The law with regards to the insurance of leasehold property, and reinstatement after damage or destruction, can be very uncertain and potentially very unfair. There is no implied obligation on either party to insure the property and there is no principle of law requiring that any insurance monies received are actually used to reinstate the property. The general rule is that rent remains payable even when the property cannot be used; and even if it the property will never be reinstated it is very unlikely that the lease will automatically be terminated. It is therefore essential that the lease contains provisions which deal with all of these issues.
Both the landlord and the tenant need to make sure that they understand exactly what the agreement is and that they know who will be liable in different situations. This includes not only who is responsible for insuring and what needs to be insured, but also what will happen if damage does occur. Who will carry out the repairs? Will the tenant have to keep on paying rent? Will it be possible to terminate the lease?
This note is designed to provide a checklist of some of the key considerations when agreeing the way in which insurance and reinstatement obligations will work within a lease.
The insurance obligation
Who is responsible for insuring?
In a standard lease of commercial property the landlord will usually want to be responsible for taking out insurance. This is clearly appropriate where the property is just one part of a larger building or estate, as the whole premises can be covered by a single policy. Where the lease is of a stand-alone building there is no reason why the tenant shouldn’t insure, but landlords will often want to retain control. The property represents a valuable long-term asset to the landlord: if the tenant fails to insure and the building is destroyed, the landlord will have a damages claim against the tenant but the reality is that most tenants will not have the funds to cover this. However, where the tenant has a long lease for which he pays a large premium and a low ground rent, it may be more appropriate for the tenant to insure, as in this situation he has more to lose if the property is destroyed.
Whose name will the insurance be in?
A tenant may want to insist that the policy is effected in joint names, to ensure that it does not lapse without both parties giving notice, and so that insurance proceeds are paid out jointly. If the landlord is unwilling to agree to this, the tenant may be able to get his interest noted on the policy, so that he is at least made aware of any claims and also of circumstances that may invalidate the insurance. However, where the policy covers multiple properties this will not be appropriate, as it will not be practical to have all the tenants on the insurance.
Who will pay for it?
Although the landlord will be responsible for insuring the property, the tenant will be responsible for reimbursing the cost of it. Where the lease is of part of larger premises, with a service charge to pay, the insurance may form part of the service charge or the tenant may have to pay an apportioned sum. Tenants need to make sure that they are happy with the way in which the apportionment is worked out. In addition, the tenant needs to look out for any excess payable under the policy and check whether the lease obliges him to cover this: it could be fairly onerous if the landlord agrees to a high excess in return for lower premiums.
What will be insured?
The property itself clearly needs to be covered, but where it forms a part of a larger building or estate the tenant also needs to see a commitment by the landlord to insure all those parts which are necessary for the tenant’s use and enjoyment of the property. For example, where the tenant has a lease of the top floor of an office block he needs to know that the lower floors, roof, stairs, lifts and other structural elements are covered.
What risks and losses will be covered?
The lease should contain a complete list of all the different risks that will be insured against (eg fire, explosion and storm), most of which are fairly standard. However, a tenant should make sure that this list is appropriate: if damage is caused by something that is not on the list, the tenant will may find that he is liable for the cost of fixing it. In addition, the tenant needs to be careful to ensure that the list isn’t too wide, and doesn’t give the landlord too much scope to add additional risks, as the tenant will be paying for these (for example, flooding in areas where this is very expensive to obtain). Cover against terrorist acts is another area that needs some thought: it is not provided automatically but it can be obtained through the Pool Re scheme. However, the cost of it will depend on the location of the property and the nature of the occupier, so it may not always be appropriate.
What will the insured sum be?
The tenant needs to make sure that the property is insured for the full reinstatement value, as this will give the landlord sufficient funds to completely replace the building if it’s destroyed. The figure needs to include site-clearance, professional fees, planning applications and any VAT payable. Provided that the landlord has an obligation to insure for the full reinstatement value, if he fails to do so the tenant will have a claim against him for any shortfall: it’s therefore in the landlord’s interests to get this figure right.
Rent suspension following damage
One of a tenant’s key concerns is whether he’ll have to keep paying rent if he can’t use the property. The usual position is that the tenant will receive a reduction or suspension of the rent that he has to pay if the property is damaged or destroyed by an insured risk, so that it is no longer suitable for occupation and use. The landlord doesn’t lose out as he will also have obtained loss of rent insurance, to cover the rent payments which he does not receive from the tenant (which the tenant will of course pay for).
When will this apply?
The tenant of part of a larger premises needs to ensure that the rent suspension applies not only if the property itself is damaged or destroyed but also if some other part of the building or estate is effected so as to prevent him from using the property (for example the access roads onto an estate or the stairs leading to his fifth floor offices). The rent suspension will generally only apply where the damage is caused by an insured risk, which is another reason why the tenant needs to ensure that this list is comprehensive. If the parties agree that a particular risk will not be insured (eg terrorism) they need to be clear on whether the rent suspension will apply: if it does not then the tenant will be paying for a building he cannot use, but if it does then the landlord will simply stop receiving rent.
How long will it last?
