Any entity that receives rental income is at risk if their income stream ceases unexpectedly. There can be significant financial risks to landlords when the loss of rental income impacts net profit, leaving the landlord unable to service borrowings. The most common reason this occurs is when the rental premises are damaged, and rental income ceases while the premises are repaired or rebuilt.
Insuring rental income enables landlords to protect their income stream while the premises are reinstated and rental income resumes. The policy is designed to compensate for lost revenue and preserve net profit.
Commercial rental income (also referred to as Rents Receivable, Gross Rentals or Loss of Rents) is normally insured under a business interruption policy, generally requiring its own item of cover.
Who should have insurance for rental income?
Any entity that earns rental income. This can include:
- An entity (e.g. company, family trust) whose main activity is to receive rental income from property.
- A business whose core activity is, for example, manufacturing or retailing, but which also earns rental income from properties it owns.
- A business that sub-lets a portion of the premises its leases.
How it works
The most common example is where the premises are damaged, and rent and outgoings abate. The landlord can claim the loss of rental income & outgoings and any extra costs incurred (subject to normal policy requirements).
By insuring rental income, landlords will protect the property’s income stream whilst the premises are reinstated and rental income resumes. The principles are much the same as with business interruption insurance for gross profit cover for a trading business, or gross fees for a professional firm. The policy is designed to compensate for lost revenue, with costs that are saved deducted from the calculation, so that net profit is preserved.
The claim is subject to a maximum claim period, called the indemnity period.
What to insure?
If you are familiar with business interruption insurance, it is normal to insure:
- Gross profit
- Additional Increase in Cost of Working
- Claim preparation costs
A similar approach is taken for property owners earning rental income.
Property owners need to consider insuring:
- Gross Rentals. This is the rental income plus outgoings that are on-charged to tenants, such as rates, insurance and common area costs.
- Additional Increase in Cost of Working
- Claim preparation costs
Just as with business interruption, an Indemnity Period also needs to be selected. This is the maximum period of claim, during which loss of rental income can be claimed.
Common shortfalls and issues we see with Rental Income policies and claims
Some common errors we have seen that can lead to under-insurance, or worse still no insurance at all include:
- Landlords cancelling rental income insurance during periods when the premises are vacant and don’t reinstate the cover once the premises are re-occupied. It is the writer’s opinion that there is no technical reason why the cover cannot be continued whilst the premises are vacant – assuming the landlord is actively looking for a new tenant.
- Failure to insure rental income at all, e.g. this typically occurs where a business that owned its premises (and therefore paid no rent) transfers the property and mortgage into a family trust and now pays an arm’s length rent.
- Failure to insure the outgoings that are on-charged to tenants.
- Failure to recognize that the insurance is not for last years’ rental income, but for future income.
- Businesses that have business interruption insurance, and sub-let surplus space to a third party, receive rental income, but overlook to insure this income stream.
- Failure to have an adequate indemnity period.
- Failure to insure for Additional Increase in Cost of Working.
Some of the more frequent issues with claims are:
- Failing to “adjust” for rent reviews that would have occurred during the indemnity period. These will be detailed in the lease agreements, and may include an annual increase, set at the CPI rate, or a yearly (or 2 or 3 yearly) rent review. This review may state that the rent will be set, based on a market rental appraisal carried out by a valuer, to establish what the expected market rent would have been had, “had the damage not occurred”.
- Failure to correctly calculate the outgoings that would have been recovered from tenants, and that need to be included as part of the insured rental income.
Just because a tenant’s lease agreement expires during the indemnity period does not automatically mean that rental income after this date cannot be claimed. Many tenants will simply renew its lease, rather than move. Each claim needs to be treated on its own merits.
