Who Should Insure Tenant Leasehold Improvements and What Are They Anyway?

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Is there anyone out there who knows what a “leasehold improvement” is? My experience makes me wonder.

This blogger’s original intention was to continue with the question of how to handle Tenant Improvement Allowances, but since that very much involves the concept of “leasehold improvements” and this blog entry explains what those are, it seemed logical to interpose this entry first. Next time, we’ll get to questions (3) and (4) from last week.

First, some context. Most negotiations about insurance provisions in a lease take place among attorneys only. That’s strange for a number of reasons. Here are some of them. How many attorneys or even non-attorney lease negotiators know diddley squat [no, not the Texas blues band] about the mechanics of insurance? Why don’t they consult with insurance professionals on insurance issues instead of asking their similarly insurance-knowledge deficient clients what to do? That’s strange because often the same clients have already covered the draft lease documents from corner to corner with scribbled comments, but marked the insurance clauses (and the condemnation clauses) as “lawyer issues.” Why do negotiators who often don’t know the difference between what property insurance covers and what liability insurance covers, let alone what really is “contractual liability coverage,” defend their positions until hell freezes over?

OK, I’ve gotten that off my chest. Now back to the issue at hand. When the topic of “leasehold improvements” comes up, it is usually about “who will insure tenant’s leasehold improvements”?
So, we need to go back to where we started – what is a leasehold improvement, and more specifically, what is a “tenant leasehold improvement”? Let’s start with: “what is a ‘leasehold’ improvement”? It is an alteration or addition or other real property improvement made to leased property. Pretty simple, huh? So, we already know that the property is leased. What does adding “tenant” in front of “leasehold improvement add? It tells you who “did” the improvement or who paid for the improvement (before “reimbursement,” if any). Perhaps we’ll also borrow from something called “qualified leasehold improvement property” in the Internal Revenue Code to refine this a little: “However, a qualified leasehold improvement does not include any improvement for which the expenditure is attributable to any of the following: (a) the enlargement of the building; (b) any elevator or escalator; (c) any structural component benefiting a common area; or (d) the internal structural framework of the building.”

This is a key concept. A tenant leasehold improvement is real property, yes it is an integral component of the real property. It isn’t something a tenant can take to its next location. Whether it belongs to the landlord on day one or the landlord needs to wait out the “reversion” period, the landlord has a property interest in the leasehold improvements, just as if the landlord has caused them to be made to the building or not.

That should clear up any question about whether a landlord can get property insurance for tenant leasehold improvements. The answer is: absolutely yes.

Before we get to the “pragmatics,” lest anyone continue reading with aa preconceived notion about whether what follows is good for one party (landlord or tenant) and bad for the other, please start with the assumption that what follows is good for both and minimizes what each party would otherwise be paying.

Now, to the pragmatics. Except in the most unique of circumstances, when the ash settles, you can’t tell what the landlord built or bought and what the tenant added or changed to a building. Suppose a tenant removed a wall. That “destruction” is a tenant leasehold “improvement.” It decreased the cost of rebuilding. How much coverage should a tenant carry for such a tenant leasehold improvement? OK, after you’ve stopped throwing things at me, forget removing a wall – let’s say “moving a wall.” Same question; same answer. Let’s replace the sinks, the lighting fixtures, and so on.

Here’s another real world, in the field, reality. When a building is appraised for insurance value, no one subtracts any “improvements” or asks “who installed these bathroom fixtures.” Except for unique situations, such as with oil refineries on leased land (assuming there are any on land leased from unaffiliated entities, and yes, those cracking towers are treated as real property for a lot of purposes), the insurance appraisal of a retail property or office building, etc. includes all of the real property improvements, HVAC, walls, wiring, etc. The premium is based on that value. Everything is already in the landlord’s property policy. And, when the building burns, the adjuster does the same thing. Further, assume that the replacement bathroom fixtures and so on were separately insured, you’d have two adjusters to battle and two insurance claims to settle, and you’d be waiting out until the later of the two was finished before you could plan on rebuilding. And, the landlord wants to rebuild everything so that the tenant is up and running and paying rent sooner rather than later.

None of this is to say a tenant might not want to insure its “right to use” the leasehold improvements even if the leasehold improvements should, by agreement, become the landlord’s property upon installation. For example, if the lease doesn’t provide that upon its termination by reason of a fire or damage from a similar peril, the landlord, from the insurance proceeds, is to pay the tenant an amount equal to the tenant’s unamortized costs for those improvements made to the landlord’s property, then such insurance may be warranted. Similarly, a tenant can purchase insurance that would cover the incrementally higher rent for replacement premises leased when its original premises are destroyed by reason of an insurable peril. The extent and availability of such coverages is beyond the scope of the blog entry.

