Triple Net Leases: the Landlord's Property Insurance Dilemma

ACREL News & Notes February 2018 Triple Net Leases: The Landlord’s Property Insurance Dilemma

Marie A. Moore, Sher Garner Cahill Richter Klein & Hilbert, L.L.C., New Orleans, LA

Today, many commercial leases are structured as “triple net” leases1 in which the tenant is obligated to pay the taxes, perform the repairs, and carry the liability insurance and property insurance2 on the buildings and improvements. The owners of the property leased under one of these leases – and the investors that acquire this property and the lease – often assume that they will receive full insurance proceeds if the improvements on this property are destroyed by a casualty. But this assumption may not be accurate. If a casualty occurs, the landlord may be left with damaged improvements and no proceeds. Not all “triple net” leases are the same; sometimes the improvements are built or financed by the landlord, and sometimes, by the tenant. Whether the landlord is the party who should receive insurance proceeds paid by reason of damage to the improvements depends on the ownership of the improvements and other factors. Generally, the party that provides or pays for the improvements and that must restore them – whether landlord or tenant – should receive the property damage insurance proceeds, at least up to the unamortized costs. However, even if the landlord provides existing improvements, or finances the construction of new improvements, it may not actually receive any of the proceeds of the property insurance maintained by the tenant unless (i) the lease requires the tenant to maintain the correct insurance; and (ii) the landlord follows up to be sure that the tenant’s actual insurance complies with those requirements. I. In What Circumstances Should the Landlord Receive the Proceeds? The landlord has the clearest claim to the proceeds paid for damage to the improvements when two factors are present: first, the landlord owns the improvements – either because they were in place when the lease was executed or because the landlord constructed or paid for them – and second, the landlord is obligated to restore the improvements if they are damaged. When the landlord has provided or paid for the improvements, it is crucial to the landlord and its lender that they, not the tenant, receive the proceeds. Similarly, when the landlord has the restoration obligations, it needs the proceeds to finance that work. On the other hand, the tenant has a real interest in receiving the proceeds when it has constructed the improvements, owns them, and must restore them – or at least, does not require the landlord to restore them. In this situation, the lease is probably a long-term “ground lease”3 under which the tenant has leased vacant ground and will construct and finance its own improvements. These tenants generally have lenders that are secured by leasehold mortgages, and both the tenants and their lenders need to be able to recover the replacement cost. The

1 The term “triple net” lease is not as clear as one might wish. In Tin Tin Corp. v. Pacific Rim Park, LLC, 88 Cal. Rptr. 3d 816, (La. App. 6th Dist. 2009), the court quoted the California Practice Guide for the point that “’the titles or labels themselves have no legal significance and are not decisive of the extent to which the parties intended to shift the expense burdens of various operating, repair, and maintenance obligations from Landlord to Tenant.” 170 Cal.App.4th at 1226 (quoting Cal. Practice Guide: Real Property Transactions § 7:37). 2 Although insurance that reimburses the owner for the replacement cost of damaged property is sometimes referred to as “casualty insurance,” the more correct term is “property insurance.” This prevents confusion with commercial general liability insurance, which protects an insured party from third party liability claims that arise out of a “casualty.” 3 A “ground lease” is generally a “triple net” lease, but it is an absolute lease in which the tenant will be the owner of the improvements and will have few obligations to the landlord with respect to them.

ACREL News & Notes February 2018 landlord may negotiate for a right to receive the unamortized portion of the improvements costs if the tenant does not rebuild, but its interest in, and claims to, the proceeds are much less than they are when the landlord has paid for the improvements or must restore them. In many cases, each party’s interest in receiving the proceeds is not this clear; for example, if the party that must restore the improvements is not the party that paid for them, the damage and destruction provisions of the lease should be crafted to accommodate the parties’ respective financial interests and obligations – as must the lease’s insurance requirements. II. What Lease Provisions Will Protect a Landlord’s Interests in the Property Insurance Proceeds?

