Author: Chris Boggs
During COVID, many if not most employees were assigned to work from home. Traditionally office-based operations discovered that remote employees may be just as efficient and effective as they were in the office. Additionally, many businesses calculated the amount of money that could be saved by lessening or totally eliminating their real estate spend.
One result of COVID's work-from-home (WFH) mandate, potentially lasting for several years, is an increase in vacancy rates within commercial office buildings. Because landlords don't make money when space is vacant, the anticipation is that landlords, as the US reopens, will begin cutting lease rates on commercial office space. Landlords will offer and tenants will be able to take advantage of favorable lease rates over the next few years.
Insurance Services Office's (ISO) Leasehold Interest Coverage Form (CP 00 60) protects the insured tenant from the potential for a financial catastrophe due to the loss of a favorable lease arising out of the inability to occupy leased space following a covered cause of loss. A lease is considered favorable when the rate per square foot, or however the rent is calculated, is somewhat or substantially less than comparable space available in the local commercial real estate market. In broader terms, the tenant is paying less than “market rates" for the space.
Favorable leases are created for many reasons. A market “bust" may lead property owners to offer “cheap" leases to attract or retain tenants. Another possible reason is that the tenant has occupied the space for so long that the periodic rent increases have not kept pace with the local real estate market. Or, the property owner charged less-than-market rates to keep a strong relationship with an anchor tenant.
Regardless the reason, the tenant has a lease rate that cannot be replicated in the local real estate market. Losing a favorable lease often results in an unplanned increase in operational expenses for many years following the actual damage and the business' return to operation.
Consider the insured whose lease is cancelled in the first year of a five-year agreement because the building suffers “major" property damage (“major" in this context means enough damage to allow the landlord to cancel the lease). The insured is forced to either find a new location or accept a renegotiated lease at a higher cost – generally in line with market rates.
Assume market prices in the example area average $15 per square foot rather than the $10 per square foot the insured is currently paying. To lease an equivalent 20,000 square feet, as previously occupied, the monthly lease jumps from $16,667 to $25,000. The monthly rent difference translates into an additional $100,000 in operating costs annually due solely to increased lease payments. Even an insured occupying only 2,000 square feet, applying the information surrounding this sample market, would experience an increase in annual lease expenses of $10,000.
Remember, the $100,000 and $10,000 are annual additional costs. If the insured is in the first of a five-year lease when the loss occurs, multiply the annual cost by the number of years remaining. The loss of a favorable lease can be very expensive.
Leasehold Interest Coverage
Leasehold interest coverage protects against the financial consequences of an indirect loss arising out of a direct loss. Three conditions apply to leasehold interest protection: 1) there must be direct property damage, 2) the damage must result from a covered cause of loss, and 3) the loss leads directly to the cancellation of a favorable lease. The policy responds only if all three requirements are met.
(Note that leasehold interest coverage does not pay the cost to rent an alternate location while the building is being repaired; this expense is paid under extra expense coverage (included with or separate from business income protection).)
Four exposures can be covered by the leasehold interest coverage form: 1) Tenants lease interest, 2) bonus payments, 3) tenant's improvements and betterments, and 4) prepaid rent. Insureds may or may not be exposed to all four expense classes.
Tenants Lease Interest (TLI)
Tenants Lease Interest (TLI) is primary leasehold interest exposure. TLI is the difference between the rent/lease the tenant actually pays and the “market value" applicable to the premises. In the previous example, the monthly TLI (or “gross leasehold interest") is $8,333 ($100,000 per year). If, at the time of the loss, the insured has 30 months remaining on its lease, the insured's total TLI is $249,990.
However, total TLI is not the amount of coverage purchased; the “net" TLI is insured. The “net" TLI is a function of the time value of money discussed in a later section.
Bonus Payments
Tenants may offer the landlord or the landlord may suggest the “purchase" of a favorable lease. A bonus payment is nonrefundable money paid by the tenant to acquire the reduced lease (this is not equivalent to a security deposit). For example, the property owner, though aware of the premise's current market value, agrees to lease a 20,000 square foot space to the tenant at $10 per square foot over the next five years rather than the market value $15 per square foot, provided the tenant pay an upfront fee of $200,000.
While the property owner gains an immediate infusion of revenue in addition to a long-term tenant in a previously unoccupied (thus unprofitable) space, the tenant gains a favorable lease that saves it $300,000 over the term of the lease (not accounting for the time value of money and the required internal rate of return).
