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[Copyright 2008 Deloitte Development LLC. All rights reserved.]

Damage Control: Covering Your Assets

Has the Commercial Real Estate Industry Learned Its Lesson Regarding Property Insurance and Insurable Valuable? Mr. Steven Gottlieb, Mr. Nathan Florio, and Mr. Thomas Hoffman

he attacks of 9/11, Hurricane Katrina, and other recent disasters provided valuable lessons regarding the process of obtaining and maintaining adequate insurance coverage and the need to properly estimate insurable values for real property assets. But has anyone been paying attention?

Unfortunately, many commercial real estate owners, operators, investors, developers, and even lenders have not. While companies have taken notice of recent large-scale events, many still underinsure their most valuable assets, even after Ground Zero and Katrina became household terms and even though each days news brings stories of turbulent weather and terrorism threats. Underinsured properties, stemming from an unrealistic insurable value estimate, place an owner in a precarious financial situation in the event of a loss. Of course, owners dont intentionally underinsure their assets, but that is often the reality. Insurable value estimates can be low for various reasons, such as a lack of understanding about the risks a property faces; confusion regarding insurance policy terms; or incorrectly developed or outdated value calculations caused by increases in construction costs, escalating market values, and/or changes in building codes. Another reason could be that such work was executed under a premise of value not appropriate for determining or obtaining insurance coverage. And that just addresses the loss itself; not the aftermath the rebuilding and loss of business activities. These factors may manifest and place real property at risk in the event of another catastrophic occurrence. What can owners do to better understand their assets insurable values and the risks their assets face? Surprisingly, a lot. This paper explores some of the pitfalls surrounding insurable values and potential solutions, considering property damages and the physical loss or damage of the asset itself. Post-9/11 Realities Insurance costs have spiraled upward since 9/11. Predictably, many companies are taking insurance issues more seriously, bolstering risk departments and providing additional staff training. However, many of those overseeing the insurable well-being of a companys assets typically have finance or insurance backgrounds and arent necessarily skilled in valuation or construction, both important when estimating insurable values. Further, risk managers may place undue reliance on inappropriate valuations when making insurance decisions, which may put the assets, and the companies themselves, at risk. Legislation aimed at insurance didnt really address the heart of the issue. Section 404 of Sarbanes-Oxley requires that companies address insurance coverage, but not the amount of coverage. Similarly, the Terrorism Risk Insurance Act may also give property owners a false sense of security; insurance monies may be available in the wake of a major event, but an individual asset may not have enough coverage in the first place [8]. Companies should also recognize that, post 9/11, many policies now provide for terrorism related loss coverage separately from physical property and business interruption components.

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The Value Question Policyholders are often at a disadvantage when collecting on a claim from their insurance carrier(s) because of their inability to recognize the parameters used in calculating insurable value, as well as misinterpreting their policy in this regard. Consider a definition of insurable value from a typical property insurance policy, that provides for the cost to repair or replace damaged property with property of like kind and quality [7]. On the surface, this definition certainly sounds all-encompassing, giving policyholders a feeling of assurance that they will recover the value of their property in the event of a loss. But that raises another question: Which value will actually be recovered? The terminology displayed in table 1 focus on the different methodologies used in estimating an insurable value for real property assets. This dizzying list of terminology in table 1 is complicated further because there are no standard definitions within the insurance industry, and policy language tends to compound the problem by vague language that is open to interpretation. Term Actual Cash Value (ACV) Economic Obsolescence Exclusion (insurance) Fair Market Value (FMV) Definition [2] The cost to replace with new property of like kind and quality, less depreciation [1]. A form of depreciation or loss in value caused by unfavorable external conditions. A provision in an insurance contract describing property or types of property that are excluded from coverage. The price, expressed in terms of cash equivalents, at which property could change hands between a hypothetical willing and able buyer and a hypothetical and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. A form of depreciation in which the loss in value is due to factors inherent in the property itself and changes in design, materials, or process resulting in inadequacy, overcapacity, excess construction, lack of functional utility, excess operating costs, etc. The replacement cost new as defined in the insurance policy less the cost new of the items specifically excluded in the policy as of a specific date. The cost to repair or replace damaged property with property of like kind and quality [2]. A form of depreciation where the loss in value or usefulness of an asset is attributable solely to physical causes such as wear and tear and exposure to the elements. The current cost of a similar property having the nearest equivalent utility to the property being valued.

Functional Obsolescence

Insurable Replacement Cost New Insurable Value Physical Deterioration Replacement Cost New (RCN)

Reproduction The current cost of an identical new property. Cost New Table 1 - Applicable Terminology* * Definitions are taken from the American Society of Appraisers (ASA), with the exception of Actual Cash Value and Insurable Value, and may vary slightly depending on the source [2].

