Insuring Tenant Alterations
 
January 9, 2007
 
Sidney G. "Sid" Saltz- Chicago

The following exchange actually took place recently between a tenant’s lawyer and a landlord’s lawyer, in connection with language in an office lease which required the tenant to insure alterations made by it and not paid for by the landlord:

Landlord’s lawyer: Tenant will be required to insure improvements paid for by tenant – these are not covered by landlord’s insurance during the term. If the building burns down and the lease is not terminated, and the building and Premises are to be restored, it is tenant’s, and not landlord’s, insurance that covers improvements paid for by tenant.

Tenant’s lawyer: You should not require the tenant to insure its alterations because the tenant is already paying for the landlord’s property insurance in its rent and additional rent and, besides, your client’s mortgage requires that it insure the building to its full replacement cost, without co-insurance.

Landlord’s lawyer: I strongly disagree with your position. The necessary result of your reasoning is that, if three tenants decided to build themselves the Taj Mahal of alterations mid-term of their leases ... $150 s.f. ... and pay for those alterations themselves, that the landlord’s insurance would have to pay to restore those improvements upon a casualty. It doesn’t. Full replacement cost does not mean restoration of a limitless value of improvements in the building. And every mortgage says the same thing ... but that doesn’t change the realities of the insurance world.

Tenant’s lawyer: I hate to tell you this, but you are not correct. I have heard that Taj Mahal argument before. No tenant has the right to do that without landlord’s consent, and no landlord would consent without dealing with the insurance issue. The point is that the insurance carried on a full replacement cost basis is exactly that. No mortgagee wants to chase all the tenants to make certain that they have the property insurance on their improvements or to see to it that all those policies have standard mortgage clauses. That would be an administrative nightmare and no lender would put up with that. If I reviewed your property insurance, I would be shocked if it expressly excluded tenant-paid improvements. This is simply a double payment by tenants, and the landlord does not even get any benefit from it. It makes no sense.

Landlord’s lawyer: We will have to agree to disagree. Your position would make property insurance unobtainable or put carriers out of business across this great land.

Well, that was quite a conclusion. The tenant’s lawyer conceded the point because he had to get the deal done, the likelihood of his client’s making alterations was not substantial and because the double cost was probably minimal, in the whole scheme of things. But who was right?

It is difficult to accept the final argument of the landlord’s lawyer. It seems hardly likely that requiring landlords to include tenant alterations in their property insurance would mean the end of the insurance industry in the United States. Perhaps his position was somewhat overstated. However, so many leases require tenants to insure their alterations, or even the initial leasehold improvements to the extent paid for by tenant – even in the face of contrary requirements of their mortgages – that landlords must perceive some benefit to them. The only reasonable explanation for the landlords’ position is that they believe that they save money by requiring the tenants to insure their alterations. However, is that really so?

Cost/Benefit

In a net lease, where all operating expenses are passed directly to the tenants, that justification simply does not stand up. If insurance premiums are included in operating expenses and are paid by the tenants, pro rata, the tenants and not the landlord are obviously paying the premiums, and if they are increased because of tenant alterations, those increased costs are passed on. Perhaps some tenant may complain that its pro rata share of operating expenses are unfairly increased by another tenant’s alterations, but since when do landlords care about that?

The gross lease may be a little more troublesome, but here again, most leases provide that the tenant does pay operating expenses, this time in excess of some base. If the base is set before the alteration is performed, the result is the same as in the case of the net lease, since the tenants are charged their pro rata share of the increases in the cost of the insurance which may result from the alteration. Even if the additional expense of the insurance is included in the base, however, the landlord is probably still not out of pocket because, except in a very poor landlord market, the base expenses are included in the base rent. It follows, in the case of both the net lease and the gross lease that the tenant is paying for the landlord’s insurance, even if that insurance covers tenant alterations.

Another question is, just what is the tenant required to insure if it performs an alteration? If it removes a wall to make two offices into one, that is an alteration, but does it increase the cost of restoring the premises? Probably not. What about moving a wall? What if the tenant installs extra supports for its file room and which constitute a valuable asset to the building, or at least need not be demolished when the tenant vacates? Should the tenant be required, toward the end of its lease, to carry replacement cost insurance on alterations which are to be demolished when the lease is over, perhaps at the tenant’s expense? It seems doubtful that most parties ever consider these questions, particularly if no alterations are foreseeable when the lease is being signed.

Landlords are typically required by their mortgages to insure the property on a full replacement cost basis. Often they are required to carry special form property insurance with an Agreed Amount endorsement. What do these terms mean and how do they impact the issue at hand?

According to David Gemperle of Schwartz Brothers, a Chicago-based insurance agency, insurance can be carried on a “full replacement cost” or “actual cash value” basis. If the valuation is on replacement cost and the property is insured for the full cost of replacing it, then the insurer will pay to replace the existing improvements after a loss. If the valuation basis is actual cash value, then physical depreciation is taken into consideration in the adjusting of the loss. Special Form pertains to the perils that are covered by the policy. Special Form is also commonly referred to as “All Risk of physical loss, subject to policy exclusions.” The Agreed Amount endorsement means that the insurance carrier has agreed to waive any coinsurance penalty in the event that the building is underinsured.

A word about underinsurance: if the property is underinsured, the carrier will pay only a portion of the cost to replace. For example, assume that the building’s true replacement cost is $100 million, but the amount of the policy is only $80 million. If there is a total loss, of course the carrier will pay only the $80 million. If the loss is $10 million, the carrier will pay only $8 million to cover the loss, since the owner co-insured the property to the extent of 20 percent. This undesirable effect can be avoided, however, by the owner’s purchasing an Agreed Amount endorsement, which is an agreement by the carrier to waive co-insurance. In that case, the carrier would be required to pay $10 million for that loss. Of course the carrier would never be required to pay more than the face of the policy which, in this example, is $80 million.

