in spending their budgeted funds. Traditionally, higher deductibles have consistently been a way to provide a savings to a board. Frankly, some boards want more. They ask, “If our condominium units are selling for less than they were in 2004, surely we could reduce our building limits, insure our condominium association for less and save premium that way?”

Not necessarily.

The market value or “sales value” of a condominium unit may have absolutely no correlation to the actual replacement cost of a project. Even though the sales price of homes in some areas of California may have decreased by as much as 30%, the construction prices (thanks in part to petroleum costs) continue to escalate. In fact, according to McGraw Hill Construction Data, the material and labor costs in San Francisco County have increased by 30.1% since December 2004:

San Francisco – Construction Index, 2000-2011 (Source: McGraw Hill Construction Data)

These construction and labor costs indexes don’t rely on arbitrary values, but on comparative costs. The building materials component of this index reflect local prices on such things as Portland cement and 2 x 4 lumber coupled with the national average price for structural steel. Labor is also an important cost consideration. The labor costs in this study reflect the escalating prices of local union wages (plus benefits) for carpenters, bricklayers and iron workers.

How to determine the correct insurable value for your property

There are at least three ways a board of directors could obtain advice determining the correct insurable value for their property:

George: Can we make this table a sidebar?

GOOD Seek the advice of a general contractor in your area who specializes in multi-family housing construction to provide you with an estimate of the replacement cost of your project.
BETTER Consult with your insurance agent/broker or insurance carrier to determine how he/she arrived at the replacement costs for your development. Most competent insurance professionals will rely on a third-party replacement cost analysis program such as Marshall & Swift Valuation (MSB). MSB relies on actual construction costs in your community and the square footage of your development to determine the “insurable value” for a project of “like kind and quality.”
BEST Hire an independent real estate appraiser to prepare a “replacement cost estimate” (land excluded) of the subject property. Be sure to provide the real estate appraiser with a copy of the CC&Rs, the Condominium Plan, and a copy of the Component List from the Reserve Study – to make certain the appraiser’s estimate includes all the Common Area elements (including appurtenant structures). Don’t forget to ask your appraiser to provide evidence of “errors and omissions” coverage so you’ll know he/she has insurance to back up their professional recommendations.

Consider purchasing some extra protection (when available). Special endorsements (“Extra Replacement Cost” or “Extended Replacement Cost”), when added to your policy, can typically provide an additional 20% to 25% margin in excess of the stated policy limits. This is an excellent way to provide a board of directors with an additional margin of protection. If there is a large fire or other catastrophe there may be a phenomenon called “demand surge” which is the term used to describe the artificially higher replacement costs which occurred after the Oakland Firestorm and Hurricane Katrina because of a shortage of construction materials and labor costs. An Extra or Extended Replacement endorsement will provide the board with a little more protection to address the reconstruction costs.

The Bottom Line

Insuring the property on behalf of all the owners is part of the board’s fiduciary duty. Nearly all CC&Rs require the board of directors to obtain and maintain an insurance policy equal to “100% of the full insurable value” of the improvements and yet most Directors & Officers Liability policies exclude coverage for lawsuits against a board in the aftermath of a property loss for failing to purchase the right forms, kinds and amounts of insurance coverage. Now is the time, prior to the loss, to work with your insurance agent or broker to make certain you have sufficient protection to assure you have the financial resources ready to rebuild.

Tim Cline, CIRMS, is President of Timothy Cline Insurance Agency, Inc. in Santa Monica. Tim is a former Chair of the CAI National Insurance and Risk Manager Professionals Networking Committee and former President of the Los Angeles Chapter of the Insurance Brokers and Agents Association of the West. His company is a member of ECHO.