Both parties benefit from the $200,000 bonus payment.
Tenants Improvements and Betterments
Tenant's improvements and betterments (TIBs) are additions and upgrades made by the tenant to the “real property." Once TIBs are made part of the building (real property), they cannot be removed and thus become the property of the building owner. This coverage part protects the tenant for its loss of use interest in the property, again, if the favorable lease is cancelled and the insured does not return to the property following a covered direct loss. However, the Leasehold Interest Coverage form does not respond if the improvements and betterments are separately and specifically insured on the property policy (as that would constitute multiple payments for the same property). TIBs are insured by the tenant when required to by the lease, otherwise, they are insured on the landlord's policy.
Prepaid Rent
As the name suggest, this is rent paid by the tenant in advance that is not returned, even if the lease is cancelled. Following the direct property loss and the resulting loss of the favorable lease insured by the leasehold interest policy, the amount of the insured's loss is calculated based on the number of months left in the lease at the time of the loss.
Calculating the Leasehold Interest Exposure
Two values must be developed before calculating the amount of leasehold interest coverage required: gross leasehold interest (GLI) and monthly leasehold interest (MLI).
Gross Leasehold Interest (GLI)
Gross Leasehold interest (GLI) is the monthly rent difference between the property's market value and what the tenant actually pays (the amount of the favorable lease). Take note that “gross leasehold interest" is calculated on a monthly basis. The monthly GLI is multiplied by an interest rate factor based on the number of months left in the lease to develop the amount of coverage to purchase as detailed in the next section. This is the basis for the insured “tenants' lease interest" (TLI) coverage. In our ongoing example, the monthly GLI is $8,333.
The GLI requires regular recalculation, with no more than 2 years between reviews. Why? Because the market value of a property fluctuates over time. When first written, there may be a $5-per-square-foot difference between market value and the amount actually paid. Two years into the lease, the commercial real estate market may have boomed resulting in a $8-per-square-foot difference between the lease payments and the market value. The reverse is also true.
Calculating GLI is simple; the difficulty arises in determining the “market rental value" of the subject premises. Market rental value may be garnered from the tenant who probably is aware of his favorable lease and knows the premises' true rental value; but more likely the information is available from local property rental value reports published by area commercial realtors. (Large commercial real estate brokerage firms often publish rental reports listing average per-square-foot costs based on the occupancy type (e.g., office, industrial, manufacturing, retail, etc.) and the location.) Regardless the source, this information must be researched.
Monthly Leasehold Interest (MLI)
Monthly leasehold interest (MLI) is developed from the three remaining leasehold interest coverage exposures: 1) bonus payments, 2) improvements and betterments, and 3) prepaid rents. Developing MLI is simpler than calculating gross leasehold interest (GLI) as only three pieces of information are required: a) the amount of the expenditure, b) when the expenditure was made, and c) how many months were left in the lease when the expenditure was made. The formula used to calculate the MLI is:
Original Cost / Number of Months Left in the Lease at time of expenditure = MLI
Assume, for example, the tenant paid the property owner $200,000 as a bonus payment to obtain a favorable 60-month lease of $10 per square foot rather than the market rental value of $15 per square foot. All the information is there to calculate the MLI for the bonus payment. Since the expenditure was made at the beginning of the lease, the bonus payment MLI is $3,333.33 ($200,000/60 months).
Even though the same three pieces of data and the same calculation method are used to develop the MLI for all three expenditure classifications, each must be calculated separately because the expenditures may occur at different times Essentially there are three MLIs.
Staying with the above example, one year into the lease the tenant installs $400,000 in TIBs to fit its operational needs. Because these are real property changes, the tenant has only a use interest in the property as the property cannot be removed. The tenant's improvements and betterments MLI is $8,333.33 ($400,000/48 months). Remember, improvements and betterments coverage in the leasehold interest form applies only if there is no other coverage on this property.
Applying GLI and MLI
Neither the gross leasehold interest (GLI) amount nor the monthly leasehold interest (MLI) amount is used as the coverage amount. Both must be converted to their individual “net" amounts to develop the amount of coverage purchased—the net leasehold interest (NLI).
