While much has been written about title insurance coverage, one subject that has been virtually ignored in the literature is that of leasehold title insurance. Little has been written on the subject because demand for leasehold policies has not been high. Two reasons account for this lack of demand: 1) a small number of leasehold mortgages; and 2) a general misunderstanding of the value of leasehold insurance.
Some property owners would not purchase an owner’s policy themselves if it were not purchased for them by the seller in furtherance of the seller’s title warranty obligations. In non-"seller-pay" jurisdictions, owner’s coverage wouldn’t be purchased by a property owner if a loan policy wasn’t first required by the lender; in these markets, the realtively modest additional premium for the owner’s coverage makes the decision a "no-brainer." Because there are relatively few leasehold mortgages, there are few leasehold mortgage lenders requiring title insurance as a condition of making a mortgage loan. Thus, few leasehold policies are purchased.
This, however, does not completely explain the lack of demand. Even when a mortgage lender is not in the picture, purchasers of fee interests are more likely to purchase title insurance than are purchasers of leasehold interests. This is in part attributable to a lack of understanding regarding the coverage afforded by a leasehold policy. For example, many people believe that a leasehold policy has no value if the policyholder has a market value lease.
Tenants will often sign a lease of significant duration and make expensive leasehold improvements without purchasing title insurance or even examining title to the premises. Most would not think of making such an investment in a fee interest without the purchase of a title insurance policy.
A title search, and the subsequent issuance of a policy, offers answers to as well as insurance against questions that are important to someone contemplating a lease of real property:
1) Is the landlord named in the lease the true owner of the premises?
2) Is the consent of a mortgagee needed to lease the premises?
3) Are there any covenants or restrictions of record that prohibit or limit the tenant’s intended use, such as might be found in prior leases?
4) Will the tenant’s possession of the premises be at risk due to foreclosure of a mortgage?
5) Who are necessary parties to nondisturbance agreements?
6) Are the leased premises subject to any easements or restrictions that may limit development or use of the leased premises?
The Policy Language
The only difference between a leasehold policy and an owner’s or loan policy is the definition of "loss or damage." A leasehold policy defines the value of a leasehold estate and adds certain items of loss not found in an owner’s or loan policy. Other than that, a leasehold policy contains all the protections, exclusions from coverage, and conditions and stipulations found in an owners or loan policy. The additional items contained in a leasehold policy are as follows (the leasehold policies discussed here are the 1992 American Land Title Association® Leasehold Owner’s and Leasehold Loan Policies:)
1. Valuation of Insured Estate. The value of a leasehold estate is defined as the difference between the fair market rental value (undiminished by claimed title defects)and the rent reserved in the lease, all brought to present value.
2. Miscellaneous Items of Loss. In addition to the lost value of the leasehold estate, the following items are included as part of "loss or damage:"
a. The cost of removing, relocating, and repairing the insured’s personal property within a 25-mile radius.
b. Rent or use-and-occupancy payments the insured may be obligated to pay a party having paramount title to that of the landlord.
c. Post-eviction rent that the insured is obligated to continue topaythe landlord for the land from which the insured has been evicted.d. The fair market value of the insured’s interest in any subleases.
e. Any damages that the insured is obligated to pay a sublessee on account of a corresponding breach of a sublease.
A sample endorsement that converts an owner’s policy into a leasehold owner’s policy is set forth on page nine. A similar endorsement converts a loan policy into a leasehold loan policy. Note that the additional coverage is not included in a policy unless this endorsement or a leasehold policy jacket is used.
A Hypothetical Claim
The value of a leasehold title insurance policy, and some of its shortcomings, can be seen through the following hypothetical example. A telecommunications company leases a parcel of land to build a communications tower and purchases a leasehold policy. A residential area borders the property. The lease term is five years with three five-year options. The lease requires removal of the improvements following the lease term. The company obtains a special permit for the use. The company paves an access drive to the tower site, brings in utilities, constructs the tower, installs its antennas and a modular equipment building, and makes landscaping improvements required as a condition of the permit. The company subleases tower space to two rival carriers and a paging company.
A week after the site is operational, the telecommunications company is sued by neighboring property owners, who rightfully claim that the property is subject to a restrictive covenant prohibiting commercial use of the property. The company is also sued by two of its sublessees for breach of lease. The company makes a claim on its title insurance policy and tenders defense of the suits to the title insurance company. The telecommunications company loses on all fronts and is forced to cease its operations and dismantle the tower. What is it entitled to recover under its policy?
As noted above, many people believe that a title insurance policy offers no value when a tenant has a market-value lease. Indeed, the value of a leasehold estate can be equal to zero if the fair market rental value at the time of the loss is equal to or less than the rent reserved in the lease. That is because, unlike the purchase of a fee, a lessee’s right of possession is usually not paid for up front. Rather, it is purchased in a series of installments of rent, and payment of rent will usually terminate upon dispossession.
This summary dismissal of leasehold coverage ignores three important issues. First, often the most important feature of a title insurance policy is the duty to defend. Title insurance companies spend approximately the same amount of money on defense costs as they do on the payment of claims. Second, the items listed above under "Miscellaneous Items of Loss" can often be quite significant. Finally, there is a general misunderstanding of how a leasehold interest would be valued in the context of a title insurance claim.