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Insurable Value Components Often the insurance company and the policyholder will have different views about what the insured is entitled to in case of a loss. For example, policyholders should understand the difference between actual cash value (ACV) and replacement cost value (RCV). This term is similar to replacement cost new from the definition chart. ACV is commonly understood to mean depreciated asset value while RCV is the cost, in current dollars, to replace the asset new. In addition to the costs of hard construction, soft or indirect costs such as insurance during construction, legal fees, and engineering and architects fees are also a factor. All costs that are incurred by the policyholder when constructing a building should be accounted for when estimating insurable value via either the ACV or RCV methodology. The point is that policyholders must understand and be able to interpret their insurance policy as it relates to insurable value at the time they negotiate coverage, not after a loss has occurred. Policy exclusions are another area in which policyholders must be cognizant of potential liability. Exclusions are items that will not be covered under an insurance policy in the event of a loss. Exclusions may include building elements that are expected to survive a destructive event, such as foundations and underground utilities, and may also include certain soft costs and developers profit. It is the policyholders responsibility to understand the policy so that the scope of the valuation can be tailored to meet the policyholders needs. If policyholders engage a third party appraiser to perform the insurable value estimate, then the appraiser needs to understand these issues as well. A Method to the Madness? The cost approach is typically the most appropriate valuation methodology to use when preparing an insurable value estimate. The cost approach is used to measure property value by estimating the cost to construct a reproduction of, or replacement for, the existing structure, including an entrepreneurial incentive, and then deducting depreciation from the total cost. When applied to general valuation procedures, the definition also calls for the addition of land value; however, this is not applicable to an insurance valuation as land is typically not an insurable asset. Figure 1 depicts a flowchart which may be helpful in calculating insurable value via the cost approach for physical property (exclusive of any business interruption estimates).

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Figure 1Components Necessary to Calculate Insurable Value for Physical Property Note that the figure above represents the case where the insurance policy states that the insurable value is to be calculated based on the replacement cost new. Some policies will require that insurable value be based on the reproduction cost new, resulting in the requirement to estimate the cost of an identical new property. In the figure above, the Actual Cash value is equivalent to the insurable value but again it is based on the terms of the insurance policy and the onus lies on the owner to understand the differences and their potential implications. Its important to note from figure 1 that the insurable replacement cost new is equal to the replacement cost new less any exclusions referenced in the policy. The three forms of depreciation (physical deterioration, functional obsolescence, and economic obsolescence) are typically deducted in the order shown to arrive at an estimate of fair market value. In addition, there is a presumption in the market that ACV is the equivalent of fair market value, although this is not always true and needs to be explored by the policyholder when reviewing the insurance policy. According to Mark Davidson, senior counsel at Proskauer Rose LLP, when valuing buildings with iconic value, there can be the possibility of discrepancy between market value and ACV [4]. Davidson also explains that certain states have defined ACV to be equal to market value. If the policy defines ACV, however, that controls the determination of the basis for repayment. For example, one of the policies for the World Trade Center contained language referring to ACV as being equal to replacement cost less physical depreciation. This again underscores the need for the policyholder to know and understand the basis for, and the valuation context contained or implied within the policyholders insurance policies. Unfortunately, in calculating insurable value, there are no standard policy rules or valuation methodologies. The methodology used to estimate insurable value must be consistent with the parameters of the insurance policy.