If the landlord has provided existing improvements or has constructed or financed the improvements, then the landlord will be best served if it carries the property insurance itself, and in a “net lease,” passes the cost along to the tenant. However, national tenants seldom agree either to permitting another party to carry the property insurance coverage on improvements that they may wish to restore, or to permitting another party to determine their premiums. In addition, landlords that view a “net lease” as a mere investment prefer that all of the insurance be administered by the tenant. When the landlord owns the improvements but permits the tenant to insure them, the landlord can lessen its risks by requiring specific coverages in the Lease. First, the landlord should require that the tenant carry “Special Causes of Loss” form coverage on the improvements. Formerly called “All Risk” coverage, this form of property policy, illustrated by ISO form CP 10 30 10 12, provides coverage for a broader range of casualty events (“Causes of Loss”) than “Basic Form” (ISO form CP 10 10 10 12) or “Broad Form” (ISO form CP 10 20 10 12) coverage. Of course, most national tenants use “manuscript policies” – policies that are tailored for the insured; however a manuscript policy can be tailored to satisfy a lease requirement that the tenant provide coverage that is no less comprehensive than the coverage provided by a Special Causes of Loss form policy. The landlord should also expressly require the tenant to carry coverage for flood, earthquake, terrorism, and other types of events that may cause damage in the improvements’ geographic location, but that are excluded from coverage even in “Special Causes of Loss” form policies. Landlords should also require their tenants to carry a specified amount of coverage – preferably coverage for the full “replacement cost” of the improvements. This “replacement cost” is the actual cost of making the repairs or replacing the damaged property with property of comparable material and quality that is used for the same purpose, and reconstructed at the same location.4 The alternative “actual cash value” coverage amount subtracts physical depreciation from this replacement cost and will not be sufficient for restoration. The landlord should also limit the tenant’s deductible and include language requiring the tenant either to provide this deductible for the restoration, or to pay the landlord the deductible amount if the lease terminates. If the tenant has a high deductible or wishes to self-insure the property loss risk, then the landlord must understand that the loss is not actually insured – at least not to the extent of the deductible – and that it will be relying solely on the tenant’s ability and willingness to pay (state laws imposing penalties on bad faith failures to pay by insurers will probably not apply to suits against the tenant). Additionally, if the tenant insures the landlord’s property with other

4 The insurer may permit the replacement improvements to be constructed at a different location, but it will not pay more than it would cost to reconstruct the improvements at the original location.

ACREL News & Notes February 2018 properties under a “blanket policy,” then in an area-wide casualty, the tenant may find a way to use the funds to restore other locations, but not the one owned by the landlord. Once the tenant obtains the correct types and amounts of property insurance coverage, how does the landlord gain rights to the proceeds? Generally, the party that maintains a property insurance policy is its “loss payee” – the person to whom the proceeds are paid. However, when the landlord permits the tenant to insure the landlord’s improvements, the landlord needs to be (i) the sole “loss payee,” or at least an additional “loss payee,” as well as (ii) an “additional insured” on this policy. The “loss payee” endorsement is different from the “additional insured” endorsement. The landlord should require both; however, even with endorsements making the landlord a “loss payee” and an “additional insured,” the landlord faces a number of risks. A simple “loss payee” endorsement (for example, ISO form CP 12 18 10 12) as well as a simple “additional insured” endorsement (for example, ISO form CP 12 19 06 07) will make the landlord a named insured as to the improvements owned by the landlord. But under both of these endorsements, (i) the landlord may have to negotiate with the tenant about the proceeds that will be paid to the landlord, particularly as to improvements and betterments, since both parties are loss payees; (ii) the landlord will have no protection against the policy being invalidated by actions of the tenant; and (iii) the insurer will not be required to give the landlord notice of cancellation. To address at the very least the risk of policy cancellation, the landlord should require the tenant to provide an endorsement in which the insurer agrees to give the landlord a certain number of days prior notice (perhaps thirty days) before cancelling or making a material change to the policy. However, insurers are increasingly reluctant to provide this endorsement. Tenants with less bargaining power may not able to provide it, and tenants with greater bargaining power may not be willing to provide it. Ironically, the landlord’s mortgagee will be provided with significant rights and protection against these risks under a standard lender or mortgagee loss payable endorsement such as the lender provisions in ISO form CP 12 18 10 12. In this endorsement, the insurer agrees to pay the lender loss payees as their interests may appear, even if a loss payee has started foreclosure or similar action with respect to the property. Even when the insured (borrower) has failed to comply with the policy, the lender will have the right to receive payment if (i) it pays the premium when the borrower has failed to do so, (ii) it submits a signed, sworn proof of loss within sixty days after the insurer’s notice of the insured’s failure to submit this proof of loss, and (iii) it has notified the insurer of any change in ownership or occupancy, or any other substantial change in risk of which the lender is aware. This form endorsement also requires the insurer to give the lender at least ten days prior notice of a cancellation for nonpayment of premiums and thirty days prior notice of a cancellation for any other reason, and requires the insurer to provide the lender with at least ten days prior notice of election not to renew on the expiration date. In a “net lease,” the landlord should always require the tenant to provide a lender loss payable endorsement for landlord’s mortgagee upon request. In fact, in light of the superior protections afforded to a mortgagee, it can be argued that the landlord should always keep a mortgage-secured loan on the leased property and the improvements that it owns. Finally, even when the Lease includes all of these tenant insurance requirements, the landlord may still be unable to obtain reliable proof that the tenant is actually maintaining all of the required coverage. Traditionally, landlords have relied on the ACORD form one-page “Evidence of Property Insurance” snapshots of the coverage (for example, ACORD 27 and

