May 01, 2002

The Value in Protecting the Tenant's Interest: Leasehold Title Insurance (2002, 16:03)


The Value in Protecting the Tenant's Interest: Leasehold Title Insurance

Probate and Property, May/June 2002, Volume 16, Number 3

By Harvey L. Temkin

Real estate developers, brokers, lenders, and lawyers understand the need to obtain title insurance when parties are either selling or financing real estate. The buyer or lender wants to be certain that the interest sought to be acquired, whether it be an ownership or a lien position, cannot be defeated by a party with paramount title. Typically, a title insurance company will examine the real estate records, as well as conduct other pertinent searches, to determine what needs to occur for the new owner or lender to obtain the desired interest.

Real estate developers, brokers, lenders, and lawyers understand the need to obtain title insurance when parties are either selling or financing real estate. The buyer or lender wants to be certain that the interest sought to be acquired, whether it be an ownership or a lien position, cannot be defeated by a party with paramount title. Typically, a title insurance company will examine the real estate records, as well as conduct other pertinent searches, to determine what needs to occur for the new owner or lender to obtain the desired interest.

Although title insurance is typically obtained in such purchase and loan situations, it is used much less frequently to protect tenants when they enter into leases. Nevertheless, since 1975, when the American Land Title Association (ALTA) first promulgated leasehold coverage, title insurance specifically fashioned for leaseholds has been available to tenants. When ALTA promulgated the policy, it also prepared a memorandum addressing certain issues inherent in leasehold coverage, including the following:

• What is the proper amount of insurance?

• How is the leasehold valued if it is lost?

• What incidental damages does the leasehold policy cover if the tenant is evicted?

• What rights under the lease are insured?

Of the issues noted above, two stand out as particularly difficult: the proper amount of insurance and the valuation of the leasehold. In the traditional title insurance situation in which a purchaser or lender is insured, determining the amount of insurance is often obvious. For a purchaser of real estate, the appropriate insurance amount is the market value of the property, which, generally, is the same as the purchase price. For a lender, the appropriate amount is the loan amount. In the leasehold situation, title insurers and proposed insureds have a much more difficult time determining the coverage amount.

How does one determine the potential damages from loss of leasehold and therefore the appropriate amount of insurance? Under the 1975 ALTA leasehold policies, the tenant could recover various incidental damages plus the fair market value of the leasehold interest insured by the policy. The fair market value of the interest would be determined by taking the difference between the fair market rent for the interest insured and the amount that the insured was contractually obligated to pay under the lease for the remainder of the term and then discounting that amount at an appropriate discount rate. In effect, the remedy under the 1975 leasehold policy combined incidental damages the tenant might suffer, such as moving expenses, with the value that the tenant might be able to prove if it had a below-market lease.

At the time of entering into the lease, when the tenant might consider obtaining leasehold coverage, it would be very difficult to determine what the value of the leasehold estate might be, because typically, at that time, the fair market rent for the insured premises would be the same as the rent being charged under the lease. It was thus difficult for a tenant to determine an appropriate amount of insurance or to see the benefit of insuring its leasehold estate. As a result, title insurers sold very little leasehold coverage.

Why Leasehold Coverage?

Although title insurers sold little coverage under the 1975 leasehold policy, the question remained whether the reason for such tepid sales resulted from the problems of determining remedies and the appropriate amount of insurance or from decisions by tenants that such coverage was not needed.

Two clear-cut situations emerge in which tenants might need leasehold coverage. In the first situation, the tenant may be ground-leasing land on which the tenant will be constructing improvements, such as an office building, a store, or an apartment building. The tenant and its lender will be investing significant amounts of money that depend on the integrity of the title to the real estate. The second situation arises when a tenant leases a facility, such as an office or a retail store, and agrees to invest significant amounts of its own money in leasehold improvements. For example, a law firm making a $2 million investment in leasehold improvements needs to know that some other party cannot defeat its landlord’s title and therefore its leasehold interest. In both situations the tenant needs protection. The 1975 leasehold policy did not, however, provide either a remedy that would address the tenant’s concerns or an appropriate method to help the tenant determine the proper amount of insurance to obtain.

