Leasehold interest coverage protects a business against the financial consequences of the loss of an attractive lease when the property is harmed or destroyed. This insurance coverage is particularly important when a company is paying significantly less than the market rate to lease its premises.
Many commercial property leases will allow a building owner to cancel the lease if the building becomes partially or totally uninhabitable due to a physical loss, so having this type of protection can be critical.
What Is Leasehold Interest Coverage?
Leasehold interest insurance covers the financial loss you'd sustain due to the cancellation of your lease. The loss must result from direct physical loss of or damage to property at the premises described in the declarations. Moreover, the damage must result from a peril insured under your policy.
A landlord might have the right to terminate the lease even if the portion of the building occupied by the tenant hasn't been damaged. The landlord might have the option, but not the obligation, to rebuild the structure if the building is totally destroyed. The landlord might not be obligated to repair or replace a severely damaged building unless and until they have received an insurance payment.
How Leasehold Interest Coverage Works
Cancellation of a lease can severely impact a small business that's paying less than the going rental rate.
For example, let's say that Floyd owns Fantastic Flooring, a business that sells carpet and other floor coverings out of a warehouse. The company leases half a 20,000-square foot warehouse from Peerless Properties. It's currently paying $.50 a square foot for 10,000 square feet, or $5,000 monthly, for the premises.
We'll say that the rental value of the warehouse is $.75 a square foot, or $7,500 per month, making this a particularly nice lease. Rental value indicates the rent the landlord could have been collecting at market rates.
Floyd negotiated his lease two years ago when rental prices in his area were depressed. Rents have since rebounded, but Floyd's lease won't expire for three more years, so he's comfortably locked into these lease terms.
Floyd's firm would likely have to pay an additional $2,500 more per month, or $30,000 per year, under the terms of a new lease at market rates if he were to lose this one. The firm would incur an additional expense of $90,000 over the next three years if it lost its lease today and had to take on a new one.
Floyd has added improvements and betterments to the warehouse since his lease began as well. These include new lighting, customized shelves, and upgrades to the loading dock. The improvements are now part of the building. Floyd doesn't own them, but he will have a use interest in them for the remainder of his lease.
Then faulty wiring sparks a fire that severely damages the building late one night. Other than some minor smoke to flooring materials, the portion of the warehouse occupied by Fantastic Flooring is unaffected by the fire. Nevertheless, Peerless Properties cancels Floyd's lease.
Fantastic Flooring is insured for the damage to its flooring materials under its commercial property policy, but it has no coverage for the economic loss it will suffer due to the loss of the lease. The company also has no coverage for the loss of use of the improvements it's made to the building. These items weren't damaged, so loss of use isn't covered under the firm's property insurance.
Floyd could have protected his business against the financial losses that result from the cancellation of his lease by purchasing leasehold interest coverage.
This coverage can be added to a commercial property policy via a separate form.
Types of Leasehold Interest Coverage
Leasehold interest insurance can include a number of coverages if a limit of insurance is shown in the coverage schedule:
- Tenants' lease interest (TLI): This is the difference between the monthly rent you pay and the rental value of the property, also referred to as the market rental rate. Fantastic Flooring's tenants' lease interest in this example would be $2,500, or $7,500 minus $5,000.
- Bonus payments: This is the unamortized portion of a cash bonus that you paid to obtain the lease and that will not be returned to you. You might have paid your landlord a $5,000 bonus to secure a three-year lease rather than a five-year lease.
- Improvements and betterments: Your business might have made improvements to your rental property that you can't legally remove, such as Floyd's lighting and upgrades. Covered lease interest includes the unamortized portion of payments you've made for improvements, although it doesn't include the value of improvements that are covered under other insurance policies.
- Prepaid rent: This is the unamortized portion of rent you paid in advance that will not be refunded to you. For example, you might have paid three months' rent in advance when you leased your property.
Requirements for Net Lease Interest
The limit shown on your policy for leasehold interest coverage is the sum of your tenants' lease interest and your monthly lease interest at the inception date of your policy. For example, your net lease interest at inception is $2,333 if your TLI is $1,500 and your MLI is $833. This is the most your insurer will pay under leasehold interest coverage if your lease is canceled on the inception date of your policy.
Your net lease interest declines each month throughout the term of your policy. The most your insurer will pay under leasehold interest coverage is your net lease interest at the time the loss occurs if your lease is canceled. Your insurer will calculate your net lease interest by adding the following:
- Your gross lease interest multiplied by the leasehold interest factor for the remaining months of your lease at the time the loss occurs
- Your monthly leasehold interest multiplied by the remaining months of your lease at the time the loss occurs
Net lease interest includes two components: Tenants' lease interest and monthly leasehold interest.
Tenants' Lease Interest (TLI)
This represents the benefit you'll receive from a favorable lease over its remaining months. Your TLI is the present value of your gross leasehold interest. It's calculated by multiplying your gross lease interest by the applicable leasehold interest factor.
A gross lease is one where the landlord pays all expenses associated with the property. Your gross lease interest is the difference between the rental value of your premises and the rent you pay each month. Your gross leasehold interest would be $1,500, or $5,000 minus $3,500, if the market rate for rent is $5,000 per month and your company is currently paying $3,500.
The leasehold interest factor is derived from a table that should be attached to your policy. The factors can vary depending on the prevailing interest rate and the months remaining in your lease. The leasehold interest factor is 33.4213, assuming that you have 36 months remaining in your lease and the prevailing interest rate is 5%. Your net lease interest is $1,500 times 33.4213 or $50,132.
Monthly Leasehold Interest (MLI)
The monthly leasehold interest reflects your monthly cost for bonus payments, improvements and betterments, and prepaid rent. These items won't apply if you haven't paid a bonus, if you haven't made improvements, or if you haven't paid rent in advance.
The monthly leasehold interest for each item must be calculated separately if you want to include these costs. Your original cost would be divided by the number of months remaining in your lease when you made the expenditure for each item. For example, your MLI would be $25,000 divided by 30, or $833, if you were six months into your 36-month lease and you spent $25,000 for improvements.
- Leasehold interest coverage protects commercial tenants against losing a favorable lease due to the premises becoming partly or totally inhabitable.
- Commercial landlords can cancel a lease under these circumstances, leaving a tenant to face significant additional expense in leasing new premises, perhaps at a steeper market rate.
- This coverage can include bonus payments, improvements and betterments, and tenants’ lease interest.
- The most an insurer will pay for a loss is net lease interest at the time the loss occurs.