How to Calculate the Leasehold Interest Exposure

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by Christopher J. Boggs, CPCU, ARM, ALCM

Two values must be developed before calculating the amount of leasehold interest coverage purchased: gross leasehold interest (GLI) and monthly leasehold interest (MLI).

Gross Leasehold Interest (GLI)

Gross Leasehold Interest (GLI) is the difference between the monthly rental market value of the property and what the tenant is paying each month. Notice that “gross leasehold interest” is calculated on a monthly basis. The monthly GLI is multiplied by an interest rate factor based on the number of months left in the lease to develop the amount of coverage to purchase (detailed in the next section). This is the basis for the insured “tenants’ lease interest” (TLI) coverage. In the previous example, the GLI was $8,333.

The GLI may require recalculation at every renewal, with no more than two years between reviews. The reason: the market value of a property fluctuates over time. 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.

Calculating the GLI is rather simple; the difficulty arises in determining the “market rental value” of the subject premises. Market rental value may be garnered from the tenant who is well aware of their favorable lease and knows the premises’ true rental value; but more likely the information is available from 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) accounts for the three remaining leasehold interest coverage exposures: 1) bonus payments; 2) improvements and betterments; and 3) prepaid rents. Plus, developing MLI is simpler than calculating gross leasehold interest (GLI) as only three pieces of information are required: a) the amount of the 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 the tenant paid the property owner $100,000 as a 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 all three expenditure classifications listed above. However, since the expenditures may occur at different times, the total costs cannot simply be added together as 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. 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 as 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 coverage on this property.

How GLI and MLI Apply

Neither the gross leasehold interest (GLI) amount nor the monthly leasehold interest (MLI) amount is used as the coverage amount when purchasing leasehold interest coverage. Both must be converted to their individual “net” amounts to develop the amount of coverage purchased – the Net Leasehold Interest (NLI).

Developing the Amount of Coverage Purchased – The “Net”

“Net leasehold interest” (NLI) is the amount of coverage actually purchased. The leasehold interest coverage form assigns two definitions to this term depending on the exposure being considered. “Tenants’ lease interest’s” definition of NLI applies the time value of money to the gross leasehold interest (GLI) to develop the final coverage amount. 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’ least interest (TLI) is the primary leasehold interest exposure. The loss of a favorable lease, as previously demonstrated in the last post, can increase the insured’s operational expenses long after the actual loss and return to operation.

TLI’s “net leasehold interest” calculation is based loosely on the time value of money, specifically a hybrid present value of a dollar calculation. The two beginning factors in NLI’s calculation are the previously-calculated “gross leasehold interest” (GLI) (the monthly difference between market value and the actual lease payment) and the number of months left in the subject lease at the inception date of the policy (if the agent is working many days in advance, it is important to remember the calculation begins with the policy’s inception date).

Unfortunately, that is the only easy part of the NLI calculation. The next choice made is the expected rate of return the insured would earn if, rather than paying rent, they invested the money. Insurance Services Office (ISO) has filed 11 “present value” factor forms ranging from a 5 percent to a 15 percent rate of return. Once the insured estimates the amount of interest that could be earned investing rather than paying rent, 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%

Appling the above information and using 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 hybrid present value calculation, the insured value would be $249,990. But because the insured has yet to suffer the lease expense, the total difference in TLI is not used in the limit’s calculation.

At renewal, the insured TLI value must be recalculated. Twelve months has passed, so the tenant has only 18 months remaining in the lease at policy inception. The new TLI net leasehold interest is $144,342.60 ($8,333 x 17.3218).

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

If the lease renews midterm, the coverage will have to be rewritten midterm to account for the lease’s new terms and conditions, the likely altered gross leasehold interest and the new lease period. Second, the rules, according to ISO, do not contemplate percentages different than those provided by the 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 they appear to be developed. Since these factors are monthly rather than annual periods, the interest rate is divided by 12 and thus becomes 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 ($11,111 x 18 months).

Combining the two definitions of net leasehold interest, the total amount of coverage this insured should purchase with 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 of the next post. These are the two most important remaining policy provisions of the Leasehold Interest Coverage Form.


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Comments

  • April 20, 2012 at 12:43 pm
    kwabena says:

    i wanted to know the total profit a leaseholder has in property

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