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Linking the Insurable Value Estimate to Market Value Another prevalent practice within the real estate industry is the inappropriate use of the insurable value estimate performed as part of a financing or mortgage appraisal as the basis of an assets insurable value. These estimates are prepared for a lender, who wants to confirm that the value of a mortgaged property is higher than the value of the mortgage in case a problem arises where the lender has to take action to protect its investment [3]. When applied to general valuation procedures, the definition also calls for the addition of land value; however, this is not applicable to an insurance valuation as land is typically not an insurable asset. In other words, the lender is concerned with having enough insurance to cover the loan amount, not necessarily the full value of the asset. More importantly, these insurable value estimates are often performed as an afterthought by the appraiser at the request of the lender, using generic market data and policy exclusions based on assumptions rather than policy specifics, by professionals with limited construction or insurance expertise. Owners often naively assume that because they received their loan, in part because the appraisal supported the loan amount, the insurable value estimate contained in the report is also appropriate. Then they compound the problem by using this estimate as a basis for determining the insurable value of their assets. Interestingly, what both the owner and the lender often overlook is the appropriateness of the insurable value in relation to the propertys market value. Despite the fact that appraisers typically consider three approaches to value (sales comparison approach, income approach, and cost approach) when estimating a propertys market value, many appraisers rely on only the first two when preparing a mortgage appraisal; the cost approach is all too often considered but not developed into an estimate of market value by the appraiser. Why? One reason may be that the appraiser is unfamiliar with the mechanics of the cost approach, especially with regard to estimating depreciation, as well as the detail required to arrive at a value estimate. Another reason is that the cost approach involves estimating land value, and not developing the cost approach is an easy way to avoid having to estimate the land value. However, the more prevalent reason for the lack of focus on using the cost approach to develop market is a belief that the cost approach does not reflect the motivations of investors, a notion discounted by none other than real estate mogul Sam Zell, who once stated that a propertys replacement cost in relation to purchase price was an important consideration when making an investment decision [6]. The point is that a market value appraisal and an insurable value estimate are different. In many cases, a bank appraisal estimates the market value of the property via a reconciliation of the sales comparison and income approaches (but without developing a cost approach), yet also includes an estimate of insurable value via the cost approach. However, without developing the cost approach into an estimate of market value that reconciles with the other approaches, how can the appraiser be certain that the insurable value estimate is reasonable? Consider an example of an insurable value estimate of a typical suburban mid-rise office building from a financing appraisal, where the reported market value is $350 million. In this appraisal, the appraiser reports an insurable value of $189 million. Because the insurable value estimate is contained within a report that also estimates the market value of the same property, the assumption by the reader is that the insurable value estimate is appropriate, even though the appraiser does not develop an estimate of market value based on the cost approach. In other words, what connection does the insurable value estimate have to the market value estimate? Many times, none, other than they are both contained within the same report. A thorough review of the insurable value estimate from the appraisal would reveal two major problem areas: a potentially incomplete cost analysis, and/or underdeveloped and potentially problematic implied land values. Lets look at the cost analysis first. A detailed analysis of the insurable value estimate indicates that the appraiser omitted and/or underestimated certain line items, as indicated in tables 2 and 3. A more reasonable cost estimate is presented in the Corrected column.

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Insurable Value from Financing Appraisal

Corrected 124,000,000 45,000,000 22,000,000 9,000,000 2,000,000 14,000,000 8,000,000 11,200,000 50,000,000 300,000 285,500,000 44,500,000 330,000,000

Base Cost $ 124,000,000 $ Exterior Walls $ 45,000,000 $ Heating & Cooling $ 22,000,000 $ Elevators $ 9,000,000 $ Sprinklers $ 2,000,000 $ Number of Stories Multiplier Not Included $ Unfinished Basement $ 8,000,000 $ Architect Fee's (5%) Not Included $ Current Cost & Local Multipliers Not Included $ Dry Sprinkler System Not Included $ $ 210,000,000 $ RCN - Base Building Tenant Improvements Not Included $ $ 210,000,000 $ Sub-Total Replacement Cost New Table 2 Insurable Value: With and Without Consideration of Market Value Source: Deloitte FAS [4, 5].

As shown in table 2, even a cursory review of the insurable value estimate would reveal shortcomings; but, since only the first column above is presented in the appraisal, the $210M, in this case, would often be assumed to be appropriate for such purposes. Next, we can examine the implied land value. While the insurable value estimate does not require an estimate of land value, one can calculate the implied land value by deducting the insurable value estimate from the market value estimate from the same report. If, as many users of these estimates unknowingly surmise, the insurable value is appropriate simply because it was prepared by the same appraiser that estimated the market value and the two estimates are contained in the same report, then it stands to reason that the implied land value (i.e., the difference between the two values) should also be appropriate. In our example, the market value is $350 million and the insurable value estimate is $189 million, implying a land value of $161 million. However, research into local land sales reveals that land value is more appropriately between $50 and $60 million, rather than the $161 million implied by the appraisers market value and insurable values. If the implied land value is grossly overstated, it follows that the estimated insurable value is grossly understated. The point is, appraisers preparing insurable value estimates and the users of the appraisal reports should make some attempt to reconcile the two estimates when they are contained within the same report. Developing the insurable value estimate into a full cost approach (which can then be reconciled with the other valuation approaches) would quickly identify any issues with the insurable value. An attempt at such a reconciliation is again found in the following table. The first column reconciles the appraisers estimated insurable value with the reported market value; the Corrected column presents the same reconciliation using more appropriate cost and land estimates.
Insurable Value from Financing Appraisal Sub-Total Replacement Cost New $ 210,000,000 Depreciation (10%) $ 21,000,000 Depreciated Cost $ 189,000,000 Implied Land Value $ 161,000,000 $ 350,000,000 Market Value Table 3 Insurable Value: With and Without Consideration of Market Value Corrected 330,000,000 33,000,000 297,000,000 53,000,000 350,000,000

