Does your home’s replacement value depreciate with its market value?

Home prices across the country are cooling a bit thanks to recent interest rate hikes by the Bank of Canada, which is slowly putting a stop to the frenzied homebuying of the last two years.

But as a home’s market value drops, does its replacement value depreciate in tandem?

Before we answer that, let’s look at the difference between these two terms.

What is a home’s market value?

A home’s market value is what a buyer is willing to pay for a property and what the seller is willing to accept. This is based on what comparable properties have sold for in the same area and the overall market conditions, such as mortgage interest rates, demand, and housing supply.

With people looking for more space and wanting to move away from the big cities, housing prices skyrocketed during the pandemic. It was common for sellers to set prices to encourage multiple bids, and buyers to pay well over asking without conditions.

What is a home’s replacement value? 

A home’s replacement value (also known as a home’s replacement cost) is the amount it would cost to replace your home entirely as a result of being destroyed by fire, flooding or other weather damage.

This figure is especially important to home insurance providers, as it helps them determine your premium.

“The basis of most modern homeowners policies would be that estimated cost to rebuild if we had to do so from the ground up today,” says Stefan Tirschler, product and underwriting manager at Square One Insurance Services.

If your home insurance policy offers replacement cost coverage, the company should replace the damaged property to the same standard as the previous one. However, if by-laws require an improved quality of construction, it's possible the insurance provider has to bring the home up to current standards when settling a loss.

What affects my home’s replacement value? 

While market value is affected by supply and demand, and interest rates, the replacement value of a home is affected by the following:

• The cost of materials like lumber, finishes, fixtures, and appliances.
• The size of the original home. The bigger the home, the more it costs to replace.
• The age of the home. If the home was old, some of the original fixtures may not exist anymore.
• Local building codes may have been updated since the home was originally built, and the new home will have to meet those codes. That could cost more money.
• Time pressure. You want to rebuild as quickly as possible, and speed and convenience can cost more money.

If you built a deck in the last two years, you’ll remember that the cost of lumber shot up significantly. Now with inflation at an all-time high and persistent supply chain issues, it’s the perfect storm to drive prices of building materials up.

Does a home’s replacement value depreciate with its market value?

There isn’t a direct link between a home's replacement value and its market value. “If we were to see a significant correction in the real estate market and the market value of a home declined by 20% overnight, that has no impact whatsoever on the actual cost to rebuild that home if it were to catch fire overnight,” says Tirschler. “The real estate market doesn't impact the reconstruction cost.”

While housing prices can be cooled with higher interest rates and rigorous stress tests, the cost of lumber, for instance, is affected by availability of wood types, natural disasters like wildfires, import fees, and trade disputes.

An easy way to distinguish market value from replacement value is that market value considers the entire property, including the land, whereas replacement value only factors in the cost of rebuilding the home and detached structures constructed on the property.

No matter what your home is worth on the market or what it costs to rebuild, make sure you have a home insurance policy to protect against any potential damage.