Oh, I forgot – the tenant is paying for its share of the landlord’s property insurance which, no matter what your insurance broker says, is priced on the whole building and not on the building less the walls moved or added by this particular tenant. So, if the tenant were to separately inure any of the tenant leasehold improvements, it would be paying twice. Oh, I also forgot, each insurance company could claim that the other insurance company covered the same property and you can’t get paid twice for the same damaged or destroyed property.

My recommendation – think this through. When your insurance broker says “it can’t be done,” find another broker. When your insurance broker says, “you shouldn’t do it,” tell her or him that this is a business matter, not an insurance matter.

This Ruminator knows that there are unique situations where the improvements can be separated or the economics dictate charging the tenant for a larger share of property insurance costs, such as when the tenant’s space is a Taj Mahal and the rest of the project is reminiscent of Soweto. Send all of those examples, each of which may be an exception to the principle expounded. But, in the case of insuring leasehold improvement made by a tenant or landlord, this Ruminator’s rule is: one insurance policy.

Brick and brickbats will be cheerfully accepted at: www.retailrealestatelaw.com.

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Comments

  1. Jack Levey says:

    Ira, I wonder how much of this confusion stems from the fact that some leasehold improvements are also trade fixtures. As such, they remain the tenant’s property during the lease and the tenant can remove them at the end of the term. Trade fixtures are neither fish nor fowl; like the mishnaic koi that has features of both the domesticated animal and the wild beast, they are both real property and personalty. Because the tenant can remove them, there may be some justification in having the tenant insure them. A century ago, the requirement that tenant insure its leasehold improvements was probably introduced by some lawyer who was unclear on distinctions between leasehold improvements, fixtures and trade fixtures, and other lawyers blindly followed his lead for decades.

  2. One twist, Ira. Because of the extent of the damage, the lease is terminated by the landlord (or the tenant), and the tenant relocates to new space. The tenant has suffered a loss of the tenant’s leasehold improvements, whether funded directly by the tenant or through an allowance from the landlord. Your Ruminator’s Rule is “one insurance policy.” So the parties have followed your rule (which I agree with), and the landlord has insured the building, including the leasehold improvements. After the casualty the landlord has the insurance proceeds to restore its building eventually. The tenant has nothing from the insured loss and so has to pay again for replacement improvements in another location. Right result? And if not, how does the tenant protect itself under your rule?

  3. David Lambert says:

    Based on what my clients (and their insurance consultants) have told me, I am not sure that this is correct – at least not in the context of a large commercial office complex. My understanding is that the landlord’s property insurance may include some value for leasehold improvements but may not typically cover the cost of replacing the leasehold improvements that are actually in place unless the landlord affirmatively requests this coverage. The issue with requesting such coverage is that some tenants (such as law firms) build out very expensive space while others (such as banks and insurance companies) pursue much less costly build outs. This raises an equitable issue since, if the landlord provide coverage for all leasehold improvements, tenants with less expensive build outs would effectively subsidize tenants with a more expensive build out. So my current understamding is that although my landlord clients’ property insurance may in fact provide some level of coverage for leasehold improvements, it does not include replacement cost type coverage for the actual leasehold improvements that are in place. Accordingly, all tenants are asked to carry their own property insurance covering their own leasehold improvements and personal property.

    • David’s raises some interesting issues and for that reason I’m making an exception to my general approach of not commenting on comments. I do so now because his keen observations really expand this discussion somewhat by taking us into the question about how parties might handle disparities.

      In my view, many insurance professionals give incorrect advice about whether leasehold improvements can be insured as part of the “building” itself. I don’t think there is any legitimate basis to say anything other than: “they can be.” The landlord has an insurable interest in them whether it owns them at the outset or only owns a reversionary interest.

      The questions David wisely poses really deal with a business issue – “in what way will the tenant be paying for such insurance? Will it pay it directly as part of its own policy, or will it be paying for it as a share of a single policy held by the landlord?”

      Unusual circumstances implicate unusual business arrangements. For example, it is very common for taxes to be allocated on a floor area, pro-rata basis regardless of the taxable value of a particular space. Essentially, parties almost always use floor area ratios as a proxy for assessed value. That isn’t “fair” (whatever that means) if there is a Taj Mahal building mixed among other building on the same tax parcel. It isn’t “fair” to count basement space and second floor space or selling area mezzanine space at a shopping center as having the same assessed value as prime, first floor space. Where there is both recognition of a possible large disparity and also bargaining power, these formulas are adjusted by negotiation.

      Similarly, where there is a large, disparate cost to replace one or a few tenant’s fit-outs compared to building standard, there might be a negotiation over how the cost would be allocated, but that shouldn’t change the principle dealing with who carries the property insurance. If a landlord wanted to “carve out” the truly excessive component of very fancy fit-outs in an office building, it could negotiate for something like: Tenant shall pay X% of the property insurance premiums plus its pro rata share of the balance of those premiums. Then, it would credit the “extra” payment against property tax shares of the other tenants, essential charging them a pro rata share of the actual premiums after having deducted X% from the actual premiums. In my view, to do otherwise would be letting the “who pays” wag the real dog – placing responsibility for insurance and rebuilding in a single set of hands.