New Leasehold Coverage

In 1999 ALTA decided to try to improve on the 1975 leasehold policy and make leasehold coverage attractive to tenants. To accomplish its purpose, ALTA requested assistance from the Title Insurance Committee of the American College of Real Estate Lawyers (ACREL) for input from the real estate bar about appropriate coverage. That effort culminated in the promulgation of a new leasehold endorsement on October 13, 2001, and the withdrawal of the leasehold policies as ALTA forms.

Format for New Coverage

As opposed to the 1975 product, in which tenant coverage could be provided either through a separate leasehold title policy or through a leasehold endorsement attached to a standard owner’s policy, leasehold coverage is now provided solely through a leasehold endorsement attached to a standard owner’s policy. This format means that, except as otherwise specifically provided in the endorsement itself, the typical exclusions and exceptions from coverage, conditions, and stipulations of the standard owner’s title policy will apply to the leasehold coverage. Similarly, lender leasehold coverage will be provided solely through an endorsement to the standard loan title insurance policy.

Extent of Coverage

To understand the new leasehold coverage, the insured must understand the definitions included in the new endorsement. Examining a few of those definitions in detail helps to show the extent of the leasehold endorsement’s coverage.

The endorsement defines "evicted" or "eviction" as meaning either (1) "the lawful deprivation, in whole or in part, of the right of possession, contrary to the terms of the lease," or (2) "the lawful prevention of the use of the land or the Tenant Leasehold Improvements for the purposes permitted by the lease." The definition thus encompasses two distinct concepts. First, if the lease grants the tenant the right to possession, and if the tenant’s possession is lost, the endorsement provides coverage unless the tenant is dispossessed by the terms of the lease. Second, if the lease permits the tenant to use the premises for a particular use and the tenant is lawfully prevented from such use because of a title matter, the leasehold endorsement provides coverage for the tenant.

Under either of the above situations, however, the issue still has to arise from a matter covered by the standard title insurance policy. For example, if a tenant is prohibited from using the premises for a purpose permitted by the lease because of a covenant or restriction that has been recorded against the property and that is shown in the title policy’s exceptions to coverage, the leasehold endorsement will not cover the tenant. Similarly, if the tenant’s use is prohibited because it violates the zoning laws of the district in which the land is located, then, notwithstanding the tenant’s having obtained leasehold coverage, the tenant is not covered for the loss unless the title insurance policy also includes a zoning endorsement that insures the tenant’s use. The tenant’s eviction is also not covered if the tenant is dispossessed by a prior lienholder if the lien was disclosed in the exceptions to coverage and was not subordinated to the lease. To have obtained coverage in that situation, the tenant should have had the prior lien subordinated and had the title company insure the lease’s priority.

Another important definition contained in the leasehold endorsement is that of "lease term," which includes, in addition to the base lease term, coverage during any renewal or extended term if a valid option to renew or extend is contained in the lease. An insured should keep this provision in mind if it extends the lease term pursuant to a lease extension negotiated after execution of the original lease. Suppose, for example, that the original lease lacks an option to extend and a tenant, after occupying premises for ten years, negotiates an extension of the term and spends another $2 million in improving the premises for the additional term: the leasehold endorsement does not cover that additional lease term, in the absence of a new endorsement providing the leasehold coverage.

A third definition in the leasehold endorsement defines "personal property" as including chattels located on land and property that, because of their character and manner of affixation to the land, can be severed from the land without causing appreciable damage to themselves or to the land to which they are affixed. This definition is important in determining the incidental costs to which the insured will be entitled. For example, the insured may recover the reasonable cost of removing and relocating any personal property that the insured has the right to remove and relocate, plus the cost of transporting that personal property for an initial 100 miles in connection with the relocation. The tenant may also receive the reasonable cost of repairing the personal property damaged by reason of the removal and relocation. Issues may still arise under the definition as to whether an item is a fixture rather than personal property and, therefore, the extent to which the insured may be entitled to recovery for removing, transporting, and relocating the item. The concept of what constitutes "appreciable damage to themselves or to the land" may be critical in making that determination.

