When it comes to insurance payouts, landlords and tenants may find themselves in a fix over property value, warns Stephen Whittaker


A residential flat lease will typically provide that insurance is maintained by the landlord at the tenants' cost and oblige the landlord to lay out insurance proceeds to effect reinstatement. If reinstatement proves impossible then often a lease will state that the insurance proceeds are to be divided between the landlord and the tenants in proportion to the value of their respective interests.



Some leases go on to say that after division of the proceeds either party can give notice to terminate the lease.



A landlord may be precluded from reinstatement by reason of a number of factors, such as prevailing ground conditions, inability to obtain planning consent or because the land is required for public purposes. In such or similar circumstances the insurance money will be divided between the parties and perhaps the lease terminated upon notice.



A provision for termination in these circumstances implies that there is no more value in the lease for the tenant, so it makes sense for the lease to be ended and to leave the landlord to do what he can with his site.



However, the insurance proceeds only represent the cost of reinstatement, not the market value of the property. A purchaser of a long leasehold interest in a residential flat will have paid market value and not the build cost. A flat worth £600,000 may cost only £250,000 to rebuild. The difference between the two represents the site value.



If the lease is terminated upon division of the insurance proceeds, the tenant will not receive his share of the site value and the landlord will achieve a windfall. If the tenant has a mortgage and the loan exceeds the tenant's share of the insurance proceeds the lender will lose its security upon termination of the lease, although the tenant will remain liable for the balance of the debt.



In the context of a commercial property let at a rack rent, the site value issue is unlikely to be so relevant. The commercial lease may provide that if a landlord cannot reinstate within a given time, which usually corresponds with the period of rent suspension, either party can terminate. The commercial tenant is then released from further obligation and is free to relocate while the landlord is again left to do what he can with his site. The landlord retains the insurance proceeds and the tenant, who has been paying a rack rental, has no interest in the site value and therefore walks away.



That said, the site value issue may impact upon the commercial tenant who pays a premium for his lease or who, by reason of increasing value of the property between rack rent reviews, can expect to receive a premium on assignment of his lease. Termination of a commercial lease without any form of compensation to the tenant may deny the tenant his proportionate share of the site value if his rent is less than the open market rent, thereby attributing a capital value to the premises.



It is certainly worth considering whether the termination provisions of a lease may deny the commercial tenant the ability to realise capital value in the commercial premises, which but for termination of the lease would have remained with the tenant.



The next edition of the Encyclopaedia of Forms and Precedents Flat Sale Scheme will offer a possible solution.



If insured risk damage has not been reinstated to render the property fit for habitation and use before expiry of a (carefully considered) specified period, either party will be entitled to serve a failure to reinstatement notice. Upon service of a notice following failure to reinstate, all the insurance money received (so far as not properly expended in or about reinstatement) will be divided between the landlord and the tenant in proportion to the value of their respective interests at the time of the damage or destruction.



Where a failure to reinstate notice has been served and possibly only following payment of the tenant's share of the insurance proceeds, the landlord, and possibly the tenant also, will be entitled to serve a notice to terminate.



Following service of a notice to terminate, the landlord will be obliged to pay the tenant an amount equal to the open market value of the lease as at the date of the notice to terminate. Thereafter the lease will terminate.



It is recognised that it may not be in the landlord's interest to allow the tenant to terminate the lease, because the landlord may not have funds to pay the tenant.



Pending termination, the tenant is left with a lease which still secures his interest in the site value. It may be that the landlord will only be able to make payment to the tenant when the landlord is able to utilise the site for another purpose. In the meantime, the tenant's continuing lease protects the tenant's interest.



Some practitioners may prefer to omit termination provisions altogether. Arrangements relating to division of the insurance proceeds should be retained and the lease left in place unless and until the landlord wishes to negotiate for its surrender to facilitate another land use.



All possible scenarios should exclude termination of the lease upon only payment of a share of the insurance proceeds. Thus, the tenant's interest in the site value will be preserved.



It is acknowledged that the possibility of reinstatement proving to be impossible may be remote. Nevertheless, it does remain conceivable that a residential flat owner could be left both homeless and out of pocket where the lease contains termination provisions which do not recognise the tenant's interest in the site value. The lender to a homeless out-of-pocket tenant should also be concerned.



When drafting or negotiating residential leases, practitioners should be alive to the fact that the landlord will be insuring to a level which equates to the rebuild cost and not the actual value of the property. If the lease includes provisions which address the possibility that the landlord cannot reinstate then the exact nature of the provisions should be considered carefully.



If the landlord is frustrated in his attempts to rebuild, he should not be able to terminate the lease unless the tenant has received compensation that more closely equates to the actual value of his flat as rebuilt. From the tenant's viewpoint the lease should remain extant, pending payment of both the relevant proportion of the insurance proceeds and a sum compensating the tenant for relinquishing his interest in the site value.



Stephen Whittaker is a property partner at Weightmans