  4. Richard Dorman says:

    My son-in-law wants to pay $85,000 to take over the lease of an airport hangar for its remaining term of 20 years. The land is owned by the county and the hangar is owned by a developer, who will be the lessor of the hangar. The lessor has a long term lease with the county for the land.

    Near as I can determine, his only “asset” is the right to use the hangar for the next 20 years. He also has to pay “maintenance” and other fees, which include insurance to protect the lessor, to the lessor.

    How does he insure his $85,000 “asset”?

  5. What about this situation: Tenant is a retailer in an outdoor mall, which is made up of several buildings incorporating multiple in-line tenants. Landlord insures the tenant improvements, and all tenants pay their share of premiums. A fire starts at the other end of the building in which Tenant is located, destroying 80% of the building, but Tenant’s space is undamaged. However, the lease allows Landlord to terminate due to destruction of x% of the building, and Landlord does so, despite there being no damage to Tenant’s space. Unfortunately, Tenant had 9 years left on a 10 year lease, and spent $500,000 on its initial build out. QUESTIONS: Are there any insurance proceeds payable to Landlord with respect to Tenant’s improvements, which were not damaged? How is Tenant made whole with respect to the unamortized amount of its $500,000 investment? It seems that the “fair” (I know, whatever that means) result would be for Landlord to reimburse Tenant upon termination, but where does LL get the $$$?

    • John Benazzi says:

      I’ll proffer that this issue is handled differently in the office and retail contexts. In the office context, I think it more appropriate for Tenants to request that Landlord maintain the insurance on “tenant leasehold improvements” (or whatever you want to call them) and therefore be responsible for restoring the same in the event of damage/destruction. And, perhaps this subject to negotiation of Tenant insuring–and therefore being responsible for restoring–above-building-standard tenant improvements (to account for the gold-plated lawyer offices that we admire. Tenant’s protection against termination–to address the concern of the previous commenter–should be negotiated by tightening Landlord’s right to terminate the Lease in the event of casualty. This risk is tempered by the fact that LLs don’t typically terminate paying tenants and the fact that in most office deals LL’s are paying the majority of the tenant improvement cost with allowances and if Tenant is required to move, they’ll get similar allowance for their new offices.

      This analysis changes for retail because of the larger investment that retail tenants (like restaurants) invest in their space relative to office tenants. There, I advise my tenant clients that they WANT to be the insuring party (and therefore responsible for restoring the same) because they are talking about a lot of money and they want to take that money with them if the lease is terminated due to casualty.

      • Sidney Saltz says:

        This blog was just called to my attention by a client/lawyer/friend of mine, who is dealing with a loss in a prime retail space in a multi-tenant building. We share the development of the retail lease form that he (and I) use on similar deals. I covered this very topic in my article published in the January/February 2006 issue of Probate and Property. What the blog and the comments do not consider is the role of the lender. If the landlord insures only the base building and the tenant insures the leasehold improvements, where is the “standard mortgage clause” on the leasehold improvements that benefits the landlord’s lender, which has certainly required that the landlord (but not the tenants) to insure the property for its full replacement cost. If the insurance proceeds paid to the lender are insufficient to restore the property so the rents can continue, the landlord will have to fund the difference from its pocket or beg the tenants to turn the proceeds of their insurance to the landlord’s lender, which certainly won’t happen. The landlord may find that the lender applies whatever proceeds it receives to pay down the loan and the landlord will have to refinance to rebuild. Thus, for its protection (and its lender’s) the landlord will have to carry insurance on the property as it is improved, and to require the tenant to pay for insurance on the same property is to require the tenant to pay twice.

        In the Taj Mahal situation, it is certainly possible for the landlord to pass a larger portion of if the insurance cost to that tenant, but since other tenants may not know about that, I am afraid that some landlord’s may use it as an occasion to double dip.

  6. Jim Henegan says:

    My general rule is that the party with the obligation to rebuild or restore should also have the obligation to provide the property insurance.

    If the Landlord is obligated to restore the Premises to the condition that the Premises were in when delivered to the Tenant (often a white box) after a casualty and the Tenant is obligated to build out the Tenant Improvements, then I would make the Tenant insure the leasehold improvements.

    If the Landlord is obligated to deliver the Premises to the Tenant substantially in the condition that the Premises were in prior to the casualty, then the Landlord should maintain the property insurance on the leasehold improvements.

  7. Does anyone have Roman Dutch Law precedent cases in this respect? I have such a case on my hands and would appreciate any leads

  8. Nadina Cole-Potter says:

    Perhaps some of the tenant issues discussed here could be covered by business interruption insurance. Not only is covering the cost to rebuild the space a concern, but business continuity is built into the business risk that should be mitigated by insurance.

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