A final definition that is crucial to understanding the new leasehold endorsement is that of "tenant leasehold improvements," which are defined as those improvements, including landscaping, required or permitted to be built on the land by the lease that have been built at the insured’s expense or in which the insured has an interest greater than the right to possession during the lease term. As will be discussed below, this definition ties into the most important change in the leasehold coverage and the remedies to which the insured may be entitled. Generally, however, if the tenant has paid for the leasehold improvement or is otherwise the owner of it, the leasehold endorsement should provide coverage.

Amounts Covered

The most important change in the leasehold coverage relates to the remedies provided and, in particular, the method of compensating the insured for the loss of its tenant leasehold improvements. Paragraph 3 of the leasehold endorsement reads as follows:

If, in computing loss or damage, it becomes necessary to value the estate or interests of the insureds as the result of a covered matter that results in an Eviction, then that value shall consist of the value for the Remaining Lease Term of the Leasehold Estate and any Tenant Leasehold Improvements existing on the date of the Eviction. The insured claimant shall have the right to have the Leasehold Estate and Tenant Leasehold Improvements valued either as a whole or separately. In either event, this determination of value shall take into account rent no longer required to be paid for the Remaining Lease Term.

The insured’s remedies under this provision include two components. First, the insured is entitled to collect the value for the remaining lease term of the leasehold estate. This element of recovery is the same as provided under the 1975 leasehold policy. The second component, however, which includes the value of any tenant leasehold improvements existing on the date of eviction, is new and significantly broadens the insured’s coverage.

Examining these two items in the context of the office lease example described above shows the enhanced value of the new leasehold endorsement. For example, if an insured has spent $2 million in constructing tenant leasehold improvements, the amount of insurance that the insured should purchase as well as the insured’s potential recovery are much easier to determine than previously. If the insured purchases $2 million of insurance and eviction occurs on the date of completion of the tenant leasehold improvements, the insured should be entitled to a $2 million recovery. On the other hand, if the eviction occurs five years into the lease term, the insurer would need to value both the tenant leasehold improvements as well as the remaining lease term.

Difficulties may arise in the valuation process. For example, the endorsement does not provide a method for valuing tenant leasehold improvements. Although drafters of the leasehold endorsement discussed whether the insurer should value those leasehold improvements based on a useful life/straight line depreciation method, on a replacement cost basis, or on a more subjective appraisal technique, the endorsement ultimately left that issue open. Issues may, therefore, arise in the future as to the proper valuation method. In addition to recovery for the value of the tenant leasehold improvements, the insured is also entitled to the value of the leasehold estate. If, for example, after five years, the lease’s rent is below market, the tenant should be entitled to recover the value of the leasehold estate for the remaining lease term. This means that the insured may recover the benefit of the below-market lease, the value of the tenant leasehold improvements, and the incidental expenses described below, but in no event may the recovery exceed the amount of the insurance. Under the new endorsement, if values for both a leasehold estate and tenant leasehold improvements exist at the time of eviction, the insured has the right to have them valued either as a whole or separately.

Incidental Items

One of the other elements of damages that the insured may recover is incidental damages that the insured may incur.

• First, the insured can recover the reasonable cost of relocating any personal property that the insured has the right to remove and relocate, together with the cost of transporting that personal property for the initial 100 miles and the reasonable cost of repairing the personal property. As noted above, the insurer and insured will have to agree on what constitutes personal property for purposes of the definition.

• Second, the insured is entitled to recover the rent or damages for use and occupancy of the land before the eviction that the insured is obligated to pay to any person having paramount title to that of the named lessor in the lease. For example, when the title policy showed an incorrect landlord and the tenant had been paying rent to that landlord, if subsequently it is determined that the tenant should have been paying rent to a different party, then the leasehold endorsement covers the additional amount owed.

