How professionals estimate the replacement cost of a commercial property

A replacement cost estimate is the cost to rebuild a property today with materials and construction of like kind and quality, without deducting for depreciation. Insurers use this figure to set a building's insurable value. For commercial and multifamily properties, the most dependable replacement cost estimates come from a qualified quantity surveyor (QS), a construction cost professional trained to measure and price buildings.

One of the reasons there is such a high percentage of underinsured properties (a 2004 Marshall & Swift/Boeckh study found around 75% of commercial buildings were underinsured) is that many policies are underwritten based on rough square-foot/meter replacement cost estimates and are often imprecise.

A wide variety of methodologies are used to determine a building replacement cost for insurance purposes – and a wide variety of individuals prepare these estimates. Insurance brokers, real estate portfolio managers, property managers may conduct insurance appraisals using software or industry cost guides.

In some cases, such as a simple, standard building, a replacement cost estimate produced by software or a costing manual may be appropriate. These tools can provide average estimated costs for commercial structures and equipment.

But there are limitations and risks when unqualified individuals conduct appraisals of commercial real estate assets and multi-family/build-to-rent buildings relying solely on previous estimates, software or cost guides. These approximate replacement costs are based on the cost-per-square-foot/meter of a similar type of building, and often rely on an architect’s zoning area and not the actual gross building area (which a qualified QS will account for). The result is only a rough estimate of rebuilding cost and does not take into account location, construction quality, actual measurements, specific features of a property or current bylaws and building codes.

Especially today, when many properties are complex – combining mixed uses or encompassing a heritage component – accurate estimating is more demanding than it was in the past. The process of calculating an accurate replacement cost estimate for a building requires a variety of data and extensive knowledge of construction.

This is why working with a third-party professional is important for delivering an unbiased and accurate insurance appraisal. Quantity surveyors are professional cost consultants who have construction experience and follow consistent and standardized processes to produce estimates based on substantiated costs.

How a quantity surveyor calculates a replacement cost estimate

A quantity surveyor builds a replacement cost estimate in six steps: reviewing building documentation, inspecting the property, measuring the gross building area, benchmarking against similar properties, estimating current construction costs and preparing a report. Each step checks the information from the one before, so the final figure rests on verified measurements and current cost data.

Quantity surveyors follow a thorough, regulated process adapted to the type of building, the needs of the owner or in the case of condominiums/apartments, the board, and whether the assessment is an annual update or a comprehensive evaluation.

Collect and review documentation from the owner or property manager

This would include, as available: building condition assessment report; architectural, structural, mechanical and electrical drawings; renovations history.

Physically inspect the property when possible

This involves taking photos, measuring in some cases and inspecting to verify and supplement supplied information. The inspection encompasses above-grade built form as well as below-grade assets such as underground parking and storage and the grounds around the building.

Measure the building area from the plans provided (if available)

Often estimates rely on measurements from the architect’s zoning area which exclude some building areas and this will lead to inaccuracies. A qualified professional will validate the gross construction area and will ensure the correct building area is used for the estimate.

Benchmark with similar properties

To verify the accuracy of insurable value, they will also benchmark estimated construction costs for the building with similar appraised properties.

Estimate construction costs. The quantity surveyor will develop a current cost estimate by cross-referencing supplied documentation, the results of a physical inspection, historical cost data and industry data that is available to them, and their own experience with construction cost increases in specific market sectors and regions.

Estimate construction costs

The quantity surveyor will develop a current cost estimate by cross-referencing supplied documentation, the results of a physical inspection, historical cost data and industry data that is available to them, and their own experience with construction cost increases in specific market sectors and regions. Published cost data, such as the construction cost ranges by building type and city in the Altus Group Canadian Cost Guide, gives a starting benchmark that the quantity surveyor then adjusts for the specific building.

Prepare a dependable replacement cost estimate report

The quantity surveyor will prepare a draft report for discussion with the property manager, owner or board. This will include a description of the building structure, services and finishings; building areas; and photos; and a summary of estimated replacement costs.

Once the report is finalized, you will receive an independent third-party report your property insurer can rely upon for current, accurate insurable value. In the event of a partial or full loss, this report will facilitate a quick and complete settlement.

Protect your investment by getting an accurate and current replacement cost estimate to mitigate risk and gain peace of mind that if the need arises, you’ll be covered.

Replacement cost vs. reproduction cost vs. market value

Replacement cost is the cost to build a structure with the same utility as the original, using current materials, design standards and building codes. Reproduction cost is the cost to build an exact replica with the original materials and design. Market value is the price a property would sell for, which includes land and income potential that a rebuild does not.

Property insurance is usually written on a replacement cost basis, so replacement cost is the figure that sets insurable value. Reproduction cost becomes relevant for heritage buildings, where original features or materials may need to be matched after a loss. Market value is established through a commercial real estate appraisal and can sit well above or below the cost to rebuild, so one figure cannot stand in for the other. The cost approach, one of the major methods of commercial real estate valuation, starts from replacement cost, then subtracts depreciation and adds land value.

How replacement cost affects insurance to value

Insurance to value (ITV) compares the amount of coverage on a building with its replacement cost. Many commercial property policies include a coinsurance clause that requires coverage of at least 80%, 90% or 100% of the building's value. If coverage falls below that level, the insurer can reduce a claim payment in proportion to the shortfall.

For example, a building with a $10 million replacement cost under an 80% coinsurance clause needs at least $8 million of coverage. If the policy carries $6 million, the owner has insured only 75% of the required amount, and the insurer would pay 75% of a covered loss, less the deductible. An outdated replacement cost estimate is a common route into this position, because construction costs can rise faster than the insured amount between reviews.

Be prepared, be safe

A regular professional replacement cost estimate for a commercial or residential property will confirm the right insurable value, and ensure that as an owner, director or manager you and this asset are sufficiently insured and well protected.

Before your next renewal, download our guide to getting the right replacement cost estimate. It explains how a replacement cost estimate differs from a property valuation, five best practices for setting the right insurable value and special considerations for condominiums and apartments.