Industry focuses on insurance issue

Real Estate Weekly, July 31, 2002 by Edward T. LaGrassa

Since Sept. 11, the real estate industry has been focused on the complicated issue of terrorism insurance. The U.S. Senate and the House of Representatives have both passed legislation addressing this matter, but the bills vary greatly and it is unclear if the two branches will be able to work out a comprise solution in committee prior to Congress' summer recess. Continued uncertainty on this matter places property owners and managers in a difficult situation, complicating their ability to operate and finance commercial property.

Until Sept. 11, insurance was relatively easy to secure. A property manager could call up an insurance broker and swiftly receive coverage under an individual or master policy at competitive rates. More than nine months after the attacks, for commercial real estate valued at under $50 million, there are approximately 15 insurers that will provide coverage. Only a handful of insurers will cover commercial buildings that are valued above $50 million. For residential properties of any value, the field is even more limited -- very few insurers are willing to offer terrorism insurance due to other liability concerns as well.

Companies that offer terrorism insurance are extremely detailed about what is and what is not covered. There will be a definite range of exposure and coverage, and insurers often exclude coverage for many of the risks about which owners are concerned. Policies normally cover explosion damage and fire, but exclude damage or harm resulting from biological, nuclear or disease-related attacks. While the insurance contracts are valid for a year, insurers typically reserve the right to cancel the policy with 30-days notice. Building owners are very concerned that insurers will cancel these new terrorism insurance policies before the expiration of a yearly contract.

If a building owner does obtain terrorism insurance, the cost can vary widely. Premiums are generally 1 to 2% of the policy limit. Higher-profile buildings will incur much higher costs than lesser-known buildings. In the United States, there are fewer than 150 buildings taller than 50 stories, and these properties are perceived to be at the greatest risk and stand to incur higher insurance costs overall. Building owners are also concerned that insurers' appetite for risk in specific areas, such as New York City, is limited and may leave many of them without any terrorism coverage.

Under normal circumstances, building owners would seek to pass the cost of terrorism insurance to tenants. Existing leases may not even include terrorism insurance pass-through provisions, and these increased insurance costs reduce the operating income of the building and, correspondingly, the value of the property. If the lease is structured with increases tied to porter's wages and not to an operating expense base, it may not be possible to pass these costs on to tenants. In a soft real estate market with reduced leasing velocity, the added. cost of terrorism insurance may complicate lease negotiations.

If a building owner decides to decline coverage, or is denied coverage, the ability to obtain financing for a property may be severely curtailed. Some lenders have instituted a blanket requirement for their loan portfolios that a borrower must have terrorism insurance, even where there is little need. A small property in Des Moines, Iowa, for instance, may be an unlikely terrorist target, but if a lender requires terrorism insurance and the owner cannot obtain it, a technical default may be triggered by certain mortgage covenants. A technical default could initiate other events such as a change in debt service coverage ratios and the ability to refinance the property. How the special servicers, who manage the day-to-day matters of the securitized debt market, will deal with these kinds of default issues over time remains to be seen.

For the larger buildings, the inability to obtain terrorism insurance is far more important. It literally affects the buying, selling and value of these properties. If a building cannot secure terrorism insurance, or can only obtain coverage with provisions and exclusions deemed unacceptable, it may affect the ratings of the bonds, and therefore the cost of the bonds. A lower rating will increase the expense of financing a transaction. Several recent high-profile property sale transactions have been affected by the inability to secure the insurance, the cost of obtaining it or the unacceptability of the terms.

The insurance issue is only one of the many lingering impacts of the terrorist attacks. However, the real estate industry and the federal government must work to resolve the matter before the uncertainty further hinders the ability to effectively operate real estate assets in New York City and throughout the nation.