• Eminent Domain and the Commercial Lease
  • March 28, 2012 | Author: James D. Masterman
  • Law Firm: Greenberg Traurig, LLP - Boston Office
  • Often, commercial landlords and tenants only pay close attention to the eminent domain or condemnation clause in a lease when the condemning authority first gives notice that either all or a part of the leased premises is about to be taken. By that time, landlords and tenants find themselves in an adversarial position not only with the taking authority, but with each other. As against the taking authority, the principal concern is the payment of just compensation once the right to take for a public purpose has been established. The objectives of the parties and how to achieve them are relatively clear. That cannot be said about the multilayered, interrelated landlord-tenant relationship. Not only are there multiple objectives and overlapping responsibilities, but the rights at issue are contractual, rather than constitutional, and subject to conflicting interpretations.

    In this GT Alert, we offer guidance on how a taking by eminent domain impacts leased real estate and the rights of the leasing parties when a taking is made. With a better understanding, landlords, tenants and their lawyers can be more deliberate in their approach to the negotiation and drafting of this frequently overlooked provision. First, a few of the basics.

    A lease creates a leasehold relationship between landlord and tenant. The leasehold estate is the property right of the tenant, set forth in a written lease, to use and occupy real estate for a stated term, usually for years, and under stated conditions. The leasehold estate is not an absolute transfer of the right of possession, but a right on condition, terminable by the landlord for the tenant’s failure to satisfactorily perform or a breach of the lease terms and conditions. The owner in fee, having transferred the right of possession under stated conditions in consideration for the payment of rent (and more), no longer owns a fee simple estate, but an estate subject to the leasehold, referred to as the leased fee. The right of the landlord to repossession at lease termination is referred to as the reversion.1

    A taking by eminent domain, or condemnation, is a proceeding in rem; that is, the power of eminent domain is exercised as against the real estate, not the owner. Condemnation divests the owner of title to the real estate and all interests in it, including leaseholds. In a total taking, condemnation extinguishes the leasehold interest, divests the owner of title and both of possession.2 All property interests are, as a matter of law, equitably converted into proportionate interests or shares in the constitutionally mandated just compensation award. That which was an interest in real property is converted into an interest in the award. Unless contracted away in the lease, the holder of a valid leasehold estate is, therefore, entitled to just compensation when all or a part of the property leased is taken during the term of the lease. Neither a tenant at will nor a tenant at sufferance own a property interest and neither is, therefore, entitled to just compensation.

    When a leased property is taken, either in whole or in part, determination of the award starts, in nearly every state, with calculation of the award pursuant to what is called the undivided fee rule, sometimes called the unit rule. Most states codify the rule in their condemnation statutes.3 The undivided fee rule provides that when there is a taking, there is one award of the fair market value of the property taken without regard to its various property interests. The amount of damages are determined as if all interests in and to the property are owned by a single entity. Contracts between the owners of different interests in the land do not affect the right of the government to take the land for public use or oblige the taking authority to pay more than the entire value of the land considered as a single, undivided unit.4 Once the award is determined, it is then allocated into proportionate shares according to the value of the various interests.5 This is referred to as apportionment. If a valid lease for years exists at the time of the taking, then both the lessor and the lessee are entitled to share in the award according to the value of their respective interests. Unless the lease provides otherwise, a lessor is entitled to the value of its leased fee and the lessee, of its leasehold, apportioned from the one award. The taking authority has no stake in apportionment. Once the taking is made and the award determined, the condemning authority drops out of the litigation.

    Leasehold value is the fair market value of the right to occupy the property under the terms of the lease for the period of time remaining on the lease term. It is commonly measured by the difference between the fair rental value of the property at the time of the taking and the contract rent due the landlord for the unexpired term, capitalized into an indication of value. The market advantage between contract rent and fair market rent is often referred to as bonus value or the leasehold advantage and it inures to lessee’s benefit measured against the market. The mere expectation that a lease may be renewed is not a legal right and not a vested property interest for which compensation is owed. However, when a lessee has an option to extend the lease, "the term of the leasehold for the purpose of determining the extent of the taking must be considered to be its longest limit."6 Leased fee value is the value of the right to receive contract rent for the term remaining on the lease. It is the capitalized value of the income stream over the life of the lease term remaining. Leased fee value is particularly well suited to valuation by the discounted cash flow method because the contract rent and the term
    duration are fixed and known (except in percentage rent leases).

    The right of a tenant to compensation is created by the existence of a valid lease, not by a specific provision in the lease stating so. If a lease is silent as to condemnation or fails to account for apportionment of the award, the lessee is entitled to just compensation for the loss or damage to the leasehold. The lease clause modifies this fundamental precept. Leases are construed, like other written agreements, so as to give effect to the intention of the parties. While there are literally hundreds of variations, a sound condemnation clause should unambiguously account for the right of the landlord and tenant with respect to the following:

    Entitlement. In the event of taking, whether in whole or in part, the provision should specify which party is entitled to the award. If the lessor retains the entire award, the better practice is to have lessee “assign” its right to lessor. If the lessee retains entitlement, and has made improvements, return of the value of invested capital appropriately depreciated may be an alternative valuation approach to that of determination of leasehold value based on bonus value as set forth above.

    Termination. Though all total takings extinguish the lease and the leasehold right of possession once title vests in the taking authority, in many states, determination of a lessee’s entitlement depends on whether the terms of the lease provide for automatic termination upon condemnation. This is particularly important in partial takings where the scope of the taking and its impact on the ability of the lessee to continue to use the leased premises for the purposes it was leased may be contested. In one Texas case, a lessee continued to pay rent solely to protect its right to compensation even though it could no longer use the property post-taking.7 A well-drafted lease clause will address termination by using benchmarks of a taking’s impact on the leased premises or on the property of which the leased premises are a part (e.g., percentage of leasehold improvements taken, number of parking spaces, signage, access, etc.).

    Repair and Restoration. If a taking results in a physical impact to the leased premises which can be repaired to a condition which permits the lessee to continue to operate, then it is in the parties mutual interest to repair and restore. There are generally three approaches to restoration provisions: (1) Lessee is not entitled to share in the award for the value of its leasehold but may use the award, or a part of it, to repair and restore the leased premises to pre-taking functionality; (2) Lessor retains all of the award but has an obligation to restore; and (3) If pre-taking functional equivalence is physically impossible, one party has the option to use the award to restore to the extent possible for a reduced rent.

     


     

    1See David M. Keating, Appraising Partial Interests, Appraisal Institute, 1998.
    2See Milton R. Friedman & Patrick A. Randolph, Jr., Friedman on Leases, § 13:1 (5th ed. 2011).
    3See Massachusetts General Laws c. 79, §29, “there shall first be found and set forth the total amount of damages sustained by the owners of such property, estimating the same as an entire estate and as if it were the sole property of one owner in fee simple.” See also, Cal Civ. Proc. Code § 1260.220; Fla. Stat § 73.101; N.Y. Em. Dom. Proc. Law § 505.
    4For a different opinion, see Gideon Kanner, The Undivided Fee Rule — A Rule of Valuation or Highway Robbery?, ALI-ABA Course of Study, 2009.
    5 See Patrick J. Rohan & Julius L. Sackman, Nichols on Eminent Domain § 12.05, 12-103 (3d ed.).
    6 United States v. Petty Motor Co., 327 U.S. 372, 375 (1946).
    7See Texaco Ref. Mfg. v. Crown Plaza, 845 S.W.2d 340 (1992).