Property Insurance: Pros and Cons of Cash Value vs. Replacement Cost

While sifting through a 40-page property insurance policy, have you ever wondered–do I need this? You're not the only one to have that thought. 

Insurance is sometimes enigmatic and inaccessible to people. This situation is worse for a real estate investor because you may have multiple properties. That means multiple insurance policies for you to pore over. You may be thinking, Which is better–cash value or replacement cost? What type of property insurance is right for me? Do I need to have my trust name on my policy? 

These are quotidian questions; everyday real estate investors like you wrestle with insurance questions. To help, here are 3 straightforward insurance explanations.

#1. Cash Value Vs. Replacement Cost: Pros And Cons

After a claim, the cash value is the amount of cash needed to repair or replace your property. The cash value of the property is affected by depreciation. In other words, the cash value is what the property is worth today. 

Here is another way to envision cash value: Cash value = cost to buy your property new - depreciation of property. That’s called the depreciated cash value. 

The pro of actual cash value policies is that there is a cheaper premium. That means you pay less cash over the life of your policy. The con is that if you suffer a loss, the actual cash value might not be enough to cover the total cost. 

The replacement cost is the money needed to repair or replace your property. Replacement cost replaces your property without a depreciation deduction. 

The pro of replacement cost is the payout in a loss covers the cost of the property. The con is that your premium will be higher over the policy's life. 

Determining which option is best for you is a personal decision. You have to assess your risk tolerance and decide how much coverage you're willing to buy.

Suppose you have a $200,000 property. You've owned the property for one year with a depreciation rate of 3.5%. You had a total loss that was covered by your insurance policy. 

  • An actual cash value policy would pay out $193,000 for your property. 
  • A replacement cost policy would pay the full $200,00 for your property.

#2. What Property Insurance Is Available To Me?

Landlord insurance is a type of property insurance available to you. Generally, landlord insurance covers:

  • Dwelling
  • Detached structures on your rental property
  • Personal property you use to maintain the rental
  • Legal and medical liability 
  • Rent loss during a covered loss

In some specific cases, your property insurance will cover rent lost. Landlord insurance will usually not cover:

  • Cost to evict 
  • Maintenance
  • Repair and replacement of appliances
  • Tenant's personal property 

Landlord insurance isn't a legal requirement in most cases. But, your lender may require it if you're financing the property. 

Property Insurance For Real Estate Investors

Real estate investors use rental dwelling policies (DP) to protect their assets. The different levels of dwelling policies are:

  • DP1, the lowest, cash value
  • DP2, average, replacement value
  • DP3, the most comprehensive, replacement value

DP1 Property Insurance

DP1 is a basic property insurance policy. It's usually the cheapest and covers named perils in the insurance policy. Here are a few examples of what a DP1 policy commonly covers: 

  • Fire
  • Smoke
  • Vandalism
  • Vehicles
  • Volcanoes
  • Windstorm & Hail

Often, DP1 is a cash value policy. Imagine a car wiping out your 10-year-old porch. The materials used to build your patio are old. Suppose it costs you $20,000 to replace your porch. In that case, the insurance may only give you $13,500 because the materials have depreciated 35% over those ten years. You'll be on the hook for $6500. 

DP2 Property Insurance

DP2 is the average property insurance policy. It is also a name peril property. Some common perils you might find that DP2 policy covers include:

  • Electrical Damage
  • Fire
  • Freezing
  • Riots
  • Smoke
  • Vandalism
  • Vehicles
  • Volcanoes
  • Windstorm & Hail

DP2 policies are usually replacement cost policies. There is no depreciation deduction, and it covers more events. 

DP3 Property Insurance 

DP3 insurance provides the most coverage for real estate investors. It is a non-named peril policy or an open policy. That means it covers all perils except for a very few. In general, a DP3 insurance policy will not cover:

  • Earth movement
  • Eminent Domain
  • Intentional Loss
  • Mold 
  • Neglect
  • Nuclear Hazard
  • War

DP3 insurance is a replacement cost policy. That means no matter the age of your home. The policy pays for the total replacement value of the property. No depreciation. 

DP3 also offers loss of rent protection. That protection occurs when your home is unlivable due to a covered peril. While repairs are ongoing, the insurance policy pays out rental income. 

Intentional Loss, Windstorm, and Hail Exceptions

A word on intentional loss. One of our clients shared this anecdote during our Royal Investing Group Mentoring Session. He was a property owner. The property burned down. Neither he nor the tenant was accused of arson. The insurance company will not pay out. It would be best to ask about your protection against arson when shopping for your policy. 

Windstorm and hail coverage is another thing that can catch unsuspecting real estate investors off-guard. Your windstorm & hail policy might determine your cover based on the following: 

  • Property type
  • Number of units
  • Location 

Each of those factors could add risk. Risk means a higher premium for you. Work with an agent you trust to get the right coverage for your properties. 

#3 I Have A Land Trust; Do I Include It On The Policy?

Yes, include the name of the land trust in the insurance policy. The insurance company will deny your claim if the land trust appears on the deed but not your policy. 

What if I don't have a land trust? 

You may be exposing your assets. Don't get caught with your pants down in the event of a lawsuit. Check out how a land trust can cover your assets and provide protection through operational anonymity.

Recap: Cash Value Vs. Replacement Cost

Property insurance is a requirement for real estate investors. While it may not be legally required, lenders will not let you borrow without insurance. Your risk tolerance will guide what insurance policy is right for you: 

  • A cash value policy has lower premiums but pays the depreciated value of your property in the event of damage or loss.
  • Replacement cost has higher premiums but pays out the total value of your property in the event of damage or loss. 
  • The most comprehensive policies offer coverage for rent loss. 
  • Insurance companies don't always cover arson.
  • Include your land trust on the policy to ensure a smooth payout. 

Insurance is your first line of defense against accidents and natural disasters. Things get complicated for real estate investors as more assets are acquired and more policies need to be purchased. Learn how we can offer you a single point of contact and the best coverage for all of your policies by taking our insurance quiz.

Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.

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