Sub Application not inheriting web.config file.

[focus.nz]

Below is the folder structure in IIS:

Default Web Site
Application1 (Virtual Directory & IIS Application)
Application2 (IIS Application)

When i try to browse to Application2 is not inheriting the settings
from the web.config file from Application1.

This works correctly if Application1 isn't a Virtual Directory.

Can anyone help on what could be causing this problem?

Thanks