February 28, 2002

Leasehold title insurance: New ALTA endorsements

By PETER OSTRANDER and DWIGHT BICKEL
Transnation Title Insurance Co.

The benefits of leasehold title insurance are often overlooked. As the costs of tenant improvements escalate and more companies are using “synthetic leases” and other off-the-ledger financing, it is time to take a new look at the investment protection available from title insurance.

Ostrander

New lessees sometimes presume that the owner has good title to the leased premises and has full power and authority to convey a leasehold estate. Lessees frequently presume there are no covenants or easements affecting the lessee’s use of the land as the lease allows. If these presumptions prove incorrect, the lessee may have significant losses that cannot be recovered.

The American Land Title Association recently developed new policy endorsement forms, available from all major title companies in the state, to address these risks and provide additional coverage.

A search of the leasehold property and subsequent title insurance gives knowledge of matters affecting title that are pertinent to the leasehold investment, and also provides insurance protection against a wide range of damages that could be suffered due to invalidity of the lease and due to the condition of the lessor’s title.

A person investing in a leasehold relies upon the owner’s title and capacity. The lessee must be sure:

The lessor is the true owner of the property
The leasehold estate created by the lease is valid and binding against the landlord
Except as disclosed, no defect in the chain of landlord’s title exists
Except as disclosed, the leasehold estate is not encumbered by a superior lien or claim
Any consents required by mortgages or any party having an estate senior to the tenant have been obtained
Except as disclosed, there are no covenants, conditions or restrictions that prohibit or limit the tenant’s proposed use of the premises
Except as disclosed, there are no easements or other restrictions that may limit development or use of the leased premises
The lessee has legal access to the premises
The owner’s title AND the lessee’s leasehold title are marketable

There could be significant damages suffered by a lessee, even after equivalent replacement premises are found. If the leased property cannot be used for the purposes intended by lessee, the costs paid to acquire and prepare that site will be lost, plus the lessee will incur similar costs to for a replacement site.

Tenant improvements for a typical ground lease would include the construction costs, the soft costs paid for design, permits, testing, professional fees (such as architects, engineers, lawyers and real estate brokers), the landscaping costs, and the costs and interest incurred for loans for the acquisition and construction of the leasehold improvements.

When the lessee suffers financial loss due to the title issues listed, often the lessee does not have an adequate remedy against the lessor. Very often, the lessor in a commercial lease is a single-purpose entity organized with minimum capital. Even if the lessor is financially capable of paying losses such as these, often the lease itself significantly limits the recourse rights of the lessee.

Unless the lessee has the negotiating leverage to obtain personal guarantees from a financially resourceful principal, a leasehold title insurance policy may provide the only protection for the lessee’s investment.

ALTA leasehold endorsements

The American Land Title Association developed a policy form intended to be used for leaseholds. It was based on the 1975 policy forms, changed to add one definition to the policy for the term “leasehold estate.” In recent years, leasehold customers rejected that form due to many inadequacies. That form simply did not address the need for investment protection that arises with a commercial leasehold.

In response to customer demand, ALTA drafted endorsements to be added to owner’s and lender’s title insurance policies when the insured acquires a leasehold estate or a leasehold mortgage. These endorsements, designated as ALTA 13 (for owners) and ALTA 13.1 (for lenders), were approved in October 2001. At the same time, ALTA decertified the inadequate leasehold owner’s and leasehold lender’s policy forms.

Now, the lessee’s financial investment in reliance upon the lessor’s capacity and condition of title can be protected by the expanded compensable damages listed in the leasehold endorsement. The title insurance underwriters in Washington appear willing to add this improved leasehold coverage without any premium surcharge above the typical premium for an owner’s policy.

Using an endorsement attached to a normal owner’s policy makes it possible to insure complex transactions where an insured may acquire both fee ownership and leasehold interests in a single project with one policy. The endorsements only add to the coverage, and only apply to the leasehold parcel.

Endorsement provisions

If you start by reading the definitions, you will see the definition of “evicted” is used as a trigger for loss events.

There are two provisions, “(a) the lawful deprivation, in whole or part, of the right of possession insured by this policy, contrary to the terms of the Lease; or (b) the lawful prevention of the use of the land or the Tenant Leasehold Improvements for the purposes permitted by the Lease.”

An unknown covenant or easement could cause significant loss to a lessee by preventing the lessee’s intended use of the property, without losing the right of possession, so the second definition is a significant benefit.

The lender’s ALTA 13.1 defines “Tenant” as the tenant under the lease and the insured lender who acquires title by foreclosure or deed in lieu. This ensures the continuation of insurance provisions of the lender’s policy form will apply to the leasehold estate acquired after foreclosure.

Section 2 of ALTA 13 deletes the coinsurance provisions of the owner’s policy because it is so difficult to value leasehold interests that virtually every leasehold insured would risk the application of the coinsurance provisions with no means of assuring a policyholder that it had avoided the issue. The ALTA loan policy has no coinsurance provisions so this paragraph is omitted in ALTA 13.1.

Section 3 provides valuation of the loss of a leasehold estate. This new definition resolves prior valuation questions related to tenant improvements, by giving the insured the option of valuing the leasehold estate and any tenant leasehold improvements either together or separately.

In addition to the loss of the lease, further recoverable damages are listed in Section 4. These represent a significant expansion from prior available title insurance. The list includes the damages described at the beginning of this discussion related to relocation and tenant improvements, then adds consequential losses that might be suffered due to loss of the value of subleases, the loss of sublease income and damages due to sub-tenants.

How much insurance is needed?

Similar to many types of insurance, it is important to have insurance protection in the amount of loss that you could suffer. However, requesting excessive title insurance will not change the standard limitation, that only actual loss is recoverable. The best practice is for the proposed insured lessee to realistically estimate the potential damages and request insurance protection for that amount.

Review paragraphs 4(a) through (g) of the owner’s leasehold endorsement to ensure the new compensable losses are considered.

The improved coverage of the ALTA Leasehold Endorsements, available without additional premium, justifies renewed interest in title insurance protection for leasehold investments.

Dwight Bickel is senior vice president and regional underwriting counsel for LandAmerica Financial Group Inc. Based in Seattle, he supports the title insurance and escrow operations of Transnation Title Insurance Co., Commonwealth Land Title Insurance Co. and Lawyers Title Insurance Corp. in the Midwest and Northwest states. Bickel is a member of the ALTA Forms Committee that drafts national, uniform policy forms.

Peter Ostrander is vice president and senior sales representative for LandAmerica, working with the National Commercial Services division of the company in its Seattle offices.

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