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.