Say a tenant has invested $20,000 in improvements at the beginning of a five-year lease. Thus, the tenant has bought the use of the improvements for five years. A fire destroys the improvement after one year and the tenant loses four years of use of the improvement. If the improvements are not repaired or replaced, this last valuation provision applies. The insured tenant will recover an amount reflecting the loss of use of the improvement for four years, or $16,000 ($20,000 original cost less $4,000, the latter representing the one year of use of the improvements).
Another, more involved example follows:
Five-year lease: 1/1/11 to 12/31/15
Installation of improvement at original cost of $50,000: 2/1/11
Date of loss: 2/12/12
Valuation (For illustration purposes, leap years are not considered.)
Number of days from loss date of 2/12/12 to lease expiration of 12/31/15 = 1,418 days.
$50,000 multiplied by 1,418 days = $70,900,000.
Number of days from installation of improvement, 2/1/11, to lease expiration of 12/31/15 = 1,794.
$70,900,000 divided by 1,794 days = $39,521.
Here the insurance is paying for the unused portion of the improvements. In this case, the tenant had slightly more than a year’s use of the improvements, that is, from the installation date of 2/1/11 to the loss date of 2/12/12.
Occasionally, a question arises concerning lease renewal options. If the lease includes a renewal option, the renewal option period is included in the loss settlement calculation.
For example, assume a tenant has a one-year lease on the building that expires on December 31. The lease includes a one-year renewal option. On August 5, the tenant alters the space by installing a partition to separate rooms at a cost of $2,000. On November 2, a fire causes extensive damage and the insured permanently closes the business. Had the loss not occurred, the insured would have stayed in business and exercised the renewal option.
In the absence of the renewal option, the tenant would recover $805 for the improvement: $2,000 X 60 days (loss of Nov. 2 to lease expiration of Dec. 31) = $120,000 divided by 149 days (date improvement installed of Aug. 5 to Dec. 31) = $805. If the renewal option period of 365 days were exercised, the settlement would be $1,654: $2,000 X 425 (60 + 365) = $850,000 divided by 514 (149 + 365) = $1,654. With the renewal option, there is a sizeable increase in the loss settlement.
Disputes exist with coverage for improvements and betterments as they do with many insurance provisions. Although it is advisable and beneficial to make lease provisions as precise as possible to reflect the intent of the parties, it is difficult, if not impossible, to draft leases that can be so comprehensive as to completely eliminate all possible disputes. It is nevertheless essential that all involved in placing coverage or adjusting losses review the lease provisions as carefully as they review the insurance coverage itself.