Owning an investment property is one step. Protecting your investment is another. One primary way you can protect your investment property is to make sure that you have the right kind of homeowners insurance. Not all policies are the same. You are going to have to choose whether you want to insure your investment based on the actual cash value or the replacement value. This choice will have a dramatic impact on the insurance settlement that you will receive.
Actual Cash Value: The Depreciated Value is all it’s Worth.
This type of homeowners insurance policy insures the value of the property “As Is” right now. The actual cash value is the cost to construct the rental less any depreciation. As the property depreciates, so does your coverage.
There is a 20 year old rental house which cost $200,000 to build. The house is well maintained and the depreciation is valued at 15%. The property was completely destroyed in a fire. The insurance coverage amounts to $170,000. Unfortunately, it will cost $290,000 to rebuild using today’s prices and materials. This puts the policy holder $120,000 short.
The upside is that an actual cash value policy is a little cheaper (about 10 – 20%). If your rental was destroyed and you would not rebuild, an actual cash value would be a good homeowners insurance policy choice.
Replacement Cost Value: What it Costs to Build it Again.
A replacement cost insurance policy will pay to replace, rebuild or repair your damaged rental property to its original condition using the same kind and quality of materials. The replacement cost is not the market value of the property. The replacement cost value is the price to build back the structure. If you have insufficient coverage, you will only get a partial payment on a claim. Most insurance companies, however, will not allow you to have less than 80% coverage.
Case Study #1
If we use the same scenario as above and choose a policy with 100% replacement cost value, when the house burns down, there is $200,000 of coverage. Many policies will include up to 125% guaranteed replacement cost to account for current building costs. This would provide coverage up to $250,000 and put the policy holder only $40,000 short.
If you decide that you would not rebuild and just want a check, however, you can expect the insurance company to only pay you the actual cost value.
Which Policy is Better?
If you own a run down rental property or one that is built with materials that are no longer used (asbestos siding, lathe and plaster, etc.) and you do not plan to rebuild the house if it was destroyed, then you should opt for the cheaper actual cost homeowners insurance policy. Nevertheless, we would recommended that you pay a little extra and choose the replacement cost policy for most investment properties. In the event of a loss, you will be fully covered.