Did you know that in response to the high number of commercial property vacancies, landlords, in an effort to entice new tenants, are increasingly offering more favorable lease terms? But even sweetheart deals like these carry some risks that business owners need to protect themselves against with well-designed insurance policies.
Generally, a lease is considered favorable when the rate per square foot is somewhat or substantially less than the rate for comparable space currently available in the local commercial real estate market. Landlords are often willing to offer these extremely favorable lease rates in tough economic times to attract tenants, who can lock into these deals not only to save now but also to enjoy a better-than-market lease agreement when the real estate market recovers.
But favorable lease agreements are not without risk. These lease agreements generally allow a landlord the option of cancelling a lease should a specified event, such as major property damage, occur. If a tenant has a lease rate that cannot be replicated in the local real estate market, then losing that favorable lease can result in an unplanned increase in operational expenses for years to come.
Here is an example: ABC Advertising enters into a five-year agreement with its landlord, paying $15 per square foot for 20,000 square feet of space. When the building suffers major property damage during the first year of the agreement, ABC’s lease is cancelled, forcing ABC to either find a new operating location or accept a renegotiated lease at a higher cost. With the current area market price for equivalent space at about $20 per square foot, ABC, to lease 20,000 square feet of space, would see its monthly lease payments jump from $25,000 to $33,333, an increase of 33 percent. Such a spike in monthly lease payments translates into $100,000 of additional annual operating costs in rent alone, a potentially crushing increase.
Business owners can protect themselves against the risk of cancellation of a favorable lease by obtaining Leasehold Interest Protection insurance. This policy covers the losses suffered by an insured tenant when a premises lease with favorable terms is cancelled as a result of damage to the premises from a covered cause of loss, thereby forcing the insured to lease a replacement premises at a significantly greater expense. Like a Business Income policy, Leasehold Interest coverage protects against the harsh financial consequences of an indirect loss that arises from a direct loss.
There are four exposures that can be insured by Leasehold Interest Protection:
- Tenants Lease Interest: the difference between the rent actually paid by the tenant and the market value of the premises.
- Bonus payment: a non-refundable amount of money paid by the tenant to acquire the reduced lease (not equivalent to a security deposit). For example, a landlord, for an upfront payment of $100,000, agrees to lease space at $10 per square foot rather than at the market value of $15 per square foot. The landlord receives an immediate infusion of revenue, and the tenant gets a favorable lease, saving the insured hundreds of thousands of dollars over the term of the lease.
- Improvements & Betterments: additions and upgrades the tenant has made to the property that cannot be removed, thus becoming the property of the building owner.
- Prepaid Rent: rent the tenant has paid in advance that will not be returned.
Given the volatility of the current commercial real estate market, savvy business owners with favorable leases must protect themselves from the devastating financial losses that can result if their lease agreements are cancelled. Contact a Risk Management professional today to learn more about Leasehold Interest Protection and how it can help you dodge this speeding bullet.