Commercial Buildings – Reinstatement Cost or Indemnity Value?
For many years there has been confusion as to what the basis of payment should be to compensate the owner of a property whose premises have been destroyed by fire and who has decided not to rebuild. If reinstatement were not to take place, the loss would be settled on the basis of indemnity but how would this be measured in valuation terms? Experience suggests either depreciated reinstatement cost or reduction in market value. Both of these methods can give very different results so which one would be used in particular circumstances?
First of all we need to look at the concept of reinstatement cost since it is an important constituent in the calculation of one of the indemnity values mentioned. A typical buildings policy will provide insurance on a reinstatement basis subject to certain restrictions.
A reinstatement sum insured for a modern commercial building is often calculated by the preparation of a cost plan or by applying a rebuilding cost per square metre to the total floor area calculated on a gross internal basis. Additions need to be made to allow for the cost of demolishing the destroyed building, for clearing the site of debris and for professional fees that would be incurred in reinstatement. Allowance may have to be made in the policy for inflation during the policy year and the rebuilding period. The Building Cost Information Service (part of the RICS), www.bcis.co.uk, is an excellent on-line source, on subscription, of building cost and inflation data. Most commercial buildings in the UK are insured on what is known as the day one reinstatement basis whereby an automatic uplift to the sum insured is provided in percentage terms for inflation. However, some policies are arranged on a different basis, possibly with some elements of inflation provision already built in. Valuers must always make it clear how they have arrived at their valuations and distinguish between the base figure and allowances for inflation. Failure to do so has, in the past, resulted in dual allowance for inflation or no allowance at all. If an insured sustains a serious loss, let us say a total loss of his building, and it has been properly and adequately insured on a reinstatement basis, it would be entitled to ask insurers to agree to pay for the reinstatement of the building. This is provided that the insured has complied with all policy conditions. However, the policy terms ensure that the insured would not be entitled to a bigger and better building, other than by paying the additional cost, and would not be able to ask for the reinstatement cost to be paid in cash without actually rebuilding and incurring the cost.
Where an insured would be entitled to reinstate a destroyed building but decides not to because, for example, it is difficult to find a tenant or the location is no longer suitable, the policy might then dictate that the insurer should “….pay to the insured the value of the property at the time of the happening of its destruction”. Unfortunately what is meant by “value” is not defined and the Courts have decided that it is the Tort definition: “place the insured by payment or otherwise in the same position as he was in before the destruction, neither better nor worse”.
In the 1980’s quite a number of cases were heard where there was a dispute between the insurer and insured as to the correct method of assessment of an indemnity value where rebuilding was not to take place. It was at a time when insurers felt strongly that the correct method of assessment should be diminution in market value. However, the Courts did not fully concur with insurers and seem to have laid down some broad terms of reference for the treatment of claims dealt with on an indemnity basis.
- Where a property is owner-occupied and in use – Depreciated replacement cost
- Where a property was for sale before destruction – Diminution in market value
- Where a property is owned by a property company – Diminution in market value
- Where the property is of a type not normally sold in the open market – Depreciated replacement cost
Obviously it is not possible to give a precise interpretation and each case must be treated on its merits but the following are worthy of consideration:
- In the case where a property is owner-occupied it is said that it would usually be impossible to find an identical replacement in terms of construction, layout and location in the open market. This being the case, depreciated replacement cost should be adopted. In valuation terms location is of fundamental importance to the value of the property, as is layout. I understand from recent valuation cases relating to fire loss, where I have been involved on behalf of insurers, that if a property destroyed cannot be replaced with a more or less identical one, in terms of construction type, location and layout, the Courts will not favour an attempt to calculate a market value for it. However, in practice there may be exceptions to this, for example, where location and layout are not of such importance to the insured.
- If a property was for sale before destruction, the insured was obviously prepared to accept a market value from the sale. In these circumstances he or she should not object to an indemnity value payment post-loss based on the same criteria, namely market value.
- Most properties owned by property companies will be tenanted and subject to leases with covenants to insure and rebuild so that the prospect of an indemnity, other than by reinstatement, is remote. Where indemnity other than by reinstatement is an issue, it is generally felt that a property company should be entitled to a payment derived from market value on the basis that the business of such companies is to trade in properties as a commodity.
How should depreciated replacement cost and market value be calculated?
Depreciated replacement cost has at its heart the reinstatement cost assessment referred to earlier when it was said to be rebuilding cost plus debris removal and professional fees. Leaving aside the argument as to whether professional fees should be included in a calculation of indemnity value, we can see that the main issue still to be determined is the method and amount of depreciation.
There are two methods of depreciation – straight-line and reducing balance. Whereas the reducing balance approach is generally used to reflect the depreciation sustained by plant and machinery, it is not usually adopted where depreciation to buildings is to be assessed. For buildings the method of depreciation remains “straight-line”, on the basis, some would say erroneously, that buildings depreciate in equal annual amounts during their life.
Depreciation on a straight line basis cannot be deducted without careful consideration of each particular case. If it is said that an office building will have a total estimated life of 50 years, it will depreciate at 2% per annum. If it is 10 years old at the time of its destruction, the deduction for depreciation on a straight line basis might be 20%, subject to actual condition of the building. If the same building were in fact 40 years old, it would need careful consideration indeed to establish whether a deduction of 80% from the reinstatement cost would be fair and provide an accurate indemnity. After all, it would be possible for an asset to be written off after 50 years but it would be extremely unlikely to have a nil value. A valuer would nearly always attribute a residual value even where the building was 50 years old and in very poor condition. Similarly, insurers should not expect to pay nothing following the destruction of the building unless its market value really was nil.
Diminution in market value is clearly not a cost based assessment but one which is closely associated with the laws of supply and demand operating in this case in the property market. Most property owners will be well aware of the constituents of a market valuation, based frequently on notional (supported by transactional evidence) or actual rental value which is capitalised using a suitable year’s purchase multiplier. If a destroyed building is valued to indemnity value utilising a market value approach, the owner of the building should not receive the full market value as compensation if that market valuation includes also the value of the site on which the property has been constructed. An amount to represent the value of the site, adjusted to reflect the cost of demolishing and clearing away the destroyed building, will need to be deducted to arrive at an appropriate diminution in market value figure.
Experience tells me that invariably an indemnity value calculated using a depreciated replacement cost approach will provide a higher figure than that using a market value method but that may not always be the case.
Perhaps then there is something to be borne in mind if buildings are to be valued for insurance. If the owner knows that they will not be rebuilt or repaired and there is no lease to direct affairs, it may not be appropriate to insure them on a reinstatement basis. However, the owner should always consider what settlement would be required from insurers if there were partial damage. It may be better to insure on a reinstatement basis so that the repair of such damage would be paid for in full by insurers. If some other basis of indemnity is to be considered great care is needed. Any valuation for sum insured purposes would have to reflect the insured’s expectations after a loss and it would be wise to check with insurers that those expectations are not inconsistent with how any claim might be settled. In some cases the policy wording might have to be changed.
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