Calculating the Leasehold Interest Exposure

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by Christopher J. Boggs, CPCU, ARM, ALCM

Two values must be developed before the insurable amount of leasehold interest coverage can be calculated: gross leasehold interest (GLI) and monthly leasehold interest (MLI). The example presented in the prior post is used as a reference throughout this post.

Gross Leasehold Interest (GLI)
Gross Leasehold Interest (GLI) is the monthly difference between the market rental value of the property and the actual rent paid by the tenant. GLI is the basis for the insured “tenants’ lease interest” (TLI) coverage. In the previous example, the monthly GLI was $8,333.

Due to fluctuations in market values over time, the GLI will require periodic recalculation. For example, when coverage is first written there may be a $3 per square foot difference between market value and the amount actually paid. Two years into the lease, the commercial real estate market may have boomed resulting in a $5 per square foot difference between the lease payments and the market value. The reverse is also true.

Some lease agreements can become favorable over time; just because the lease payments were at market value originally does not mean they have kept up with the market. Commercial real estate in a given area may have boomed resulting in a sharp increase in market value the current lease agreement does not reflect. Annual monitoring of market pricing may reveal a new exposure not previously present.

Calculating the GLI is rather simple; the difficulty arises in determining the subject premises’ “market rental value.” Market rental value can sometimes be garnered from a tenant who is well aware of their favorable lease and knows the premises’ true rental value; but more likely the necessary information is found in local property rental value reports published by area commercial realtors. Large commercial real estate brokerage firms often publish rental reports listing average per square foot costs based on the occupancy type (office, industrial, manufacturing, retail, etc.) and the location. Regardless the source, this information will necessitate research and what better way for an agent to set himself apart from the crowd.

Monthly Leasehold Interest (MLI)
Monthly leasehold interest (MLI) values apply to the three remaining leasehold interest coverage exposures: 1) bonus payments; 2) improvements and betterments; and 3) prepaid rents. Developing MLI is simpler than calculating gross leasehold interest (GLI) as the only three pieces of information required are: a) the amount of the subject expenditure; b) when the expenditure was made; and c) how many months were left in the lease when the expenditure was made. The formula used to calculate the MLI based on this information is:

  • Original Cost / Number of Months Left in the Lease at time of expenditure = MLI.

Assume, for example, the tenant paid the property owner a $100,000 bonus payment to obtain a favorable 36 month lease at $10 per square foot rather than the market rental value of $15 per square foot. All the information is there to calculate the MLI for the bonus payment. Since the expenditure was made at the beginning of the lease, the bonus payment MLI is $2,777.78 ($100,000/36 months).

The same three pieces of data and calculation methods are used to develop the MLI for the two remaning expenditure classifications listed above. However, since the expenditures likely occur at different times during the lease period, the total costs cannot be added together. The amount of time remaining for the tenant to enjoy the use interest of the investments differs based on when the expenditure is made within the lease period thus each MLI must be calculated separately. Essentially there are three MLI’s.

Staying with the example tenant above; one year into the lease the tenant makes $200,000 in structural modifications to the building to fit its operational needs. Since these are real property changes, the tenant has only a use interest in the property since they cannot remove them. The tenant’s improvements and betterments MLI is $8,333.33 ($200,000/24 months). Remember, improvements and betterments coverage in the leasehold interest form only applies if there is no other property coverage available.

How Gross Leasehold Interest (GLI) and Monthly Leasehold Interest (MLI) Apply

Neither the gross leasehold interest (GLI) nor the monthly leasehold interest (MLI) is used as the coverage amount. Both must first be converted to their individual “net” amounts to arrive at the actual amount of insurable limits – the Net Leasehold Interest (NLI).

Developing the Amount of Coverage Purchased

“Net leasehold interest” (NLI) is the amount of coverage actually purchased. Two definition of “net leasehold interest” are used in the leasehold interest coverage form depending on the exposure being considered. The “Tenants’ lease interest” definition of NLI applies the time value of money to the gross leasehold interest (GLI) to develop its insurable limits. The three remaining exposures base the definition of NLI on the monthly leasehold interest (MLI) and the amount of time left in the lease when the policy is written. Both calculations are explained below.

