Tenants' Improvements and Betterments—Important Considerations

Not Everything the Tenant Adds to the Rented Space Is TIB

TIB are added to the real property and become the property of the building owner. The tenant cannot legally remove them when the lease ends or the space is vacated. Trade fixtures, on the other hand, are fixtures installed by the tenant that can be legally removed by the tenant, and these are not the property of the building owner.

While trade fixtures are also covered as BPP on the tenant's policy, it is important to understand which category property falls into. As described above, TIB losses are valued differently than losses to other types of BPP. If the tenant does not repair a trade fixture, the valuation is actual cash value (ACV). If TIB are not repaired, only a proportion of the original cost is paid.

The following are examples.

• The tenant installs $500,000 trade fixtures at the beginning of a 10-year lease. Exactly 5 years into the lease, the trade fixtures are damaged in a covered loss, and the trade fixtures are not repaired because the tenant closes the business. At the time of the loss, the ACV of the trade fixtures is $400,000, and the tenant is paid $400,000 less the deductible.

• Tenant installs $500,000 TIB at the beginning of a 10-year lease. Exactly 5 years into the lease, the TIB are damaged in a covered loss. TIB are not repaired because the tenant closes the business. At the time of the loss, the ACV of the TIB is $400,000. Tenant is paid only $250,000, though, the portion of the original cost the tenant has not realized the value of. This is often referred to as the unamortized value of the TIB.

  The policy describes the valuation method in the following way.

  • (a) Multiply the original cost by the number of days from the loss or damage to the expiration of the lease ($500,000 x 1,825 days = $912,500,000).

    (b) Divide the amount determined in (a) above by the number of days from the installation of improvements to the expiration of the lease ($912,500,000/3,650 days = $250,000).

  Had the lease included a 10-year renewal option, the lease period is considered to be 20 years for purposes of this calculation. The tenant has the use of the TIB for up to 20 years.

  • (a) Multiply the original cost by the number of days from the loss or damage to the expiration of the lease ($500,000 x 5,475 days = $2,737,500,000).

    (b) Divide the amount determined in (a) above by the number of days from the installation of improvements to the expiration of the lease ($2,737,500,000/7,300 = $375,000).

This type of valuation is unique to TIB. Typically, property policies use the value of the property on the date of loss to determine the amount paid. Original cost is not part of the equation.

What Does the Lease Require?

Does the lease require that the tenant insure the TIB? Many do, and, at first glance, it may seem as though including the value of the TIB in the BPP limit should be sufficient. If the tenant is required to insure TIB for the benefit of both the tenant and the building owner, though, this may not be enough. BPP includes the tenant's "use interest" in the TIB.

As seen in the valuation example above, if the TIB are damaged and not repaired, an amount less than ACV could be paid, depending on when in the lease period the damage occurs. If the intent of the lease is that ACV be paid even if the damaged TIB are not repaired, building coverage for the TIB is needed.

If the lease makes the building owner responsible for insuring the TIB and the tenant does not wish to cover its own exposure, then coverage for TIB should be removed from the tenant's policy. The Additional Property Not Covered (CP 14 20 11 91) endorsement can be used to remove TIB from the description of covered property. Failure to take this step could result in a coinsurance penalty at the time of loss.

Ordinance or Law Coverage

It is common practice to include ordinance or law coverage in policies that cover a building. Endorsements can be added, and some insurer enhancement endorsements automatically provide some level of coverage. The tenant who has made improvements and betterments to its rented space, though, also has an ordinance or law exposure.

The following is an example.

• The tenant, prior to moving into its rented space, added $500,000 in TIB including new flooring, new interior walls, electrical wiring, plumbing, a restroom, and lighting fixtures. Unfortunately, a fire occurred. Even though there was only $100,000 damage to the TIB, there was significant damage to the rest of the building. The town orders demolition of the entire structure, which includes undamaged TIB. Further, building codes have changed since the TIB were initially made, and complying with the current codes will cost an additional $50,000.

Prior to 2017, it was difficult to cover this exposure using only ISO forms and endorsements. The Ordinance or Law Coverage for Tenant's Interest in Improvements and Betterments (Tenant's Policy) (CP 04 26 09 17) endorsement makes it easy to provide this much needed coverage. The following coverages can be included.

• Coverage A—Coverage for Loss to the Undamaged Portion of Tenant's Improvements and Betterments
• Coverage B—Demolition Cost Coverage
• Coverage C—Increased Cost of Construction Coverage
• There is even a Post-Loss Ordinance or Law Option that will pay to bring the insured into compliance with ordinances or laws that change after the date of loss.

The tenant will also have a longer suspension of operations due to the enforcement of the ordinances or laws. As such, the tenant needs a modification of the business income coverage as well. The Ordinance or Law—Increased Period of Restoration (CP 15 31 09 17) endorsement is the tool commonly used to address this exposure. It includes in the period of restoration the additional time required to comply with ordinances or laws.

Not All Building Items the Tenant Is Responsible for Are TIB

It is common for a commercial lease to make the tenant responsible for insuring or paying for damage to certain components of the building. A few examples follow.

• Building glass
• HVAC equipment
• Improvements the landlord makes to the space in anticipation of the tenant moving in
• Improvements that were made by a previous tenant and left in the space

Although the tenant may be responsible under the lease for repairing or replacing these items after loss or damage, they are not TIB because the tenant did not acquire or make them at its expense. There are two ISO endorsements that were designed to cover this exposure.

