Unexpected inflation and increasing replacement costs could combine to present an unpleasant surprise to your expectations for property insurance coverage in a time of need. Many tend to think of real estate properties as stable fixed assets, well-positioned against many risks. However, for improved properties covered by replacement cost policies, one important question to ask and find out answers to is whether your property has adequate insurance limits in an environment of increasing construction costs.
Single Family Home Construction Cost Inflation
Construction costs for single family residential homes recently experienced significant increases nationally. The national median per square foot pricing for single family detached homes in 2021 increased 21% according to the National Association of Home Builders (NAHB) in its review of recent Survey of Construction Data. According to the NAHB:
“Median sale and contract prices per square foot of floor area went up across all US regions, undoubtedly, reflecting skyrocketing building materials prices and fast rising labor costs that pummeled home building in 2021.”
This data suggests that there may be a sizeable gap between market values or purchase prices, even for homes constructed in the last two years and replacement cost values used for insurance purposes.
Commercial Cost Inflation Is Not Going Away
Commercial construction costs have also increased significantly, but to a lesser extent. Turner Construction Company’s Third Quarter 2022 Building Cost Index reports an 8.62% increase in non-residential construction costs from the third quarter of 2021. Construction industry inflation is not in an asset manager’s rear view mirror. Construction cost increases may moderate in the near term, but the data suggests that inflationary pressures are not dissipating any time soon. Labor and supply chain issues are still present. According to Dodge Data & Analytics, the number of nonresidential projects in planning stages is up 28% from October 2021 in spite of the Federal Reserve’s 2022 campaign of interest rate hikes.
Beware of Gaps Between Value and Replacement Cost
Replacement cost analysis for insurance is particularly critical in a time of decreasing property values as the potential for significant gaps between commercial property market values and replacement cost values emerges. Notwithstanding the significant construction cost inflation being experienced today, commercial property values have decreased by 13% year to date in 2022, according to Green Street Advisors Commercial Property Price Index. Despite national trends, the answer to the question of market value can change significantly from market to market, neighborhood to neighborhood and property to property based on many varying factors. Nevertheless, the disconnect between insurance coverage limits and property valuations is a huge issue, according to Oswald Companies Vice President Bryan Williams. In the current environment, commercial builders’ risk underwriters are focusing more intently on coverage specifications and insuring contingencies, as well as hard costs for new construction. Also, escalation clauses ranging from 5% to 10% are being incorporated into policies.
Providing Information Is Essential to Appropriately Size Coverage
In working with insurers to determine the best coverage at the most competitive terms, information is critical. Working with a checklist appropriate to a property’s particular circumstances can be beneficial for both the insured and the insurer. The following is an underwriting information needs checklist for commercial builders risk coverage courtesy of Oswald Companies:
UNDERWRITING INFORMATION REQUIREMENTS – WHAT DOES A CUSTOMER NEED TO PROVIDE?
- An application – New Construction or Renovation/Rehabilitation (sometimes both)
- Construction budget(s)
- Construction timeline, featuring milestone dates for each building/fire division (ideally in the form of a Gantt chart)
- Project Geotech 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 performed on an existing building)
- Renderings of completed buildings/structures
- Plot plan featuring distances between buildings, with the occasional need to show equipment/material lay down areas
- Protective Safeguards anticipated (fencing, lighting, electronic surveillance, watchmen service, hot works permit system, water damage mitigation plan, etc.)
- Lenders’ insurance requirements, if any, if known
IF COVERAGE FOR BUSINESS INTERRUPTION (DELAY IN START-UP) IS DESIRED, ALSO REQUEST THE FOLLOWING:
- Pro-forma income statement for loss of income or rents – Ideally, for the period of time it would take to clear the site and rebuild from scratch following a late term occurrence – APPLIES TO PROJECT OWNERS ONLY.
- Documentation for estimated project “soft costs,” which refers to additional expenses that may be incurred if the project’s completion is delayed due to a covered cause of loss and most commonly encompasses the following:
- Accounting fees
- Advertising and promotional expenses
- Engineering and/or architectural fees
- Extended general conditions expense
- Insurance premiums
- Interest upon money borrowed to finance contract work
- Legal fees
- Loan fees and costs
- Permits and municipal fees
- Project administration expenses
- Real estate taxes
- Security costs
KJK will continue to monitor construction industry trends. If you have any questions, please contact Jon Pinney at (JJP@kjk.com; 216.736.7260) or Richard Morehouse (RAM@kjk.com; 216.736.7292).