Net Leasehold Interest (NLI) and Tenants’ Lease Interest (TLI)
Tenants’ lease interest (TLI) is the primary leasehold interest exposure. The loss of a favorable lease, as previously demonstrated, can increase the insured’s operational expenses long after the actual damage is repaired.

TLI’s “net leasehold interest” calculation is based loosely on the time value of money, applying a hybrid present value of a dollar calculation. The two beginning factors in NLI’s calculation are the previously-calculated “gross leasehold interest” (GLI) and the number of months left in the subject lease at the inception date of the policy (it is important to remember that the calculation begins with the policy’s inception date).

Unfortunately, the next step in calculating the TLI is essentially a guess. In this third step, the insured estimates the expected return on investement that would be had if, rather than paying rent, the lease payments were invested.

Insurance Services Office (ISO) offers 11 “present value” factor forms ranging from a 5 percent to a 15 percent rate of return. Once the insured estimates the expected return on investment, the calculation can resume.

Again, using the example presented earlier:

  • The developed GLI is: $8,333
  • The number of months left in the lease at policy inception is: 30
  • The chosen interest rate (rate of return): 5%

Considering the above information and applying the the 30-month factor found in the “Leasehold Interest Factors for 5%” (CP 60 05), the TLI is $234,867.30 ($8,333 x 28.1852). Without the application of the time value of money, the insured value would be $249,990. Essentially, the reduction in limit relates to the time value of money (the insured has not yet suffered the expense) combined with the method for calculating loss payments (detailed in the next post).

At renewal, the insured’s TLI must be recalculated. Only 18 months remain in the lease when the policy is renewed; thus the new TLI net leasehold interest is $144,342.60 ($8,333 x 17.3218).

Two questions arise from the above example. What if the lease renews in the middle of the policy period? And, is there any option to use a lower percentage and interpolate the factors? The current economy may not allow any small company to make 5 percent on their money.

If the lease renews midterm, the coverage must be rewritten midterm to account for the new terms and conditions contained in the lease, the likely altered gross leasehold interest (GLI) and the new lease period. Second, the rating and calculation rules, according to ISO, do not contemplate percentages different (higher or lower) than those provided by the 11 filed endorsements.

As stated earlier, these factors are hybrid simple-interest present value calculations. The reason the term “hybrid” is applied is based on how the factors appear to be developed. Since the calculations are based on monthly rather than annual periods, the interest rate is divided by 12, making them a monthly interest rate; however, the developed monthly interest rate does not match the amount a simple interest, present value calculation produces over several months.

Net Leasehold Interest (NLI) and Monthly Leasehold Interest (MLI)
Monthly leasehold interest (MLI) applies to bonus payments, tenant’s improvements and betterments and prepaid rent. Calculating the MLI for each of these three expenditures was detailed in an earlier section.

Once each of the three MLI’s are individually calculated, they are added together to generate the TOTAL monthly leasehold interest (TMLI). To develop the value of the second definition of net leasehold interest (NLI), the TMLI is multiplied by the number of months left in the lease at the inception date of the policy.

Referring once again to the previously presented sample tenant, and rounding to the nearest dollar, their total MLI is $11,111 calculated as follows:

  • Bonus Payment MLI: $2,777.78
  • Tenant’s I&B: $8,333.33
  • Prepaid Rent: $0

With 18 months remaining in the lease at the inception date of the policy, the MLI net leasehold interest is $199,998.

Combining the two definitions of net leasehold interest, the total amount of coverage this insured should purchase when there are 18 months remaining in the lease is $344,340.60 ($144,342.60 + $199,998). This is definitely an exposure worth insuring.

Following

Calculating loss payments and how vacancy is handled is the focus on the next post. These are the two most important remaining policy provisions of the Leasehold Interest Coverage Form.


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