Halloween Special: The Most Frightening Clause in Commercial Leasing?

Landlords have devised what I believe to be one of the scariest lease clauses for the tenants I represent. Like a skeleton, they bury it deep within the operating expense section of their lease. It’s a ticking time bomb that may never ignite. But if and when it does, tenants may see a frightening bill for roughly four months of rent. This clause can be a deal breaker, and in two recent cases, my clients have walked away from a deal in favor of a landlord with a more tenant-friendly lease.

The clause makes insurance deductibles part of a building’s operating expenses. It may look fairly innocuous. It may be as simple as adding the word “deductibles” into the operating expense section of their lease. But here in Florida, where every summer brings the potential for a catastrophic storm,  those deductibles can cripple a small business.

My first experience with this practice began in 2005. I stood in front of my home in Boca Raton as the eye of Category 3 Hurricane Wilma passed overhead. I’ll never forget the sight of the sun shining through the round outline of the eye. I have lived in South Florida for over 50 years and thankfully, it is the only time I have experienced the eye of a hurricane.

Eye of Hurricane Dorian, 2019

At the time, I worked for a landlord with 1 million square feet of office and warehouse properties in South Florida. Our portfolio came out of the storm pretty well. Our  biggest biggest expense was landscape cleanup, removing downed trees and branches from our parking areas. That was clearly an operating expense. But Hurricane Wilma cost insurance companies $9.2 billion in claims, resulting in unprecedented increases in property insurance rates.

In order to control rates, carriers responded by adding windstorm deductibles, which eliminated smaller claims and limited exposure.  A 5% windstorm deductible is now fairly common. Based on the experience with Wilma, my former company made a key change to our lease. We added that insurance deductibles would be passed through to the tenants as an operating expense. We were one of the first to implement this change and other landlords followed suit. In five of the last seven leases I’ve negotiated, the landlord has included a clause making deductibles an operating expense paid by the tenant.

Typical deductibles clause in operating expenses section of  a recent lease

When I was representing landlords, that was a great thing. We had zero exposure in the event of storm damage. It was 100% covered by insurance and by the tenants. Today, as I specialize in representing tenants, I am vehemently opposed to the practice. We are in a full blown (pun intended) property insurance crisis in Florida. Whether or not you believe in climate change doesn’t matter. The insurance companies are expecting more climate related losses. Even if you still believe the earth is flat, your insurance rates are going up. 

What amazes me is that few if any of the brokers I have spoken to are aware of the practice and there must be hundreds or even thousands of tenants who are in the dark.  Many attorneys don’t pick it up, but as a Tenant Representation broker, it is one of the items I look for. Whether a tenant will accept the risk is up to them, but in many cases, they will not.

You can review the math below, but based on my calculations, a 5% windstorm deducible will cost the tenant approximately 4 months of rent.  Because rent is tied to building value, the 4 months will remain fairly constant across building types and classes. The question I ask my clients is “are you willing to write a check for four months of rent if a storm hits?”

The Math

Let’s look at a typical tenant and see what happens in the event of storm damage. Let’s take an average office tenant of 3,000 square feet. They are paying an average rate of $24 net plus $12 in expenses which is $9,000 per month. Based on a conservative 7% return to investors, a building at a net rental rate of $24 per sf is worth $343 per square foot ($24/0.07). If the building were to be destroyed by a storm, we’d only have to replace the building and not the land. So allocating a customary 30% of the value to the land, the building will be insured for $240 per square foot (70% of $343).  Therefore, with a 5% deducible,  the exposure for the tenant in the event of storm is $240 x 5% or $12 per square foot.  With the deductibles clause, the tenant covers the first $12 per square foot in damage.  For 3,000 square feet that is $36,000, equivalent to four months of rent. So whether the damage is $12 per sf or $120 per square foot, the tenant pays up to $12 per sf for any damage.

Most leases, whether net of modified gross make the tenant responsible for all expenses or increases in expenses for a property. But I believe the deducible clause crosses a line. The tenant, as part of their operating expense, is paying for the landlord’s cost for insurance that covers 95% of the property. But they are also effectively acting as the landlord’s insurance company for the other 5%. The landlord is 100% protected against storm damage.  I just can’t accept that it is fair for the tenant to be the landlord’s insurance company. And even if the tenant pays for the deductible, shouldn’t it be a capital expense that is spread across several years? Even worse, what if you have 3 months left on your lease and you are hit with a storm that costs you 4 months of rent?

It’s good to be king, but sometimes the king needs to be overthrown. That is my point. How do we do that? I have three possible solutions:

  1. Frankly, I believe the practice should be illegal. We should have some legislation, but the insurance companies and property owners have significantly more resources to fight it. In addition, this is a problem that is below the radar. Most people are unaware of the issue and it may not come to light until another major storm hits South Florida.
  2. Windstorm deductibles have been increasing in order to control skyrocketing insurance premiums. Landlords would have to pay significantly higher premiums in order to eliminate the deductibles. That cost would have to be passed to the tenants in the form of higher operating expenses resulting in higher rents. But would a tenant prefer to pay a higher monthly rent rather than taking on the risk of a bill for up to 4 months of rent? As a tenant, I would consider paying more rent or buying supplemental insurance to cover the deductibles. That could possibly be added to the tenant’s general liability policy that all landlords require. The problem is that there is no insurance product on the market to cover the tenant’s share of deductibles. (are you listening AFLAC?) Until enough demand is created, no insurance company is going to create a product and the insurance companies are in no hurry to take on any additional storm-related risk.  
  3. Good old American free enterprise. The way I have been handling the situation is for my clients to vote with their wallets. So far, I have had two clients refuse to sign leases with deductible clauses and lease at other properties. On other deals, we have negotiated to eliminate the clause or to a cap the potential liability. A new wrinkle I just experienced is a case where an institutionally owned property is under a national blanket policy with no windstorm deducible, so the tenant responsibility is negligible. But this has barely put a dent in the landlord’s pocket. If I don’t lease the space, another tenant is either willing to take the risk or more likely is unaware that the risk exists. If enough tenants refuse to sign leases with deducible clauses, then market pressure will eliminate the practice. Landlord’s who do not include deductible clauses can use it as a marketing attribute and further shed light on the problem.

The first step is identify a problem that few people are aware of. One of the most important things I can do as a Tenant Representative is to help my clients avoid costly surprises. This is only one way that I accomplish just that. As a tenant representative, I  (1) help you find the ideal space for your business, (2) negotiate the best deal on that space and (3) protect you from unforeseen expenses. You don’t know what you don’t know and what you don’t know can hurt you. I would be happy to discuss your company’s real estate needs and help you to negotiate the best terms on your ideal space.

I anticipte this being a highly controversial post. I welcome your comments at ks@kenstrends.com.

About Ken

Sr. Vice President Brokerage and Tenant Representation at Levy Realty Advisors, LLC
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