Who Says A Landlord Should Restore After A Fire?

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In our last two postings, we Ruminated about some of the issues involved in negotiating a lease’s damage and destruction provisions. If you missed those postings, start HERE and then continue HERE. Today, we’re going to Ruminate about whether and when a landlord should or will repair or restore its tenant’s premises or any other part of the property for that matter.

First we’ll fall back on the same questions we ask when someone isn’t paying what they owe. Is it that they can’t or that they won’t? That’s an important part of the analysis, because if “they can’t,” then learn the tune of “Dixie,” because that’s what you’ll be whistling. If you don’t know the tune, click HERE. You see, if the landlord just plain doesn’t have the money, you can’t even collect a damage judgment. And, given that most landlords are single purpose, single asset (the property in question) entities, if the property has burned to the ground, there ain’t nothing. Fortunately, this “pure” you “can’t get blood from a stone” landlord isn’t as common as you might think. You’d need a situation where a great deal of the property (and thus the landlord’s equity) was destroyed and there are no insurance proceeds or financially qualified tortfeasors to “chip in.”

The more common situation is where there isn’t enough cash to do the repair or restoration. Even with “insurance,” a landlord can find itself in such a situation. Sometimes, the insurance coverage is just inadequate. Perhaps, the damage isn’t fully covered. Perhaps, the carrier will go belly up. Perhaps, perhaps, perhaps. The reality is that, though possible, these possibilities are improbable. What isn’t improbable is that many landlords like to get “very afraid” of these highly improbable possibilities when negotiating their leases. Frankly, the time to “worry” is when buying the insurance because that’s when those risks can be covered. Perhaps tenants will understand why a particular landlord’s insurance coverage costs three cents more per square foot as compared to “across the street” if they knew the carrier was AAA rated and that the insurance was for an “Agreed Amount” more than sufficient to cover the risk and that all sensible endorsements were in place – Demolition, Ordinance or Laws, etc.

A greater, but highly overrated concern, is that the lender will “grab the insurance proceeds” and pay off (or down) the loan. Unless the collateral couldn’t be restored, that’s unlikely to happen, though the “fear” is common. More importantly, if the affected tenant or one or more of the major tenants have “played” the SNDA negotiations game properly, the lender will be obligated to allow insurance proceeds to be applied to repairs and restoration. Either way, it would be disingenuous to deny that if a major part of the property is destroyed, there wouldn’t be a problem resulting in the landlord “not being able” to restore the property. We’ll return to this in a moment.

The most likely scenario is that funds will show up when the insurance company is “good and ready.” It has been said: “to delay is to deny.” [See clause 40 of the Magna Carta or this book: Delay Deny Defend.] So, tenants, like it or not, you may have to wait if the cost of repairs is beyond the pale. We’re not going to explore that situation today.

On top of the issue of “available” funds, one can not ignore the reality of construction and zoning codes. While insurance policies can be endorsed to cover the increased cost of rebuilding in accordance with modern codes, there isn’t always the right to rebuild under later-adopted, more restrictive zoning ordinances. Commonly, the ability to rebuild “as of right” is limited to where less than half of a building has been destroyed. Codes vary as to whether half means floor area, interior building volume or dollar value, but there are situations where a property owner just may not be allowed to rebuild what burned. Often, something else can be built, but it isn’t always the prior use, e.g., retail, office or industrial.

So, where does this leave us at this junction? As a “circuit breaker,” if a landlord can’t rebuild because there just aren’t enough funds or the law won’t allow it, then the landlord is genuinely taking a hit (as will its tenant). Sometimes, a tenant just needs to face that reality. On the other hand, it would be “unpleasant,” to say the least, if a tenant saw its lease terminated and then saw the property rebuilt shortly thereafter. Basically, if the space is rebuilt or satisfactory alternative space is rebuilt within some “decent” period of time, a tenant should have the opportunity to reoccupy the property. The landlord should bear the risk that the market value of the “new” space is higher than before the casualty. After all, it traded use of its space for an agreed-upon period of time in return for a promised stream of agreed-upon income. That was the basic bargain. Although we’ve never seen such an agreement, it makes sense that a tenant of space that can’t be restored should have the right to occupy other then vacant space at the property under the same lease terms (adjusted for the size of the space) for the balance of the lease term. [See last week’s posting for thoughts about what should be done when the lease term is running out.] To protect that right, especially against someone who might buy the damaged property, certain precautions should be taken. For one, if a fire results in the lease being terminated, the right to “revive” the lease in re-built space must expressly survive. And, a memorandum of lease should be of record and it should repeat the “survival “ nature of tenant’s right to occupy replacement space and revive the lease. Otherwise, a buyer will be taking the space free of the previously terminated lease.

