Casualty and Condemnation Insurance
Credit Tenant Transactions
There is a specialty product in commercial real estate lending known as a “Credit Tenant Loan” (CTL). The common characteristics of credit tenant transactions are:
- A mortgage loan is made on a single-tenanted free-standing building.
- The property is leased by a tenant that is investment grade rated.
- The lease is triple-net or bondable, meaning that the tenant is responsible for maintenance, taxes, insurance, etc.
- The owner of the property is a special purpose entity
(SPE) with no other assets except the property.
- Most or all of the rent is assigned by the owner (SPE) and paid directly to the lender in order to amortize the loan on the building.
- Term of the lease is 15-20 years, and the rent is usually a fixed monthly payment for the term.
- Term of the loan is usually concurrent with that of the lease.
To a lender or investor, the cash flow thrown off by the rental payments due under this “credit tenant lease” can be seen as the risk equivalent of the senior unsubordinated debt obligations of the tenant. Since the tenant is investment grade, the loan on the property (which is being amortized by the assignment of the rent payments) is the debt equivalent of the corporate bonds which may be issued by the entity.
Thus, real estate loans made in a credit tenant structure can be pooled and securitized as investment grade debt, providing immense liquidity to this niche of the commercial real estate market.
Need for Insurance
Because the amortization of the loan is largely dependent on the cash flow thrown off by the lease, investors require that any early termination rights (“holes”) in the lease need to be eliminated or insured over. Within a triple-net lease, these holes are referred to as condemnation or casualty clauses. This insurance has come to be called by many names, including casualty/condemnation, special hazard, casualty gap, condemnation gap, lease enhancement, and loss of rents. For purposes of this discussion, we’ll just refer to these as condemnation insurance and casualty insurance.
Within a triple-net lease there will be an explicit or implicit right for the tenant to terminate prior to the end of the initial term due to a partial or total condemnation of the premises as a result of a governmental entity exercising its right of eminent domain. In every case where eminent domain is exercised, the condemning authority must pay fair compensation to the owner of the property to offset the value of the property taken. However, the calculation of this amount is often subject to protracted legal maneuvers. From the perspective of a CTL lender, the uncertainty surrounding the timeliness and adequacy of payment from the condemning authority introduces excessive real estate risk into what is supposed to be a credit based transaction.
Therefore, in order to mitigate the lender’s concerns, condemnation insurance is required.
The insurance policy is written for the entire term of the loan and is for the benefit of the lender only. Essentially it states that, should the lease on the mortgaged property be terminated by the tenant as a result of condemnation, the lender will be paid the entire unamortized balance of the loan within 15 days of a claim being submitted. In return, the insurer takes over the lender’s position as first mortgagee and all rights of recovery associated with it. The lender is made whole without the time and expense of foreclosing or litigating over the condemnation award.
The premium for the policy is paid up-front and the policy is non-cancelable once the premium has been paid. Terms of up to 30 years are available. Pricing varies based on the condemnation wording in the lease and the perceived ease with which the tenant may exercise the termination right.
Many triple-net leases also include a tenant right to terminate in the event the building is substantially destroyed by fire or other perils. The extent of damage required to permit termination varies widely and has a dramatic effect on pricing of the insurance. For example, some leases will permit termination if damage occurs which cannot be repaired within 90 days. Other leases permit termination only if 50% of the building is destroyed, and then only during the last five years of the lease. Regardless, the casualty insurance policy addresses tenant termination just like it does for condemnation. If the tenant terminates, the policy pays the lender the unamortized balance of the loan and the insurer takes over the lender’s first mortgage position.
Properties that would represent undesirable risks for traditional insurance carriers also are unattractive to the lease termination insurers. Examples are high-profile buildings in perceived terrorist locations such as New York City and Washington D.C., sites in high severity earthquake areas such as California, and coastal properties subject to hurricane. These may not be completely uninsurable for lease termination, but the pricing may make the transaction uneconomical to complete.
Many factors contribute to determining how much insurance is actually available for a specific transaction. It is beyond the ability of this article to specify all of them. Suffice to say that any single asset in excess of $100MM loan value is going to be difficult to insure at a competitive price, and amounts much lower than that may all that is available for less desirable transactions.
The three main providers of casualty and condemnation insurance are Chubb Custom Insurance Company, Houston Casualty Company and Lexington Insurance Company. These carriers distribute the product through exclusive arrangements with select agencies. Financial Specialty Risk Managers, LLC., will access one or more of these carriers as necessary to best serve the needs of the customer.