$ $ $ $ $

In order for the appraisers insurable value estimate to reconcile with the market value, the land value would need to be $161 million, or 46 percent of the value. However, market indicates land value is more likely to be closer to $50 million. In this case, insurable value is underestimated by $108 million (the difference between the initial $189 million depreciated cost and the corrected $297 million depreciated cost). The lesson here is that, without a thorough analysis and a comparison of the cost items in an insurable value estimate to market value, it is likely that an insurable value estimate can be severely understated. Please note that the example was not developed to illustrate that the insurable value estimate is, or should be, equal to market value. Rather, the point of the

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example is that there should be some relation between the insurable value estimate of the improvements and the market value of the overall property, especially when these two values are prepared by the same appraiser and presented within the same report. Not all owners rely on the appraisals insurable value estimate, or even the carriers estimate. Insurance carriers will increase insurable value by some factor each year, reports Bill Motherway of Tishman Construction [5]. We do [an internal valuation] each year, then check the results against the carriers estimate, continues Motherway, and if the internal estimate is within a few percentage points, Tishman Construction will accept the carriers estimate. Further, every four to five years Tishman gets a third-party appraiser to revalue the assets. The lesson is clear: Conventional valuation concepts that are familiar to most real estate appraisers are not necessarily the same as insurance-related valuation concepts, and owners should confirm that the preparer of an insurable value estimate understands the differences. Consider the Rebuild Another important valuation related issue that policyholders often overlook is that the structure, as it currently exists, may not be replaceable in the event of a loss. The insurance coverage should contemplate this possibility. This is especially a concern in older buildings, where three factors can cause an increase in rebuilding costs: the original materials are no longer available; changes in building codes may necessitate a different rebuild than the original construction, most likely at an increased cost; and changes in the market may cause the rebuild to be different. Will these additional costs be covered by the policy? Increases such as these may be covered through a sub-limit, such as a law and ordinance provision. Typical L&O provisions are a backstop in the event that increases in costs caused by changes to laws, codes, ordinances, etc. promulgated subsequent to the time at which the property was originally constructed are not captured by the policy. For example, when it came to rebuilding the World Trade Center, public scrutiny caused the need for the Freedom Tower and adjacent buildings to be rebuilt with additional stairwells, areas of refuge in case of future catastrophic events, improved egress, and the blastwall system. Whenever you have a building that is old, high profile, or totally destroyed, you need to think long and hard if the insurable value captures the cost to rebuild in the event of that kind of disaster, says Attorney Mark Davidson [4].

ommercial real estate owners, operators, investors, and lenders are in the difficult situation of confirming that their most prized possessionstheir real property assetsare not undervalued for insurance purposes. The real estate industry needs to take the lessons learned from recent events to heart and review their policies to gain a better understanding of exclusions, premises of values, and coverage limits. They should confirm that their insurable values have been estimated based on appropriate methodologies and assumptions, preferably by a professional services firm experienced in performing insurable value estimates for real estate assets. Risk departments should work closely with these professionals to gain a full understanding of the specifics of the firms insurance policy, and use those specifics in the valuations. Lastly, companies should move away from the current practice of using the insurable value estimate prepared as part of the financing appraisal to set the limits of their property damage coverage.

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REFERENCES 1. Allen Financial Group. 2. American Society of Appraisers definitions. 3. Appraisal Institute Federal Line (October 2004): 3. 4. Davidson, Mark. Comments from a Deloitte FAS interview on September 10, 2007. 5. Motherway, Bill. Comments from a Deloitte FAS interview on September 20, 2007. 6. NYU Annual REIT Symposium (April 5, 2006). 7. Pappa, SPPA, Ronald J., and M. Gilinsky, Esq., Anderson Kill Loss Advisors, Actual Cash Value and Replacement Cost Value: How to Get the Most from Your Property Insurance (Summer 2007). 8. Terrorism Risk Insurance Act (TRIA) was enacted in 2002, renewed in 2005, and will expire in December 2007. The extended bill, called the Terrorism Risk Insurance Revision and Extension Act (TRIREA) of 2007, is being debated in Congress as of this writing. 9. The Appraisal Institute, The Dictionary of Real Estate Appraisal, 4th ed. (Chicago: The Appraisal Institute, 2002), 67. Steven Gottlieb Deloitte Financial Advisory Services, LLP sgottlieb@deloitte.com Nathan Florio Deloitte Financial Advisory Services, LLP naflorio@deloitte.com Thomas Hoffman Deloitte Financial Advisory Services, LLP thoffman@deloitte.com

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