Well, we’ve sure taken a big detour from the main topic at hand – what if the insurance proceeds are insufficient? Here’s what we think. We think a landlord should be obligated to “belly up” an appropriate amount on top of or “ahead of” any insurance proceeds. That amount will vary by the size of the overall project. After all, a multi-building, multi-tenant project isn’t going to disappear just because one set of premises or one building was badly damaged. The landlord is going to continue in business and if it has the money to do so, it should honor its lease with the affected tenant. If the rest of the project is still standing, it will be able to “wrest” the proceeds from its lender and it often will be able to borrow for construction. After all, is such a landlord going to “walk away”? If it does walk away broke, it shouldn’t have any fear of having to pay a judgment obtained by a tenant. If it walks away rich, it should pay any such judgment.

So, do we have a lease provision that can be used to illustrate a way to handle this? Does Carter have pills? [See HERE for the answer.] In fact, like Carter, we do. Beware, however, this is a custom crafted agreement. It isn’t “plug it in” boilerplate. Ruminations offers the following for pedagogical purposes only.

Landlord shall also have the right to terminate this Lease in the event the estimated cost of repairing or restoring damage to the Building by reason or fire or other casualty, as such cost is determined by Landlord in good faith, exceeds the amount payable to Landlord pursuant to any property insurance actually carried by Landlord or required to be carried by Landlord (such excess being the “Excess Repair Cost”) by more than the Restoration Cost Threshold. Notwithstanding the preceding or anything in this Lease to the contrary, any self-insured retention amount or any deductible amount under any property insurance policy (other than with respect to earthquake insurance) shall be treated as if it were an amount payable under that property insurance policy.

“Restoration Cost Threshold” means Five Hundred Thousand Dollars ($500,000.00) if there is more than five (5) years remaining in the Term at the time of the damage. If, at the time of the damage, there is less than five (5) years remaining in the Term, then “Restoration Cost shall mean Five Hundred Thousand Dollars ($500,000.00) multiplied by the Term Fraction. The Term Fraction is the fraction whose numerator is the number of days remaining in the Term on the date of damage and whose denominator of which is 1,826. If the Excess Repair Cost exceeds the Repair Cost Threshold by less than Five Hundred Thousand Dollars ($500,000.00) and Landlord elects to terminate this Lease by reason of the Excess Repair Cost exceeding the Repair Cost Threshold, Tenant shall have an option to extend the expiration date of the current Term of this Lease for an additional time period by the number of days that would make the number of days remaining in the Term equal to 1,826, thus increasing the Repair Cost Threshold to Five Hundred Thousand Dollars ($500,000.00). The last day of the Term, as so extended, shall be the “New Expiration Date.” Tenant shall have the right to make such election at any time on or before the thirtieth (30th) day after Tenant receives notice from Landlord that Landlord has elected to terminate this Lease by reason of the Excess Repair Costs exceeding the Repair Cost Threshold. In the event Tenant exercises its option to extend the current Term as provided in the preceding sentence, and an option to extend the Term remains under this Lease, the time period for exercising the renewal option provision of this Lease shall be extended to a date that is nine (9) months prior to the New Expiration Date, but the Rent and expiration date of the option period, and the date for exercising any remaining option to extend the Term shall not be extended or affected. The Minimum Rent payable between the date of damage and the New Expiration Date shall be the same as it would have been had the Term continued and then been extended pursuant to the provisions of this Lease that set for the Minimum Rent amounts payable during renewal periods.

As always, your comments and suggestions are invited. Just click “Comments” just below the title of this posting.

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