Real Estate Business Review

Rose D. Wilson

Commercial property insurance policies must include correct property valuations when businesses purchase or renew them.

Businesses should ensure that their commercial property insurance includes correct valuations when purchasing or renewing their policy. This can prevent coinsurance penalties during covered property losses and provide sufficient protection. Calculating insurance-to-values (ITVs) accurately plays a key role here, and an ITV approximates the total cost of replacing or restoring the insured property.

An organization may end up with inaccurate ITV calculations for various reasons—whether they leverage ineffective property valuation methods, intentionally underestimate costs to secure lower premiums, or be influenced by factors beyond their control (e.g., inflation). However, such inaccuracies are common. Data from the industry shows that 75 percent of commercial properties are underinsured by at least 40 percent.

These findings demonstrate the importance of commercial property valuations for businesses. This article aims to provide more detailed information about ITV, show how factors should be considered when determining the value of a property, explain the pitfalls of property undervaluation, and provide best practices for developing and improving property valuations.

ITV Explained

In the event of property losses, an accurate ITV calculation ensures adequate coverage for a business by providing an equal ratio between the amount of insurance it obtains and its estimated value.

Nevertheless, properties may have multiple values, including the following—the market value represents what a property might sell for in the current real estate market. Property value is affected by lot size, building condition, and location. The property's assessed value is determined by the municipality where it is located, and local property taxes are typically based on such a value. Replacement value represents the current cost of replacing or rebuilding a property. Material and labor costs, architect services, debris removal needs, and building permit requirements determine a property's replacement value.

Insurance experts recommend calculating ITV based on a property's replacement value. Getting an accurate estimate of this value may involve getting a third-party appraisal, using inflation-adjusted fixed-asset records, or using a simple benchmarking tool (e.g., price per square foot). Appraisals often require more time and resources than other property valuation forms, but they are generally considered the most thorough and accurate.

Factors influencing the value of a property

Businesses should use replacement value estimates for ITV calculations and consider these factors when determining the correct valuation for a property.

Property valuations should include both direct and indirect costs, such as consulting fees, engineering services, and other expenses not directly related to rebuilding. Older structures should be valued with additional construction costs associated with repurposing outdated building materials. During the rebuilding process, older properties may also require specific modifications to comply with modern building codes (e.g., plumbing improvements, energy efficiency upgrades, sprinkler system changes, and safety enhancements). Further compounding of construction costs could lead to an increase in property values. The accessibility of a property may be compromised during demolition and rebuilding operations if it is located at a steep angle or is adjacent to a neighboring structure. The valuation of properties should also consider these factors. Custom property elements (such as stained glass) may require specialized construction work, increasing rebuilding costs. Therefore, property valuations must take into account these unique characteristics.

A guide to improving property valuations

Businesses can also review these additional best practices to ensure accurate ITV calculations and improve property valuation measures.

The insurers consider third-party appraisals the gold standard for valuing property since they ensure that competent and objective professionals conduct the calculations. A trusted and reputable appraiser is, therefore, crucial. A company following the Uniform Standards of Professional Appraisal Practice and the Appraisal Institute's Code of Professional Ethics and Standards of Professional Practice is highly recommended. Additional resources, reference guides, and validated tools can help ensure an accurate property value beyond an appraisal. Insurance companies rely heavily on the Marshall & Swift Valuation Service Cost Manual. More than 30,000 component costs covering 300 building occupancies are available in this resource. Teamwork is essential when determining a property's value. For property valuation decisions, gather data from several qualified sources (such as accountants, contractors, real estate experts, risk managers, insurance professionals, and chief financial officers). Property values are constantly changing. Property valuations should be updated regularly to stay up-to-date. For example, the appraisal should be conducted at least every three to five years. The need for property valuations may increase even further. Changes in property exposure, operations, improvements or modifications to buildings, implementation of new technology or equipment on site, shifting market conditions, and construction trends (e.g., inflated labor and material costs) will determine the frequency. When updating property valuations, working with trusted insurance professionals is the best way to maintain adequate coverage and avoid coinsurance penalties.

A proper property valuation is crucial to obtaining adequate commercial property insurance. Businesses can avoid coinsurance penalties and stay protected by understanding how to conduct accurate ITV calculations.