Developing the Coverage Limit – The Net Leasehold Interest
“Net leasehold interest" (NLI) is the amount of coverage purchased. The Leasehold Interest Coverage form assigns two definitions to this term - depending on the exposure considered. The NLI definition applicable to “Tenants' lease interest's" applies the time value of money to the gross leasehold interest (GLI) to develop the ultimate coverage amount. The three remaining exposures base the NLI definition on the monthly leasehold interest (MLI) and the amount of time left in the lease when the policy is written. Both calculations are explained in the following paragraphs.
Net Leasehold Interest (NLI) and Tenants' Lease Interest (TLI)
Tenants' lease interest (TLI) is the primary leasehold interest exposure. The loss of a favorable lease, as demonstrated earlier, can increase the insured's operational expenses long after the return to operation.
TLI's “net leasehold interest" (NLI) calculation is based loosely on the time value of money, specifically a hybrid present value of a dollar calculation. The two beginning factors in NLI's calculation are the previously-calculated “gross leasehold interest" (GLI) (the monthly difference between market value and the actual lease payment) and the number of months left in the subject lease at the inception date of the policy (if the agent is working many days in advance, it is important to remember the calculation begins with the policy's inception date).
Unfortunately, that is the only easy part of the NLI calculation. The next choice made is the expected or required internal rate of return the insured would earn if, rather than paying rent, they invested the money. Insurance Services Office (ISO) utilizes 11 “present value" factor forms ranging from a 5 percent to a 15 percent rate of return. Once the insured estimates the amount of interest that could be earned investing rather than paying rent, the calculation can resume.
Again, using the earlier example:
- The developed GLI: $8,333
- Number of months left in the lease at policy inception: 30
- The chosen interest rate (expected rate of return): 5%
Applying this information utilizing the “Leasehold Interest Factors for 5%" (CP 60 05), the TLI (amount of TLI insured) is $234,867.30 ($8,333 x 28.1852). Without the application of the hybrid present value calculation, the insured value would be $249,990. But because the insured has yet to suffer the lease expense, the total difference in TLI is not used in the limit's calculation.
At renewal, the insured TLI value must be recalculated. Twelve months have passed, so the tenant has only 18 months remaining in the lease at policy inception. The new TLI net leasehold interest is $144,342.60 ($8,333 x 17.3218).
Two questions arise in the above example. What happens if the lease renews in the middle of the policy period? And, what if the economy will not allow any small company to make 5 percent on their money, is there any option to use a lower percentage and interpolate the factors?
Midterm Renewal
If the lease renews midterm, the coverage must be rewritten midterm to account for the lease's new terms and conditions, the likely altered gross leasehold interest and the new lease period.
Interpolation of Interest Rate
ISO rules do not contemplate percentages different than those provided by the 11 filed endorsements (no interpolation is allowed).
Net Leasehold Interest (NLI) and Monthly Leasehold Interest (MLI)
Once each of the three MLIs is individually calculated, as previously detailed, they are added together to generate the total monthly leasehold interest (TMLI). To develop the value matching the second net leasehold interest (NLI) definition, the TMLI is multiplied by the number of months left in the lease at the inception date of the policy.
Referring once again to the previously presented sample tenant, and rounding to the nearest dollar, their total MLI is $11,667 calculated as follows:
- Bonus Payment MLI: $3,333.33
- Tenant's I&B: $8,333.33
- Prepaid Rent: $0
If we assume the policy is written with 30 months remaining in the lease at the inception date of the policy, the MLI net leasehold interest is $350,010 ($11,667 x 30 months).
Combining the two NLI definitions and applications of coverage, the total amount of coverage this insured should purchase with 30 months remaining in the lease is $584,877 ($234,867 + $350,010). This is the amount the insured could be out making this an exposure definitely worth insuring.
Loss Calculation
Although the amount of coverage listed on the Leasehold Interest Coverage Schedule (CP DS 07) is based on both definitions of net leasehold interest (NLI) at the inception of the policy, the amount of loss payment is based on the number of months left in the lease at the time of the loss. The policy specifically states that the coverage amount decreases as each month passes.
Calculating Net Leasehold Interest Loss for Tenants' Lease Interest (TLI)
At the inception date of the example policy, there were 30 months left in the lease. Multiplying the “gross leasehold interest" (GLI) by the 5 percent leasehold interest factor found in the applicable endorsement (CP 60 05) produced a TLI net leasehold interest of $234,867.