ACREL News & Notes February 2018

ACORD 28). However, landlords can no longer rely on these simple, short outlines of coverage (if they ever could). The current ACORD form documents state on their face that they are not binding on the insurer. The insurers assert that they are filled out by the brokers and agents, not by the insurers, and that a one-page form cannot take the place of a policy contract comprising pages and pages of coverages and limitations on coverages. W. Rodney Clement Jr., Is a Certificate of Insurance a Worthless Document?, 24 PROB. & PROP. 46 (May/June 2010). In addition, just because a landlord is a certificate holder does not mean that this certificate holder is a “loss payee” or “additional insured” – a separate endorsement must grant that status. Also, the certificate of coverage does not obligate the insurer to give notice of cancellation to the certificate holder – instead, it merely refers the certificate holder back to the policy and its endorsements to ascertain whether it will be given notice. In fact, an evidence of coverage form does not even give certificate holders assurance that the listed coverages are in place – it states on its face that it conveys no rights to the certificate holder. As a consequence, to determine whether the tenant is actually providing the promised insurance, the landlord must obtain and review the tenant’s actual insurance policies or at least the Declarations pages, the Schedule of Forms, and all required endorsements. Unfortunately, most national tenants will not provide this much information about their national policies. III. Conclusion. In light of these risks, the attorney for a landlord that owns the improvements on net leased property must advise his or her client of the risks inherent in permitting the tenant to insure these improvements, and should stress that the landlord will be best protected if it covers its own improvements. However, if the landlord must permit the tenant to maintain the insurance on the landlord's improvements, the lease should require that: (i) the tenant provide at least the coverage provided by a “Special Causes of Loss” policy of property insurance, with coverage for the additional risks that the landlord wishes to be insured; (ii) this coverage be for the full “replacement cost” of the improvements with only an agreed deductible amount, and with an Agreed Value or similar endorsement in which the insurer accepts a stipulated “replacement cost” or otherwise waives co-insurance penalties; (iii) the landlord be a “loss payee” and “additional insured” on this coverage, with an endorsement in which the insurer agrees to give the landlord prior notice of a cancellation or a material change to the policy; (iv) upon request, the tenant provide landlord’s lender with a lender loss payable endorsement; and (v) the tenant be obligated to provide the landlord with a copy of the policy, or at least the Declarations Page, Schedule of Forms, and required endorsements, upon request, along with the one-page evidence of coverage form. Last but not least, the landlord and its lawyer must draft the casualty provisions of the Lease with consideration of the fact that the tenant will control the property insurance proceeds. The landlord should assure that the tenant, not the landlord, has the restoration obligations – or, if the landlord must restore, assure that (i) it is not required to start work until it has received the tenant’s insurance proceeds and deductible amounts, and (ii) it is not obligated to restore in excess of the proceeds and deductible amounts it actually receives. Finally, the lease should stipulate that if the lease terminates by reason of a casualty, the tenant is personally obligated to pay the landlord or permit landlord to recover the full restoration costs of the property.