• Third, the insured is entitled to recover the amount of rent that, by the terms of the lease, it is obligated to pay to the landlord after eviction for that portion of the premises from which the insured has been evicted. Although it is difficult to conceive of many situations in which an insured might be obligated to continue to pay rent after eviction, the insured would nevertheless be entitled to recover such amounts if it could prove them. For example, if the leasehold title coverage included a zoning endorsement and the tenant was not permitted to use the premi-ses for the insured use, the tenant could be required to continue to pay rent to the landlord but not be able to continue to use the premises for the intended use. Coverage should apply in that situation.

• Fourth, the insured is covered for the fair market value of any lease or sublease that the insured has in place at the time of eviction. For example, if the insured has subleased the premises and is now evicted, the insured may recover the benefit of the value of that sublease. In addition, the insured can also collect amounts it is obligated to pay to lessees or sublessees for the termination of those leases or subleases as a result of the eviction of the insured.

• Finally, the insured is entitled to its reasonable costs in securing a replacement leasehold equivalent to the leasehold estate. These costs should include items such as brokerage commissions, travel expenses, costs to obtain land-use, zoning, building and occupancy permits, architectural and engineering fees, attorney fees, and other consultant fees incurred in finding replacement property and negotiating a new lease.

Miscellaneous Items

Two miscellaneous items should also be noted.

• First, to the extent that tenant leasehold improvements are not substantially completed at the time of eviction, the insured is entitled to the actual cost it has incurred, less the salvage value, for those tenant improvements. Those costs specifically include those incurred to obtain land-use, zoning, building and occupancy permits, architectural and engineering fees, construction management fees, costs of environmental testing and reviews, landscaping costs and fees, and costs and interest on loans for the acquisition and construction.

• Second, as to the leasehold estate, the owner’s leasehold endorsement specifically excludes Subsection (b) of Section 7 of the "Conditions and Stipulations" of the owner’s title insurance policy. Based on this exclusion, the insured need not worry about the coinsurance requirements in determining recovery amounts for the leasehold estate. The deletion of this provision makes sense, because, based on the method of valuation, it would be very difficult to apply the coinsurance provisions in the leasehold situation.

Conclusion

The new leasehold endorsement provides a valuable tool for tenants and lenders in appropriate situations. In those cases in which a tenant is spending a significant amount in tenant leasehold improvements, the tenant should consider obtaining title insurance coverage much the same as the coverage it would obtain if it were actually acquiring the fee simple title to real estate. Similarly, in those situations in which a lender is lending on such improvements, it should insist on the same coverage as it would typically require in other real estate loan situations.

Although the revised leasehold endorsement makes it much easier to determine the appropriate amount of coverage and to determine the remedies to which the insured might be entitled in cases of failure of title, difficult valuation and interpretation issues may still arise. For example, determining the value of tenant leasehold improvements five years into a ten-year lease term may pre-sent significant challenges. Similarly, difficulties may arise in valuing leases and determining whether they are, in fact, below market. Notwith-standing these difficulties, the new leasehold coverage still offers valuable protection.

Finally, in connection with leasehold coverage, the insured or its counsel must continue to focus on the same issues as would be involved in obtaining a fee simple title insurance policy. For example, all of the exceptions to coverage must be examined to determine how they will affect the tenant’s proposed use. In the absence of subordination, prior liens may, depending on the law in the jurisdiction, prevail over the tenant’s interest and will not be insured without the title company’s being satisfied with an appropriate subordination agreement. Covenants and restrictions listed in the exceptions should also be reviewed to determine how they might affect the tenant’s proposed use. Appropriate endorsements for the tenant’s coverage should be negotiated in the same manner as they would be in a fee simple ownership situation.

Although the leasehold endorsement still presents some interesting valuation challenges, ALTA should be commended for its efforts at promulgating new title insurance coverage, which will help tenants in the real estate industry ensure that their interests are protected.

 

Harvey L. Temkin is a partner with Reinhart Boerner & Van Beuren, SC, in Madison, Wisconsin. This article is based on a similar article published in 19 Acrel News No. 4, Dec. 2001. Reprinted with the permission of the American College of Real Estate Lawyers.