COMMENTARY | COLUMNISTS | HOLLY MCGLINN

Proper insurance for landlords and tenants

When searching for the perfect space, a tenant might consider herself lucky to find one in which the previous tenant has invested significantly in building out the space.

Take, for example, a restaurant with newer upgraded floors, custom wall coverings, high-end countertops on all bars — the works. The landlord is happy because the space rents quickly because of all the upgrades.

The new restaurant tenant provides the landlord with an insurance certificate naming the landlord as “additional insured” on the general liability policy and provides proof of workers’ compensation and property insurance (generally business personal property and contents, and business income).

The landlord’s lease also requires that the tenant insure her tenant improvement work — in the insurance world known as TIB (tenant’s improvements and betterments), which means the new restaurant tenant must insure the total value of the improvements made to the space including anything permanently attached, such as fixtures, paint and flooring.

In this example, suppose the tenant did not add TIBs to the policy, since everything was put in place by the prior tenant. The landlord is, of course, responsible for insuring the value of the building. Everyone is happy and the deal is done.

Fast-forward six months. A kitchen fire spreads and results in total damage to the restaurant and the building. Both the landlord and the tenant call their insurance carriers.

The landlord has a property insurance policy for the value of his building of $1 million He came up with this value when he bought the building, before the prior restaurant tenant added $200,000 in upgrades.

The landlord never increased his building limit since he did not view the prior tenant improvement work as his responsibility. The new restaurant tenant similarly did not view the prior tenant improvements as her responsibility as they were part of the space when she moved in.

So what happens next? Everybody loses.

Frequently, a commercial lease will read that the TIB work installed by a tenant becomes the landlord’s property when the lease expires. Landlords often forget to re-evaluate the value of their building to factor in this work.

So in this case, the landlord should have increased his building coverage to $1.2 million when the prior lease ended. Since this did not occur, the landlord will suffer two financial hits.

The first is a coinsurance penalty. Coinsurance is an esoteric and frequently misunderstood term. Essentially, insurance carriers want their clients to insure to the value of the property.

If you are underinsured and have a claim, a coinsurance penalty applies. The larger the gap between what you did insure for and what you should have insured for, the larger the coinsurance penalty.

A coinsurance penalty is then applied as a deduction on the insurance claim paid out by the insurance company. In this example, the maximum value of the insurance claim potentially paid out by the insurance company was only $1 million and now that will be further reduced by the coinsurance penalty resulting in a significant financial hit to the landlord.

The second financial hit for the landlord will be the fact that the new restaurant tenant did not insure for the prior restaurant improvements and therefore the tenant will recover only the value of her insured business personal property and loss of income.

In this case, there would be a $200,000 shortfall in order to return the restaurant to its prior condition. The landlord will therefore likely lose the new restaurant tenant and be faced with building out the property again while potentially having to increase his property insurance costs to cover the full value of the building.

Of course, the new restaurant tenant will likely not be able to return the restaurant to its prior condition and lose the huge benefits she had when she walked into the prior build-out and be faced with the costs of finding a new location and essentially starting over.

There are simple solutions for both landlords and tenants to protect themselves under this scenario. The landlord can diligently increase the building limit to absorb any tenant improvement work each time a tenant moves out, or the lease can stipulate that the prior tenant’s TIB work is to be insured by the new tenant, who can add it onto the policy.

It is important to note that new tenants cannot simply take it upon themselves to insure the prior tenant’s TIBs. Without a specific provision in the lease making the tenant responsible, they don’t have an insurable interest and insurance carriers would not pay the claim on their behalf. After all, no one can insure property that they don’t own or aren’t financially responsible for.

If the circumstances are different and a lease is not ended or terminated making way for a new lease, but rather assumed or reassigned, the course of action is slightly different.

The tenant needs to be proactive about asking what TI work has been done and how much it cost, and also ensure what lease provisions are in place regarding tenant improvement work to make sure the policy provides adequate coverage.


McGlinn is a commercial lines producer with San Diego-based Alcott Insurance and an active member of CREW San Diego. She can be reached at holly@alcottinsurance.com.

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