Cap, Spread Out Insurance Deductible Pass-Through

Keeping the operating costs that you pass through to tenants low gives your shopping center or office building a competitive edge. So, to keep insurance costs low while making sure that you have adequate coverage, consider a policy with low premiums and a high deductible. But if you pass through a portion or all of those low premiums to tenants, you should negotiate the right to pass through a portion or all of the high deductible as well.

We'll explain how to use your lease's insurance provisions to make the tenant share as much of the costs as it will agree to, which, as usual, will come down to bargaining power. And we'll give you a Model Lease Clause: Make Reasonable Compromise for Insurance Deductible Pass-Through, that you can adapt and use in your leases.

Sharing Deductible Expense

Typically, owners maintain property insurance that covers major casualty events, like a fire or roof collapse. Every policy that's bought for the building is likely to have a deductible. “The issue is whether the owner can pass through to tenants all or a portion of the restoration costs not paid by insurance because of the the deductible,” says Los Angeles attorney and Insider board member Sheldon A. Halpern.

“The tenant will say that the owner should have adequate insurance and look to that insurance if there's an occurrence covered by insurance,” Halpern notes. “But the owner will point out that if it had a zero deductible, its premiums would be higher and the tenant would pay a higher insurance pass-through amount than it would pay if the insurance policy had low premiums and a high deductible,” he points out. Many owners feel that if they're saving tenants money by charging them their share of low insurance premiums, they should at least be able to pass along a portion of the high deductibles to the tenants, he notes.

If there's a casualty triggering coverage under your property insurance policy, you don't want to be left paying the deductible alone. Determine during lease negotiations whether you want to—or can—pass through the cost of your insurance deductibles.

PRACTICAL POINTER: Check any loan documents, REAs, and other documents that may contain insurance requirements, Halpern warns. They may limit the amount of permitted deductibles. In addition, consult with an insurance professional about the types of insurance for which higher deductibles might be appropriate; this article focuses only on property insurance, not liability and other types of insurance.

Prepare for Pushback

Prospective tenants often balk at paying for capital improvements. And this includes paying for deductibles to replace capital improvement items that are covered by insurance.

The tenant's position will be that it shouldn't be responsible for expenditures that relate to the ownership of the building and are not part of typical operating costs. It will argue that it shouldn't be unexpectedly hit with a big expense if a deductible for a big-ticket item, like a new roof, must be met after an insured casualty. (Of course, the tenant will be responsible for only its proportionate share of the deductible, but even its share may be substantial.)

From the tenant's point of view, it's already paying for its share of your insurance policy through operating cost pass-throughs, and it's your responsibility to make sure that the insurance is adequate to cover whatever might happen. But this leaves you in the position of footing the bill for an improvement that, although long-term in nature, still benefits the tenant while it rents from you.

Two-Step Solution

To appease a tenant that's afraid of being unexpectedly hit with a big expense and wants to exclude your insurance deductibles from its operating expense pass-throughs, do two things: (1) agree to limit the amount of the insurance deductible that you can pass through in a year; and (2) insist that the tenant pay the portion of the deductible that exceeds the limit in later years. This way, you're not ultimately responsible for absorbing the excess, and the tenant can pay the excess over time rather than all at once. This compromise is similar to the one that's frequently reached with regard to other capital expenditures.

To achieve this compromise, your insurance clause, like our Model Lease Clause, should first obligate you to maintain all-risk property insurance; boiler and machinery insurance; and, if the owner chooses, earthquake, flood, and terrorism insurance. To give the tenant some assurance that your insurance costs won't be out of the ordinary, provide that your insurance coverage (and perhaps even insurance deductibles) don't differ greatly from the insurance coverage and deductibles of owners of comparable first-class buildings in the area [Clause, par. 1].

You'll also need to provide that the insurance deductibles passed through don't exceed a set dollar amount—or “cap—in any calendar year [Clause, par. 2]. You'll want to negotiate higher caps for earthquake, flood, and/or terrorism insurance, since the deductibles for these types of insurance are likely to be substantially higher. But note that the tenant may try to require you to pick up a more substantial percentage of the deductible for these types of insurance.

You'll have to amortize, over the “useful life” of the improvements that are being repaired or replaced with the insurance proceeds, the portion of the deductible that exceeds the cap [Clause, par. 2]. Note that if the useful life extends beyond the term of the lease, the tenant will probably insist that its payments cease at the expiration of the term.

Finally, the tenant's payments of the amortized cost of the excess portion should include an interest factor—based on a rate similar to those used by owners of comparable first-class buildings in the area, or perhaps based on your actual financing costs [Clause, par. 2].

For example, you buy boiler and machinery insurance with a deductible of $750 for your building. But you and the tenant agree to cap the amount of the deductible that can be passed through in any calendar year at $500. When a fire destroys your building's boiler, you file an insurance claim for a new boiler, a capital improvement. You pay the entire deductible, but you can pass through only a certain percentage of the amount in that year. Determine the useful life of the new boiler and the interest that owners of comparable buildings charge, then amortize the excess over what the tenant is required to pay in that year over the useful life at the comparable percent, so that over the useful life, the tenant will pay a smaller amount per year instead of paying all at once, up front.

Use Clause Uniformly

Tenants with bargaining strength may feel that they should be exempt from insurance deductible or other pass-through costs. But, if feasible, owners should try to insist that since other tenants have agreed to this, they won't make exceptions for one tenant. “Otherwise, it becomes a mess trying to deal with operating cost pass-throughs,” says Halpern. “If an owner is consistent about applying charges, it works in the owner's favor,” he suggests.

“Be upfront and clear from the beginning,” says Halpern. “It behooves an owner to ask for what it needs up front and then work through negotiations with the tenant,” he says. “For example, don't limit insurance pass-throughs to the common areas unless ‘common area’ is defined very broadly to include the building structure,” he adds.

Insider Sources

Sheldon A. Halpern, Esq.: Pircher, Nichols and Meeks, 1925 Century Park East, Ste. 1700, Los Angeles, CA 90067; www.pircher.com.

Aaron M. Potter, Esq.: Pircher, Nichols and Meeks, 900 N. Michigan Ave., Ste. 1050, Chicago, IL 60611; www.pircher.com.