Freeholder insurance shortfalls leaving landlords exposed to rising rebuild costs

For many landlords of leasehold properties in the UK, since the Autumn Budget and the Royal Assent of the Renters’ Rights Bill, it has been a testing time, to say the least. Another potential issue on the horizon is whether your building is underinsured, as there are a few key factors which could spell financial disaster if the worst were to happen.

As far as delegations of responsibility are concerned, the landlord typically oversees internal repairs, upkeep and tenant relations, while the freeholder usually maintains responsibility for the building’s structural integrity. The latter also extends to include incumbent buildings insurance policies.

Establishing an arrangement like this provides a sense of reassurance, security, and stability. However, a worrying gap is opening up between two key elements:

• The level of cover provided by freeholders
• The actual costs of rebuilding in today’s economy

Inflation in the UK’s construction sector has reached levels that make historic and legacy insurance valuations more or less obsolete, leaving leasehold landlords exposed to a larger amount of financial risk.

The reinstatement value trap

A common misunderstanding within this issue involves what a property should be insured for. Many property owners make the mistake of assuming the market value (the price a property would be worth if sold) is the benchmark for an insurance valuation. The figure that matters, however, is known as the reinstatement value.

A property’s reinstatement value represents the total cost to rebuild the property from scratch if it were completely destroyed. Unlike market value, which is influenced by factors such as location, catchments, local demand, features, and so on, reinstatement value is dictated by the costs of building materials like bricks, mortar, steel and timber, as well as the average cost of building labour.

In many parts of the UK, especially in high-value urban areas, the market price might exceed the rebuild cost. On the flip side, for listed buildings or properties with unconventional construction, the cost to reinstate can far outweigh what the property is worth on the open market. For more information about reinstatement values and why they matter for property owners and landlords, you can consult the technical guidance provided by the RICS-regulated surveyor team at Cosey Homes.

Why is this shortfall widening?

The UK construction industry has faced numerous challenges over the last few years. According to data from the Building Cost Information Service (BCIS), the costs of both materials and labour have surged well beyond general inflation rates. This is largely attributed to:

• Global supply chain disruptions
• Wholesale energy price hikes (which is affecting the production of concrete and steel)
• A chronic shortage of skilled workers

As a result, tender prices have shot up exponentially.

This is where the “leasehold gap” becomes especially important. While a landlord who owns a freehold property is already accustomed to the process of reviewing their insurance annually, a leasehold landlord effectively has no say in the matter. It’s the freeholder’s diligence that they’re essentially bound to.

If a freeholder hasn’t commissioned a professional Reinstatement Cost Assessment (RCA) in several years, the “sum insured” on the block policy is almost certainly based on historic and outdated figures which wouldn’t provide sufficient coverage in today’s economy. Even if a policy were to include a “Day One Uplift” or inflation indexing, assuming these automated increases will keep pace with the same level of hyper-inflation seen in building materials and labour costs is ambitious at best.

The risks of underinsurance and the “Average Clause”

It often isn’t discovered until after a claim has been made, but one of the biggest risks of an outdated freeholder policy is the “Average Clause.”

This is a mechanism whereby the insurer reduces the payout if a building is found to be underinsured.

For example, if a block of flats is insured for £1 million, but a professional assessment after a fire incident, determines that the genuine rebuild cost is £2 million, the building is 50% underinsured.

Under the Average Clause, the insurer is entitled to reduce any claim by that same percentage. Even if the damage is partial by comparison (such as a £100,000 roof repair), the insurer would be allowed to only pay out £50,000.

In leasehold properties, the resulting shortfall must be covered. Since a freeholder’s insurance payout would be insufficient, the remaining costs are typically enforced to the leaseholders via a service charge demand or a levy. For landlords, this can mean unexpected bills of five figures and higher, which can completely eradicate years of rental profits, not to mention threatening the viability of their investment.

Proactive steps for landlords

The correlation between a freeholder’s insurance responsibilities and a leaseholder’s payment obligations can be tricky. When shortfalls occur from failing to maintain adequate insurance cover, disputes can arise, whereby liabilities for deficits are questioned. This is why it’s essential to understand the specific wording of leases if landlords are concerned about their exposure. Anybody who is facing disputes regarding service charge increases or insurance shortfalls may find the litigation resources at Brady Solicitors, a specialist UK property law firm, helpful.

As a leasehold landlord, you cannot afford to be a passive observer of the building’s insurance policy.

Even though you don’t have any jurisdiction over the policy itself, you do have a vested interest in its validity, accuracy, and level of cover. As such, it’s recommended to:

• Request the insurance summary from the freeholder or managing agent.
• Scrutinise the “sum insured” and the date of the most recent valuation.
• Check when the last RCA was performed and whether it falls within the RICS-recommended three-yearly window.
• Consider your own landlord insurance policy which covers your contents, loss of rent and property owner’s liability.

The current economic environment has intensified the importance of close reviews and scrutiny of insurance policies. Long gone are the days of “setting and forgetting”. However, by ensuring the freeholder is fulfilling their obligations to maintain accurate rebuild cover, landlords can safeguard their portfolios from the devastation of uninsured losses.