Leasehold Interest Coverage
Leasehold interest coverage protects a business against the financial consequences of the loss of an attractive lease. This coverage is important when a company is paying significantly less than the market rate to lease its premises.
Cancellation of a Lease
Many property leases allow the building owner to cancel the lease if the building becomes partially or totally uninhabitable due to a physical loss.
The landlord may have the right to terminate the lease even if the portion of the building occupied by the tenant has not been damaged. If the building is totally destroyed, the landlord may have the option, but not the obligation, to rebuild the structure. The landlord may not be obligated to repair or replace a severely damaged building unless and until it has received an insurance payment.
As the following example demonstrates, cancellation of a lease can severely impact a small business that is paying less than the going rate for rent. It also demonstrates the importance of leasehold interest coverage.
Floyd owns Fantastic Flooring, a business that sells carpet and other floor coverings out of a warehouse. The company leases half of a 20,000-square foot warehouse from Peerless Properties. It is currently paying $.50 a square foot for 10,000 square feet or $5,000 monthly. The rental value of the warehouse is $.75 a square foot or $7,500 per month.
Rental value means rent the landlord could collect 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 years. If Floyd were to lose his lease, his firm would have to rent another property at market rates.
Under a new lease, the firm would likely pay an additional $2,500 more per month, or $30,000 per year, for rent. If the firm lost its lease today, it would incur an additional expense of $90,000 over the next three years.
Floyd has added a number of improvements and betterments to the warehouse since his lease began. 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.
Late one night, faulty wiring sparks a fire that severely damages the building. 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. However, Fantastic Flooring has no coverage for the economic loss it will suffer due to the loss of its lease. The company also has no coverage for the loss of use of the improvements it has made to the building. These items weren't damaged, so the 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 a lease by purchasing leasehold interest coverage. This coverage may be added to a commercial property policy via a separate form.
Leasehold Interest Insurance
Leasehold interest insurance covers the financial loss you sustain due to the cancellation of your lease. For a loss to be covered, it must result from direct physical loss of (or damage to) property at premises described in the declarations. Moreover, the damage must result from a peril insured under your policy.
Leasehold interest coverage may include any of the following, if a limit of insurance is shown in the coverage schedule:
- Tenants' Lease Interest This is the difference between the monthly rent you pay and the rental value of the property (the market rental rate). In the previous example, Fantastic Flooring's Tenants' Lease Interest is $2,500 ($7,500 minus $5,000).
- Bonus Payments This is the unamortized portion of a cash bonus that you paid to obtain a lease and that will not be returned to you. For example, you paid your landlord a $5,000 bonus to secure a 3-year lease rather than a 5-year lease.
- Improvements and Betterments Your business may have made improvements to your rental property that you can't legally remove. Covered Lease Interest includes the unamortized portion of payments you've made for improvements. It does not include the value of improvements that are covered under other insurance.
- Prepaid Rent This is the unamortized portion of rent you have paid in advance that will not be refunded to you. For instance, you paid three months' rent in advance when you leased your property.
Net Leasehold Interest
Under leasehold interest coverage, the limit of insurance is expressed in terms of net lease interest. If your lease is cancelled, the most your insurer will pay for a loss is your net lease interest at the time the loss occurs. Net lease interest includes two components.
Tenants' Lease Interest (TLI) This represents the benefit you will receive from a favorable lease over its remaining months. Your TLI is the present value of your gross leasehold interest. It is calculated by multiplying your gross lease interest by the applicable leasehold interest factor. Your gross lease interest is the difference between the rental value of your premises and the rent you pay each month. For example, suppose the market rate for rent is $5,000 per month and your company is currently paying $3,500. Your gross leasehold interest is $1,500 ($5,000 minus $3,500).
The leasehold interest factor is derived from a table attached to your policy. The factors vary depending on the prevailing interest rate and the months remaining in the lease. For example, assume that you have 36 months remaining in your lease. If the prevailing interest rate is 5 percent, the leasehold interest factor is 33.4213. Your net lease interest is $1,500 X 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 will not apply if you have not paid a bonus, made improvements or paid rent in advance. If you wish to insure these costs, the monthly leasehold interest for each must be calculated separately. For each item, your original cost is divided by the number of months remaining in your lease when you made the expenditure. For example, suppose that six months into your 36-month lease, you spent $25,000 for improvements. Your MLI is $25,000 / 30 or 833.
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, if your TLI is $1,500 and your MLI is $833, your net lease interest at inception is $2,333. This is the most your insurer will pay under leasehold interest coverage if your lease is cancelled on the inception date of your policy.
Your net lease interest declines each month throughout the term of your policy. If your lease is cancelled, the most your insurer will pay under leasehold interest coverage is your net lease interest at the time the loss occurs. 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