Costs of Defense
Three different parties have sued our hypothetical policyholder. Significantly, although title insurance policies (including leasehold policies) limit the amount of damages paid to a policyholder according to the amount of insurance purchased, there is no corresponding limit on defense costs. If the telecommunications company had not purchased title insurance, it would have had to shoulder these defense costs on its own.
Miscellaneous Items of Loss
Dispossessed tenants can incur significant expenses in relocating personal property. Also, it is reasonable to conclude that "removing, relocating, and repairing" includes reinstalling personal property. In our example, the leasehold policy compensates the telecommunications company for its expenses in removing the tower (because it is to be removed following the lease term, it is fair to characterize the tower as personal property), its telecommunications equipment and modular building, and reinstalling them in a new lease location.
Also, the policy compensates the telecommunications company for damages it is obligated to pay its sublessees for breach of lease. Note that the leasehold policy does not limit the type of compensable damages: The policyholder is compensated (up to policy limits) for any damages it is obligated to pay its subtenants.
Finally, the company will be compensated for the loss of the benefit of its bargain with its sublessees.
Valuation of the Leasehold Estate
There is no case law valuing leasehold estates under title insurance policies. One can, however, make an analogy to the valuation of leaseholds for purposes of eminent domain. Cases valuing leaseholds in eminent domain proceedings have generally employed the same formula as is found in the ALTA® leasehold policy, namely, the fair market value of the leasehold minus the rent reserved in the lease. (See Nichols on Eminent Domain ?13.05.) The fair market value of the leasehold would likely be the rent the property would bring if placed on the market.
A fundamental mistake many make is to ignore the fact that the leasehold estate is valued at the time of loss, not at the time of entering into the lease. Listed below are a number of factors that could influence the fair market rental value of a leasehold estate and fairly be considered by a court valuing a lease:
a. Changes in Market Rents
Since the value of the leasehold is determined at the time of loss, the leasehold becomes more valuable if market rents have risen in the interim.
b. Leasehold Improvements
Leasehold improvements should be taken into account. Simply put, the rental value of improved property is greater than that of unimproved property. In our example, the policyholder would be compensated for the value that the road, utilities and landscaping contribute to the rental value of the premises. The value of the tower is ignored be-cause it is personal property, and the company has already been compensated for its relocation and reinstallation.
Where a tenant holds title to its lease hold improvements and loses them upon dispossession, the analysis is simpler. Consider, for example,a ground lessee that holds title to a building it has constructed on leased property. In such a case, the title in-surance policy should be written to expressly insure the tenant’s title to the building, and the tenant would be compensated for the value of the building separate from the value of its ground lease.
c. Increased Value Due to Land Use Approvals
The obtaining of land use approvals can substantially increase the value of real property, including leasehold interests. In our example, the securing of a special permit significantly increases the value of the leased property. It not only enables the communications carrier to install and operate the tower and its own equipment, it also allows the company to sublease to three other carriers.
d. Intrinsic Value to Lessee: The Right to Remain in Undisturbed Possession
One commentator has suggested that because leases fall into a class of property not commonly bought and sold, in some circumstances the best and only test of market value is the intrinsic value to the owner. With a market value lease, that is the value of the right to remain in undisturbed possession for the lease term. That value may depend upon the use made and the nature of the insured’s business, but expected profits cannot be considered. (See Nichols at ?12D.04.)
Sometimes a particular site may have unique value to a particular lessee. In appropriate circumstances, this unique value might be taken into account in valuing a leasehold estate. For example, Tavern on the Green is a restaurant located within Central Park in New York City. If it had to move, it would no longer be "on the green." In valuing a leasehold estate, this type of intrinsic value might be considered. In our example, the telecommunications company may get optimum coverage from the top of a certain hill or the roof of a certain building. If it had to replace the site, it is not inconceivable that the company may need to develop two new sites to replicate the coverage provided by the old site.
e. Cost of Development of Replacement Property
Of significant concern to the telecommunications company is the cost of locating and developing a new site for its tower. Some of these costs are clearly covered by a leasehold policy and are discussed above. Others, however, are not necessarily covered. The company needs to locate and lease another site that is technologically compatible with its communications network. The costs of developing the new site include the costs of testing the new site for reception and "fit" into the communications network, negotiating and leasing the site from the new landlord, and securing the necessary land use approvals for operation of the new site. It may also need to construct and operate a temporary communications facility until the new site is operational.
These "soft" costs are likely not covered by an ALTA® Leasehold Policy. That is not, however, the end of the story. An insured wishing to purchase title insurance covering these development costs can do so by negotiating an endorsement to its leasehold policy (such an endorsement may not be available in some states.) Of course, the amount of insurance should be increased to reflect the additional coverage.
f. Consequential Damages - Loss of Revenue
This can be a significant item of damage for a tenant who is dispossessed from its leased property. Loss of business is not, however, covered by title insurance. Title insurers are restricted to a single line of insurance by the laws of most states and cannot insure against lost revenue. Coverage for consequential damages for loss of business revenue is more appropriate to business interruption insurance.
