Plug Five Loopholes in Damage and Destruction Clause

Unfortunately, fires, floods, and other casualties can happen at the shopping center or office building you own. If you’ve signed typical leases with your tenants, they probably place some limits on your restoration obligations. But after a casualty, it may not be cost effective or practical for you to restore the tenant’s space or your building or center. However, if your lease’s damage and destruction clause isn’t very specific about your rights and obligations in this situation, it might not be enough to allow you freedom and flexibility when it comes to decisions about fixing damage.

For example, a typical lease gives the owner the right to terminate the lease instead of restoring the space if more than a certain percentage—say, 30 percent—of the space or building is damaged. But there are other circumstances when restoring the space or building may not be cost effective or practical for you. Ask your attorney about adapting our Model Lease Clause: Protect Interests After Casualty at Center, Building to plug the loopholes in your lease that would otherwise leave you on the hook for restoring space that you can’t or don’t want to.

Avoid Costly, Impractical Restoration

It’s essential to say in the lease that you’re not obligated to repair, reconstruct, or restore the space or building—and that you may terminate the lease—if a certain percentage of the space or building is unusable [Clause, pars. a and b]. But don’t stop there. Make sure that the lease also lets you escape any restoration obligations in five scenarios:

Scenario #1: Lender keeps insurance proceeds to pay off mortgage. Most mortgages allow the lender to keep the insurance proceeds after a casualty instead of applying them to the cost of rebuilding. Although a lender typically won’t keep this money, it may decide to do so if, for some reason, it wants to terminate its relationship with you and use the money to pay off the mortgage balance. This could happen if the mortgage is near maturity, if the value of the property as collateral has declined, or if you’ve been in default (e.g., making late payments or violating other loan terms).

If the lender keeps the insurance proceeds, you’ll have to use your own money to restore the space or building. That’s why it’s crucial to say in the lease that you don’t have to rebuild if the lender elects not to release the insurance proceeds to you [Clause, par. c].

Scenario #2: Insurance doesn’t cover restoration. For many reasons, insurance may not cover the cost of the restoration. The insurance proceeds may not be big enough to cover the restoration cost. Or the damage may not be covered at all because it falls under an exclusion in the insurance policy, such as a pollution exclusion. Or the lease may not require you or the tenant to have the type of insurance that would’ve covered the incident. For example, suppose an earthquake strikes your city and destroys your building. But if the risk of an earthquake is extremely low in that area, the lease might not have required either you or the tenant to buy earthquake insurance.

For whatever reason, if the insurance proceeds don’t cover the restoration costs, you’ll be the one to pay. So say in the lease that you can terminate the lease instead of restoring the space or building if the insurance doesn’t fully cover the damage from the casualty [Clause, par. d].

Practical Pointer: Expect the tenant to demand that you remain obligated to restore the space or building if the insurance shortfall is your fault—for example, if you let your insurance lapse of didn’t get enough coverage. Also, the tenant may want you to agree to restore the space or building, regardless of the amount of insurance proceeds, as long as the restoration cost is less than a set dollar amount. Or the tenant may want the space restored as long as it agrees to fund any insurance shortfall.

Scenario #3: Fire or casualty occurs at end of lease. If the casualty damages or destroys the space or building toward the end of the lease, it may not be economical for you to restore the damaged area. So give yourself the right to terminate the lease if the casualty occurs within, say, the last 24 months of the lease term (or any renewal or extension) [Clause, par. e].

Practical Pointer: Expect the tenant to try to limit your right to terminate by shortening your window of opportunity to the last six or 12 months of the lease. The tenant may also demand that you must still restore the space or building if the casualty occurs during the last six or 12 months and the tenant has exercised a renewal or extension option.

Scenario #4: Tenant is in default. Say in the lease that you don’t have to restore the space or building if the tenant is in default at the time of the casualty [Clause, par. f]. You shouldn’t have to spend money to rebuild when the tenant isn’t living up to its lease obligations.

Practical Pointer: The tenant will try to restrict your right not to restore the space or building to “material”—that is, major—defaults or monetary defaults, such as failing to pay rent. In other words, if the tenant is in default because of some minor violation, such as failing to dispose of its garbage according to building rules, it won’t lose its lease. This is fair.

Scenario #5: Space is vacant. Make sure you don’t have to restore the space or building if the tenant had vacated the space before the casualty [Clause, par. g]. You shouldn’t have to pay to rebuild space that a tenant isn’t using—even if the lease doesn’t require continuous operation by the tenant. In this situation, the tenant shouldn’t care if the damage is repaired anyway.

The tenant may argue that this hurts its ability to sublet or assign. It may also insist that you must restore the space or building if it has vacated the space only temporarily or as allowed by the lease (say it had a co-tenancy right to go dark during any period that the anchor tenant was closed).

Be Prepared for Tenant Negotiations

Generally, most tenants will accept these additional limits—with some of the variations we’ve discussed. But a savvy tenant might be concerned that you’ll use the limits to “cherry pick” leases. That is, even though circumstances are the same for two spaces, you’ll terminate one lease and not the other because you can get a higher rent for the space whose lease you’re terminating. To prevent this, the tenant may ask you to agree to be “reasonable” when deciding to terminate. Try not to give in to this request. If you do, you could end up in court battling over whether you were reasonable. As a compromise, you can agree that you’ll treat all “similarly situated” tenants in the same way. The definition of “similarly situated” will depend on the configuration of the building or center.