Assume that six months into the policy period, the building suffered major damage causing the insured tenant to lose its favorable lease. At the time of the loss, there 24 months remaining on the cancelled lease.
Because the insured tenant benefited from the favorable lease for six months of the policy period, paying a leasehold interest loss for the occupied period would violate the principle of indemnification. To uphold indemnification, the TLI net leasehold interest is recalculated at the time of the loss. The new (and recoverable) TLI net leasehold interest is calculated by multiplying the previously developed GLI ($8,333) by the 12-month interest rate factor found in the endorsement used at inception—5 percent in this example.
Applying the relevant information and forms, the recoverable TLI in this example is $190,157.40 ($8,333 x 22.8198). However, this is the maximum the insured can receive.
If the landlord cancels the lease due to the direct property loss but renegotiates the lease with the tenant, still at lower than “market rates," the insured will get the lesser of the recoverable TLI or the difference between the old lease and new lease for the remainder of the prior lease's term. Recall that market value in our example is $15 per square foot; the tenant pays only $10 per square foot. In the aftermath of the direct property loss, the property owner cancels the lease, but renegotiates a new one with the tenant at $12.50 per square foot. The tenant does suffer increased operational cost, but not to the amount anticipated.
At $10 per square foot, the tenant's monthly lease payment was $16,666.67. Under the renegotiated lease of $12.50 per square foot, the tenant's monthly payment is $20,833.33—a monthly difference of $4,166.66. Because there were 24 months left in the lease at the time of the loss, the insured tenant receives a maximum of $100,000 ($4,166.66 x 24 rounded to the nearest whole dollar) for his TLI loss. This amount is the lesser of the two calculations and is the amount owed as per the policy form.
Calculating Net Leasehold Interest Loss for All Other Leasehold Interest Exposures
Essentially, the same provisions applicable to a tenant's lease interest (TLI) loss settlement apply to the remaining three leasehold interest exposures. Coverage amounts are reduced monthly during the policy period, and the amount of coverage calculated at the date of loss is the maximum the insured tenant receives.
In the loss presented above, the insured has enjoyed use of the premises for six months, thus the amount subject to loss, and payable, is reduced from $350,010 to $280,008 ($11,667 x 24 months remaining in the lease). But again, this is the maximum the insured can receive. Should the landlord agree to allow the tenant to continue using the premises by renegotiating the lease or through some other arrangement, the leasehold interest policy states that the insured shall receive the lesser of the loss sustained or the “net leasehold interest" at the time of the loss.
Calculating the “loss sustained" may be complicated by the presence of insurance on the TIBs or the landlord's crediting of the “bonus payment" towards the new $12.50-per-square-foot lease (rather than the $15-per-square-foot market value). Providing a simplified actual loss sustained example for these expenditures is difficult.
One key point concerning both loss calculations is that the policy pays for the time remaining in the lease, not the time remaining in the policy period. If there are 24 months left in the lease, yet only six months remaining in the policy period, this coverage pays for the 24-month loss.
Vacancy Provisions
Simply, if the tenant insured under this coverage form vacates the building for more than 60 consecutive days, and the building meets the definition of “vacant," there is no coverage if a lease-cancelling property loss occurs.
Vacant within the Leasehold Interest Coverage Form means there is not enough equipment or furniture to conduct normal operations. Placing a desk and chair in a manufacturing operation does not negate the fact that it is “vacant."
However, the existence of a sublease alters the vacancy provision (and exclusion). With a sublease in place, the vacancy provision in the leasehold form mimics the same provision in the Commercial Property form stating:
- We will not pay for any loss or damage caused by any of the following even if they are Covered Causes of Loss:
a) Vandalism;
b) Sprinkler leakage, unless you have protected the system against freezing;
c) Building glass breakage;
d) Water damage;
e) Theft; or
f) Attempted theft. - With respect to a Covered Cause of Loss not listed in (1) (a) through (1)(f) above, we will reduce the amount we would otherwise pay for the loss or damage by 15%.
How You Use This Information
Leasehold interest coverage is likely the most neglected property exposure. Such neglect can cost the insured thousands of dollars following a major property loss.
Market conditions along with other factors influence the need for this coverage. Agents desiring to set themselves apart must understand this overlooked coverage and explain the exposure and coverage to the insured.
Last Updated: October 28, 2020