• Scheduled Building Property Tenant's Policy (CP 14 01 09 17)
• Unscheduled Building Property Tenant's Policy (CP 14 02 09 17)

Both endorsements cover property when the tenant is required to insure it or to pay for its loss or damage. The Scheduled Building Property Tenant's Policy endorsement requires that each covered type of property be scheduled with a limit, while the Unscheduled Building Property Tenant's Policy endorsement does not. With this second endorsement, one limit can be added to cover unscheduled building property other than glass. In both endorsements, glass is covered separately from other types of property and has its own limit and deductible.

What If the TIB Are Not Damaged?

The tenant's BPP coverage applies to the TIB when they are damaged by a covered cause of loss. What if they are not damaged?

The following is an example.

• Going back to our earlier example, the tenant installs $500,000 TIB at the beginning of a 10-year lease. Exactly 5 years into the lease, there is significant fire damage to the building, but this time, the TIB are not damaged in the fire. The landlord, exercising its right under the lease, cancels the lease. The tenant is not legally permitted to remove the TIB and has lost the use of the TIB for the remainder of the lease period.

The following is an example of commonly used lease language that could create such a problem.

Notwithstanding anything to the contrary elsewhere in this Lease, Landlord, at its option, may terminate this Lease on thirty (30) days notice to Tenant given within ninety (90) days after the occurrence of any of the following:

• The Premises and/or building in which the Premises are located shall be damaged or destroyed as a result of an occurrence which is not covered by Landlord's insurance; or
• The Premises and/or building in which the Premises are located shall be damaged or destroyed and the cost to repair the same shall amount to more than twenty-five percent (25%) of the cost of replacement thereof.

If the lease does not create this problem for the tenant, then the law might. An example is found in California's civil code: If the building is destroyed, the lease terminates automatically.

California Civil Code

Section 1925. Hiring is a contract by which one gives to another the temporary possession and use of property, other than money, for reward, and the latter agrees to return the same to the former at a future time.

Section 1933.

The hiring of a thing terminates:

1. At the end of the term agreed upon;
2. By the mutual consent of the parties;
3. By the hirer acquiring a title to the thing hired superior to that of the letter; or,
4. By the destruction of the thing hired. [Emphasis added.]

The solution to insuring this exposure is found in ISO's Leasehold Interest Coverage Form (CP 00 60 06 95), and a few insurers have incorporated some coverage into their enhanced property forms. Coverage applies when the lease is canceled because of damage to the premises by a covered cause of loss.

ISO's form can serve multiple purposes, but the focus here is on the TIB.

A. COVERAGE

• We will pay for loss of Covered Leasehold Interest you sustain due to the cancellation of your lease. The cancellation must result from direct physical loss of or damage to property at the premises described in the Declarations caused by or resulting from any Covered Cause of Loss.…

  • c. Improvements and Betterments, meaning the unamortized portion of payments made by you for improvements and betterments. It does not include the value of improvements and betterments recoverable under any other insurance, but only to the extent of such other insurance.

    Improvements and betterments are fixtures, alterations, installations or additions:

    • (1) Made a part of the building or structure you occupy but do not own; and
    • (2) You acquired or made at your expense but cannot legally remove.

With this coverage, the tenant is now paid for the unamortized portion of the original cost of the TIB, and the claim settlement is much like the settlement of a direct damage loss to TIB that are not repaired.

Adding coverage for improvements and betterments to a Leasehold Interest Coverage Form is another way to protect the tenant's investment in the TIB.

Premium

Typically, a building rate is lower than the rate on BPP. If a tenant adds $500,000 TIB to the rented space, then the tenant is paying a BPP rate on that property. The landlord, insuring exactly the same property, is paying a building rate. The solution here is to remove the TIB from the BPP limit and cover it subject to its own limit of insurance, allowing a separate rate to be applied.

ISO has an endorsement used for this purpose: Your Business Personal Property—Separation of Coverage (CP 19 10 06 95). Care should be taken when using this approach, as the TIB are no longer included in the policy's BPP limit and the TIB limit selected must be sufficient. Also, if Ordinance or Law Coverage for Tenant's Interest in Improvements and Betterments (Tenant's Policy) (CP 04 26 09 17) is to be used, one must first break out the TIB from any other limit, which is another good reason to use this endorsement.

The Building Owner's Policy

Although this article is focused on the tenant's coverage needs, let's take a moment to discuss the building owner's policy.

There is a common misunderstanding when a tenant makes improvements and betterments to the rented space and the lease makes the tenant responsible for insuring that property. The misconception is that the landlord does not need to concern itself with the value of the TIB. After all, the tenant is responsible for them.

The problem with this approach is that TIB become part of the building; they fit the description of building on the building owner's policy and are covered property. The description of building in the Building and Personal Property Coverage Form includes completed additions.

The coinsurance condition does not refer to ownership of the property or who is required to insure it under the terms of the lease. The coinsurance condition in the Building and Personal Property Coverage Form simply states:

If a Coinsurance percentage is shown in the Declarations, the following condition applies:

• a. We will not pay the full amount of any loss if the value of Covered Property at the time of loss times the Coinsurance percentage shown for it in the Declarations is greater than the Limit of Insurance for the property. [Emphasis added.]

If the building owner does not include the value of the TIB in its own building limit, there could be a coinsurance penalty at the time of loss.

Perhaps the building owner does not want to cover the TIB; it could be that the lease makes the tenant responsible for insuring them. It could also be the case that the building owner would not want to repair or replace them if they are damaged. In that case, the building owner's policy should be endorsed to reflect this intention. The Additional Property Not Covered (CP 14 20 11 91) is commonly used for this purpose. It removes particular types of property, TIB in this case, from the description of Covered Property.

Conclusion

There are many exposures involving TIB. Understanding what the tenant has done to the rented space, what the lease says, and what insurance tools are available to cover these exposures are good first steps to properly protect the tenant.