It can be seen that if the property is insured on a “full replacement cost” basis, the tenant alterations can readily be covered by the landlord’s insurance and, in fact, are certainly required to be so covered by the landlord’s mortgage. As shown, that insurance is typically paid for, in its entirety, by the tenants in the building.

How does the landlord know about the tenant improvements and how much to insure them for? This is easy. Nearly every lease requires the landlord’s consent to the tenant’s performing improvements, except for insignificant ones. The tenant is also required to obtain consent to the plans and specifications, to provide lien waivers (which will disclose their cost) and to provide some form of as-built drawings. All these requirements are to satisfy the landlord’s legitimate interest in knowing what is going on in its building and its condition from time to time. They also have the effect of enabling the landlord to assure that its property is fully insured.

Enter the Lender

It is easy to see why lenders require landlords to carry the insurance and why they want it to be on a full replacement cost basis. As the tenant’s lawyer pointed out in his second response, lenders usually require standard mortgage clauses in the property insurance and want to be certain that the property is fully insured so as to cover the loan amount or to enable the property to be rebuilt to protect the cash flow from tenants which is to service the debt. Does the tenant’s insurance satisfy this requirement?

Typically, leases which require tenants to insure their alterations do not require their insurance to contain a standard mortgage clause. Many leases do require that the proceeds be payable to the landlord, particularly if the landlord and not the tenant is to do the restoration, but do not require that the proceeds to be paid to the lender. It can be seen that, even if the mortgage permitted the landlord’s obligation to be satisfied by providing fill-in insurance by tenants, the lender’s insistence on getting the money after the loss would not be satisfied on those situations. The lender’s concern about receiving all the insurance proceeds is further evidenced by the fact that many non-recourse mortgages have carve-outs which impose personal liability on the borrower, and possibly a guarantor, to account to the lender for insurance proceeds. In addition, there is an even stronger reason why lenders would be unhappy having part of the insurance obligation fulfilled by tenant insurance; lenders would have the administrative burden of continually satisfying themselves that the improvements were actually insured to their true replacement cost – an obvious administrative nightmare.

Unless the property is owned free and clear of any mortgage, and is likely to stay that way, it would be wrong to consider the lease requirements separate and apart from the mortgage requirements and wrong to impose obligations on tenants that are not consistent with the landlord’s obligations under its mortgage.

Who Is to Rebuild?

The flip side of the question of who is to insure the alterations is the question of who is obligated to restore the alterations after a casualty? Some leases provide that the money is to be paid to the landlord, who is to restore. Others require the tenant to restore. Some are silent. If the lease provides that the proceeds are to be paid to the landlord and the landlord’s mortgage requires all proceeds to be paid to the lender, that presents another issue. What does the mortgage provide regarding the lender’s obligation to make the proceeds available to rebuild? If the lender can apply the proceeds to pay down the loan, the tenant will get no benefit out of the payment of premiums for the insurance and may be out of business at the property. If the proceeds are available or the landlord does not turn them over, and does restore, at least the tenant does get the benefit out of its premiums, even if it has paid for it twice.

On the other hand, the lease may provide that the tenant is to restore its alterations. This creates another nightmare, this time for both the landlord and the tenant. If it is a multitenant building, it will mean that there will be many different contractors working in the building at the same time, each competing for the freight elevators, the docks and other facilities, and possibly creating jurisdictional labor problems. Clearly this will be intolerable for landlords. Perhaps the landlord will require that no work be done by the tenants’ contractors until the landlord’s own restoration is completed. No doubt, the lease will not extend the rent abatement after the landlord’s work to cover the time for the tenant’s restoration. Then an issue of where the landlord’s obligation ends and the tenant’s begins may appear. If the alteration consisted of moving or adding some walls, and it involved a structural modification, can the landlord’s contractor leave structural unsoundness? Does the landlord even want the tenant’s contractor to be doing that work? Do the tenant’s contractors really have to work simultaneously to deal with such issues? If the tenant’s contractor must start and stop, how is the additional cost to be paid, since the insurance proceeds may not cover that?

The Taj Mahal Argument

The landlord’s lawyer quoted in the beginning of this article does not seem to have considered all of these issues, and in particular, he did not seem to have considered whether the requirement in his lease really was in the landlord’s best interest, or even whether the requirement had any benefit to the landlord at all. His Taj Mahal example could easily have been dealt with by requiring the tenant to pay for any increase in the landlord’s insurance premiums resulting from those alterations, without requiring the tenant to insure them. In fact, it might even be possible, in that situation, for the landlord to make some extra money, albeit not legitimately, by collecting extra premiums from that tenant while allocating the total cost of the insurance to all the tenants – a not uncommon double dip.

Conclusion

Unfortunately, the lease provisions criticized in this article are very common. Why are they in leases? This might be attributed, in part, to the failure of landlords to fully understand their effect. In the long run, the parties involved in a lease may be wiser to omit a requirement which, for its seeming benefit to landlords, is really a negative for both parties.

For more information, e-mail Sidney G. Saltz at sidney.saltz@hklaw.com or call toll free, 1-888-688-8500.

“Insuring Tenant Alterations” by Sidney G. Saltz, published in Probate & Property, Volume 20, No. 1, January/February 2006. © 2006 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.