The rent suspension can last for whatever period the parties agree between them. It will usually be until the premises are reinstated and usable again, with a long stop date of say three years (this will usually be the same as the period covered by the loss of rent insurance). The period should generally be fixed by reference to how long the property would take to rebuild if it were completely destroyed. A problem arises if the property hasn’t been reinstated at the end of this time, and this is why tenants may insist on an ability to terminate the lease in these circumstances (see below).
What payments will be covered?
The rent suspension may catch just the principal rent or it may be extended to other sums such as service charge and insurance rent. A tenant will certainly want these sums to be suspended, as while he can’t use the property he isn’t getting the benefit of them; in addition, he likely to be paying out at the alternative premises that he is renting while the repair works are carried out. The landlord, on the other hand, may still have to provide services to other tenants on the estate, meaning that his costs are not really reduced, and will still have to pay the insurance, so his view will be that the tenant should remain liable. One option may be for the landlord to obtain loss of rent insurance that covers these types of payment, though the tenant will of course have to pay the associated higher premiums.
The reinstatement obligation
The property has been destroyed by an insured risk, the rent has been suspended and the tenant has moved out. The landlord has successfully claimed the full reinstatement value and the focus now turns to rebuilding, but whose responsibility is this?
Does the tenant’s repairing covenant apply?
The tenant will probably have a general obligation to reinstate and repair the property. However, as he will have paid for the insurance he needs to make sure that he is not obliged to repair the premises where the damage has been caused by an insured risk.
Who will reinstate?
Where the policy is in the name of the landlord, and damage is caused by an insured risk, the money will be paid out to him. However, unless the lease expressly states that he must use the monies to reinstate the property he is not under any express obligation to do so. Even though a court would probably find that the landlord must nonetheless use it in this way, it is sensible to include a clear statement in the lease that the landlord must use the money to reinstate. The tenant may also want to insist that the landlord is obliged to make up any shortfall in the event that the insurance monies are insufficient (unless this shortfall is because of something the tenant did).
What will the reinstated property be?
The parties may want to consider including provisions which define the standard of reinstatement, or allow the tenant some kind of a say in the process. For older buildings in particular, it won’t always be possible (or desirable) to reinstate with an identical property. The tenant will have two key concerns: that the property is of an equivalent size and no less suitable for its purposes; and that, where there is an open market rent review, the landlord cannot replace the property with something far superior and then increase the rent accordingly.
Despite the fact that the property may have been damaged to the point where it cannot be occupied or used, the lease will continue through until its contractual end date, together with the tenant’s liability for rent (subject to any rent suspension). Where it becomes apparent that it is not going to be possible or appropriate to reinstate that property it is important that the lease includes provisions to allow for termination.
Can the tenant terminate?
Where the property is rendered unusable, the tenant is going to need to relocate his business while the necessary works are carried out. For most tenants, the ideal position would be a right to terminate the lease immediately so that he can make a fresh start in new premises. However, this will leave the landlord with no building, no tenant and no rent (as the loss of rent insurance will probably stop paying out once the lease is terminated). The fairest way to deal with this is often to give the tenant the option to terminate the lease only in the event that property has not been reinstated by the end of the period of the rent suspension.
Can the landlord terminate?
The landlord usually won’t want the lease to be terminated, but if it becomes apparent that reinstatement is impossible (perhaps because planning permission cannot be obtained) the landlord will want to terminate the lease so that its reinstatement obligations come to an end.
What happens to the insurance monies?
Where the property is not going to be reinstated, and the lease will be terminated, there is no strict rule as to who the insurance proceeds belong to and it will be up to the court to decide this in the absence of any express provisions. As it is generally the landlord who is going to be worst off in this situation, because the tenant will not have any ongoing rights or obligations, it is usual to agree that the landlord retains the proceeds. However, where the lease is likely to have some capital value the parties may want to agree a reasonable apportionment in advance.
Historically tenants have taken on liability for damage by uninsured risks: the landlord has no obligation to reinstate, there is no suspension of rent and the tenant’s repairing covenant will usually mean he has to carry out any necessary repair works – even though he may have a short term lease with only a year or two left to run. However, tenants have become increasingly aware of the potentially devastating financial consequences of this: for example, if the property isn’t covered for terrorism and gets blown up in a terrorist attack, the tenant will be liable to rebuild the property from scratch, at his own expense. This kind of liability is likely to put many tenants out of business.
In recent years there has been a gradual recognition that this is unfair. The problem, of course, is that no-one is at fault so there is no “fair” solution, but given that it is the landlord who has the long-term capital interest in the property, it generally seems more appropriate that he should bear the (majority of) the losses. Thought should also be given to how the suspension of rent and termination provisions should work where damage has been caused by an uninsured risk.
While it can be tempting to treat the insurance provisions in a lease as boring legal stuff to be left to the lawyers, there is a lot to be gained by thinking about them upfront. Tenants should in particular be conscious of the risks that they are taking on if they remain liable for uninsured risks or if they don’t have the right to terminate at the end of any rent suspension period. The more that can be agreed in advance and included in the heads of terms, the less time will need to be spent on expensive negotiations between the parties’ lawyers.