Determining the Amount of Insurance Coverage
Because the damages that may be suffered by an insured are difficult to quantify at the time of issuance of a title insurance policy, it is not surprising that there is no general agreement regarding how to determine the amount of insurance for a leasehold policy. There are, however, some general guidelines and considerations that can be useful in determining the amount of insurance.
One method for figuring the amount of leasehold insurance is to use a rent multiplier, such as five times the yearly rent. Although there is no apparent basis for using any particular multiplier (any of which can fairly be characterized as being plucked out of thin air), the practice has created somewhat of a following in the industry, perhaps because of a lack of competing methodologies. Moreover, some states regulate the amount of insurance that is to be purchased, partially through the use of rent multipliers. In New York, the minimum amount of insurance for a leasehold policy is set forth in the TIRSA (Title Insurance Rate Service Association) Rate Manual, as approved by the New York State Insurance Department, and is determined according to one of the following methods:
A. (1) For lease terms of six years or less, an amount equal to the total aggregate rent payable under the lease; or
(2) For lease terms of more than six years, an amount not less than the first six years of aggregate rent (for percentage leases, estimated rent may be used); or
(3) Not less than the fair market value of the land and improvements at lease commencement; or
(4) Not less than the appraised value of the land and improvements at lease commencement; or
B. If there is proposed construction, the projected cost of improvements may be added to the amount specified in (1) through (4) above;
C. When insuring an assignment of a leasehold estate, the minimum amount of insurance is the greater of the following:
(1) The full consideration for the estate, including all mortgages assumed or taken subject to; or
(2) The value of the leasehold es tate calculated by the method in A(1) or A(2) above.
In addition to the above, the amount of insurance should account for the value of leasehold improvements. Where a tenant is constructing improvements to the leasehold estate or holds title to its leasehold improvements, the leasehold improvements should be insured to their full value (or cost).
Where a tenant negotiates coverage for the estimated cost of developing a new lease location, the amount of insurance should include these estimated development costs. Most sophisticated tenants should be able to provide a fairly accurate estimate of these development costs.
It should be kept in mind that determining the amount of leasehold insurance is anything but an exact science. Moreover, the amount of insurance purchased does not determine the amount of damages that may be payable in the event of a title failure, but rather, merely sets a limit on the amount of recovery.
Tenants are not by nature larger risk takers than are owners of fee interests in real property. Anyone contemplating a lease of real property, particularly long-term leases or where significant leasehold improvements are to be made, should consider the purchase of leasehold title insurance for all the same reasons the owner of a fee would purchase a policy.
Leasehold Conversion Endorsement
This policy is hereby amended as follows:
1. The following sub-paragraph is added to paragraph numbered 1 of the policy’s Conditions and Stipulations:
(h) "leasehold estate:" the right of possession for the term or terms described in Schedule A hereof subject to any provisions contained in the Lease which limit the right of possession.
2. The following numbered paragraphs are added to the Conditions and Stipulations:
18. Valuation of Estate or Interest Insured
If, in computing loss or damage incurred by the insured, it becomes necessary to determine the value of the estate or interest insured by this policy, the value shall consist of the then present worth of the excess, if any, of the fair market rental value of the estate or interest, undiminished by any matters for which claim is made, for that part of the term stated in Schedule A then remaining plus any renewal or extended term for which a valid option to renew or extend is contained in the Lease, over the value of the rent and other consideration required to be paid under the Lease for the same period.
This paragraph applies only to any leasehold estate or interest described in Schedule A.
19. Miscellaneous Items of Loss
In the event the insured is evicted from possession of all or a part of the land by reason of any matters insured against by this policy, the following, if applicable, shall be included in computing loss or damage incurred by the insured, but not to the extent that the same are included in the valuation of the estate or interest insured by this policy.
(a) The reasonable cost of removing and relocating any personal property which the insured has the right to remove and relocate, situated on the land at the time of eviction, the cost of transportation of that personal property for the initial twenty-five miles incurred in connection with the relocation, and the reasonable cost of repairing the personal property damaged by reason of the removal and relocation. The costs referred to above shall not exceed in the aggregate the value of the personal property prior to its removal and relocatio
"Personal property," above referred to, shall mean chattels and property which because of its character and manner of affixation to the land, can be severed therefrom without causing appreciable damage to the property severed or to the land to which the property is affixed.
(b) Rent or damages for use and occupancy of the land prior to the eviction which the insured as owner of the leasehold estate may be obligated to pay to any person having paramount title to that of the lessor in the Lease.
(c) The amount of rent which, by the terms of the Lease, the insured must continue to pay to the lessor after eviction for the land, or part thereof, from which the insured has been evicted.
(d) The fair market-value, at the time of the eviction, of the estate or interest of the insured in any sublease of all or part of the land existing at the date of the eviction.
(e) Damages which the insured may be obligated to pay to any sublessee on account of the breach of any sublease of all or part of the land caused by the eviction.
This paragraph applies only to any leasehold estate or interest described in Schedule A.