A Case Study in Financial Ruin

Summertime is a good reminder of the No. 1 mistake people make in real estate. Why is it so critical to have sufficient insurance on your property?

CAST STUDY IN FINANCIAL RUIN

About five years ago, a major wildfire destroyed many homes in Black Forest – not far from Colorado Springs. We had a loan on a residential investment rental for a borrower a few years prior. Our loan amount was $150,000 and the property was worth nearly $350,000. On all our loans, we require property insurance. The borrower had a residential policy for $150,000. In 2013, a wildfire quickly destroyed hundreds of homes in the area, including ours. The house was a total loss, burning to the foundation.

WHAT HAPPENED AFTER THE EMBERS COOLED?

Our borrower filed a claim with his insurance company for the maximum amount of the policy, $150,000. The insurance company paid this amount to the borrower and the lender. The $150,000 was not enough to rebuilt the property. The borrower paid off our loan of $150,000 and was left with a residential lot that needed about $25,000 in cleanup from the fire. The lot is worth maybe $30,000 thanks to little demand for a contaminated, vacant lot without trees.

THE BORROWER EFFECTIVELY LOST $200,000

Our borrower effectively lost his property and $200,000 in equity due to the fire, only to be left with a tainted lot. There wasn't nearly enough money to rebuild the property.

THIS CAN'T HAPPEN TO YOU – THINK AGAIN

Last year, a wildfire threatened the entire town of Breckenridge – residential properties and the downtown district. A fire a few weeks back in Summit County came within 200 feet of 1,300 homes. Another within the city limits of Colorado Springs destroyed hundreds of homes. And this same scenario has played out throughout the state, including Boulder, Evergreen, Golden, Parker, Castle Rock, Basalt, El Jebel and more. The risk is real to both residential and commercial property owners.

HOW CAN YOU PREVENT MAKING THE SAME MISTAKE?

It is much more expensive to build a new house today than it was in the past. Building codes have changed, materials and labor are more expensive and land use requirements have evolved as well.

All of this adds to increased costs if there is a major disaster. Many times, insurance does not keep up with increases in costs. 

You, as a property owner, have the burden of updating your policy to ensure the correct coverage. If you are under-insured, you are out of luck if the policy should be needed.

ENSURE YOU HAVE THE PROPER COVERAGE

When checking on insurance, it is imperative to focus on replacement cost. The amount of coverage you need is not what the house would sell for or what the tax assessor thinks the house is worth. You need to have ample coverage to actually rebuild residential or commercial structures. This number could be radically different than the tax assessment or market value.

WHAT IS REPLACEMENT COST?

This is an insurance calculation that specifies how much a building or structure would cost to replace at its pre-loss condition. 

This number is basically the amount it would take today to rebuild or repair a property if it were damaged. It is important to note that the replacement cost is not what your property is worth; it is merely a calculation of what is would cost to build the house. To accurately determine replacement cost of a property, an agent goes room by room assessing the floor coverings, building construction, finishes, etc. The replacement cost is typically only important in a loss situation or to set rates.

HOW TO DETERMINE REPLACEMENT COST?

Most insurance companies have a worksheet that they provide to specify details of each room – construction type, floor coverings, fireplaces, materials used, etc. – to get an accurate picture of the rebuild cost. Many insurance companies can also send out an adjuster to help calculate this. When I purchased my house, I went this route and walked through with an adjuster, discovering my replacement cost was about 20 percent higher than what I had purchased the property for. You should re-evaluate the value every couple years to ensure it's keeping pace with building costs.

WHAT SHOULD YOU DO?

Will you make one of the biggest real estate mistakes?

A few simple steps can prevent financial ruin. Now is the time to act to ensure your replacement cost is updated. It's a simple process. 

Will you take the risk or will you take the necessary steps to protect your financial health?