Lease Enhancement

Lease Enhancement Tear Sheet

Part I - Lease Enhancement Casualty and Condemnation Insurance

One reason a triple net lease would not qualify as a bond lease is the tenant’s right to terminate the lease or abate rent due to a total or partial taking of the improvements, parking and/or lack of access to the subject property.  This occurs through the power of condemnation under eminent domain statutes of local, state, federal or provincial governments. 

In addition, these leases may provide that if a casualty occurs, the tenant has the right to terminate the lease if the damage exceeds a specified amount or takes more then a specified amount of time to repair or rebuild. 

A possible solution is a Casualty and Condemnation Lease Enhancement policy that can provide a continuation of the payment of the base rent or payment of the principal balance of the loan.  Lease Enhancement casualty coverage requires that there be “all risk” property insurance coverage in force for the improvements at the time of the event that triggers a tenant termination. The coverage under the Lease Enhancement policy is subject to the policy conditions and exclusions.  

This policy can be extended to include transactions wherein an adverse party has an interest in the proceeds of the casualty policies and/or condemnation proceeds which may reduce the available funds to pay off the outstanding principal balance at the time of lease termination. See Short Falls sections below.

The premium is determined by (1) the amount and term of the mortgage, (2) the extent of damages that would trigger the right of the tenant to terminate due to condemnation or casualty, and (3) whether any other party has an interest in the proceeds of a condemnation award or insurance policy payment in the case of casualty.

Underwriting includes a physical inspection as well as a search of the local, state, federal or provincial records for potential situations that might give rise to a condemnation or a condemnation that interferes with access to the subject property or the amount of parking required by the lease.

Part II - Lease Enhancement Casualty and Condemnation Short Fall Insurance

A. Adverse Party Short Falls

There may be a need for Lease Enhancement insurance in a land lease where the leaseholder (tenant) builds the improvements on the property and is required to repair or rebuild the improvements if the improvements suffer physical damage or damages from a partial taking under eminent domain statutes.

Although a lease is triple net, wherein the tenant has all the maintenance and repair responsibilities, some such leases permit the leaseholder to terminate in the case of a casualty or taking. The lease would indicate how, in the event of termination, the insurance proceeds or condemnation award is to be allocated between the fee owner and the leasehold owner and whether one party’s rights are subordinated to the others. Each may have the right to obtain a mortgage for their interest in the property.

If the event permitting a termination of the lease occurs and the lease is then terminated, it is possible that there will be insufficient funds to satisfy the mortgage, due to the entitlement of the other party or its mortgagee to an allocated portion of the insurance proceeds or condemnation award. The short fall policy insures the potential insufficiency of funds to satisfy the mortgage of one party, if the insufficiency is caused by the other party being paid some portion or all of the insurance proceeds or condemnation award. The policy does not insure an inadequacy of insurance proceeds due to an insufficient amount of coverage or the damages that emanate from an uninsured peril. 

The following are examples of the use of Lease Enhancement insurance:

  1. The landlord is entitled to the value of the land before the tenant receives any portion of a condemnation award for the value of its leasehold including the value of the improvements or the fee owners, and leaseholders’ interests in the award are pari passu as respects a condemnation award.
  2. The tenant is entitled to the unamortized cost of the improvements they had constructed on a straight line basis over the initial term of the lease. The balance of the award either goes entirely to the landlord or is split with the leaseholder. Note: a problem exists if the tenant gets full cost of the improvements regardless of when the termination event occurs during the lease. 

B. Lease Enhancement for Large Projects

Some properties, especially involving a sale and leaseback of a facility, generate cash flows that will support a debt structure greater then the replacement value of the underlying asset.

In the case of the tenant exercising its right of termination due to property damage, there will be insufficient insurance proceeds available to pay the loan balance at the time of the termination of the lease, if the lender requires payment of the outstanding loan. The size of the loan may prevent the use of the standard Lease Enhancement Policy, which wraps the full amount of the loan.

A structured solution has been used which provides that the insurance will be triggered if damages or the taking is above a stated threshold, which may or may not be the same as that which the lease provides for the tenant to terminate due to property damage.

If the trigger is met, and the tenant has exercised its right of termination and there is a positive difference between the amount of the loan balance and the stated amount of underlying insurable value, the Fee or Leasehold Value, then the short fall policy would pay that difference, if any.

The Fee or Leasehold Value would generally be the replacement cost or the actual cash value (depreciated value) of the improvements; it also may include a specified amount of rents insurance and or extended rents insurance. In the case of a condemnation, the value of the underlying land may be included in the stated Fee or Leasehold Value in calculating the short fall, if any.

The policy can be structured with different short fall coverage if the building is rebuilt or not.

C. Rejectable Offers of Purchase in the case of Physical Damage

A property that was the subject of a sale and leaseback may include a lease provision requiring the tenant to offer to purchase the property (including the condemnation award or insurance proceeds) at a stipulated price, when there is a termination of the lease due to a casualty or condemnation. The schedule of amounts to be paid by the tenant generally is structured to equal the amortized loan balance of the original loan at the time of the sale/leaseback. If new financing has been put into place, the schedule would be inadequate to fully liquidate the loan balance at the time of a termination of the lease due to a casualty or condemnation.

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