Commercial property vacancies remain high across the country. Economists and commercial real

estate professionals paints a less-than-pretty picture for commercial property owners and

landlords in the near future.

Empty or partially empty buildings produce no income (and create other claims problems that arise

out of vacancy). Tenants, like buyers on the residential side, are in control right now; and may

remain in control through 2010 and into 2011. To entice tenants and generate some level of

income, landlords may be willing to offer extremely attractive lease rates until the economy

fully rebounds.

Clients able to take advantage of these "deals" by locking in favorable long-term leases will not

only save now, but will enjoy a better-than-market lease arrangement when the market does turn.

Landlords will not think well of these generous lease arrangements in the middle of the next boom

- even though necessary right now.

Property owners know the commercial real estate market will eventually bounce back, just not

when. Lease agreements generally allow the landlord the option to cancel a lease should a

specified event occur, such as direct property damage. These cancelation options are likely being

reviewed and strengthened while the market is down.

The Need for Leasehold Interest Protection

Leasehold interest coverage (CP 00 60) protects the insured tenant from the potential of an

additional financial catastrophe due to the loss of a favorable lease arising out of the

inability to occupy the leased space following a covered cause of loss. A lease is considered

favorable when the rate per square foot, or however the rent is calculated, is somewhat or

substantially less than comparable space available in the local commercial real estate market. In

broader terms, the tenant is paying less than "market rates" for the space.

There are many reasons for the existence of a favorable lease. Beyond the current situation where

property owners are offering favorable leases to attract or retain tenants as detailed above;

some insureds have occupied space as a tenant for so many years that the periodic increases have

not kept up with the local real estate market; or the property owner wanted to keep a strong

relationship with the tenant.

Another consideration is a change in property ownership. The new owner may not have the same

operating mentality as the prior owner. The property may also be passed to the next familial

generation, and the new generation may not have as strong a relationship with the tenant or is

more interested in getting the highest price possible.

Regardless the reason, the tenant has a lease rate that cannot be replicated in the subject real

estate market should the need to find another location arise. And losing a favorable lease

following a specified event can result in an unplanned increase in operational expenses for years

following the actual damage and the business' return to operational normalcy.

Consider the insured whose lease is canceled in the first of a five year agreement because the

building suffers "major" property damage ("major" is a subjective term, but in this context it

signifies enough damage to allow the landlord to cancel the lease). The insured is forced to

either find a new location from which to operate or accept a renegotiated lease at a higher cost.

Market prices in the area of this example insured are $15 per square foot rather than the $10

they were paying under the current lease. To lease an equivalent 20,000 square feet, as

previously occupied, the monthly lease jumps from $16,667 to $25,000. The difference in monthly

rent translates into $100,000 in additional annual operating costs due solely to increased lease

payments. Even an insured occupying only 2,000 square feet, applying the information surrounding

this sample market, would experience an increase in annual lease expenses of $10,000. This

example is referenced throughout this three-part series.

Leasehold Interest Coverage

Like business income, leasehold interest coverage protects against the financial consequences of

an indirect loss arising out of a direct loss. Three conditions apply to leasehold interest

protection: 1) there must be direct property damage; 2) resulting from a covered cause of loss;

3) directly leading to the cancellation of a favorable lease. The policy responds only if all

three requirements are met.

(Note that leasehold interest coverage does not pay the cost to rent an alternate location while

the building is being repaired, that's the job of extra expense coverage (included with or

separate from business income protection).)

Tenants lease interest, bonus payments, tenant's improvements and betterments and prepaid rent

are the four exposures insured by leasehold interest coverage. Insureds may or may not be subject

to all four expense classes.

Tenants Lease Interest (TLI). TLI is the primary leasehold interest exposure. Tenants lease

interest is the difference between the rent/lease actually paid by the tenant and the market

value of the premises. In the above example the monthly TLI (or "gross leasehold interest") is

$8,333 ($100,000 per year). If, at the time of the loss, the insured has 30 months remaining in

its lease, the insured's total TLI is $249,990. Total TLI is not the amount of coverage

purchased; only the "net" TLI is insured. The "net" TLI is a function of the time value of money

(discussed in a later section).

Bonus Payment. Tenants may offer to or landlords may suggest the "purchase" of a favorable lease.

A bonus payment is nonrefundable money paid by the tenant to acquire the reduced lease (this is

not equivalent to a security deposit). For instance, the property owner in the previous example,

though aware of the premise's current market value, agrees to lease the space to the tenant at

$10 per square foot rather than the market value $15 per square foot for an upfront payment of

$100,000. The property owner gains an immediate infusion of revenue and a long-term tenant in a

previously unoccupied (thus unprofitable) space; and the tenant gains a favorable lease that

saves them $200,000 over the term of the lease (not accounting for the time value of money and

the required internal rate of return).

Improvements and Betterments. These are additions and upgrades made to the "real property" by the

tenant. Once made part of the building (real property), they cannot be removed and thus become

the property of the building owner. This coverage part protects the tenant for its loss of use

interest in the property, again, if the favorable lease is canceled and the insured does not

return to the property following a covered direct loss. However, the leasehold interest coverage

policy does not respond if the improvements and betterments are separately and specifically

insured on the property policy (as that would constitute multiple payments for the same

property).

Prepaid Rent. As the name suggest, this is rent the tenant pays in advance that is not returned,

even if the lease is canceled.

Following the direct property loss and the resulting loss of the favorable lease terms insured by

the leasehold interest policy, the amount of the insured's loss is calculated based on the number

of months left in the lease at the time of the loss.