What part of an eminent domain award should belong to a tenant? We’ll save you the trouble of scrolling down to the bottom – we think it is the portion attributable to the leasehold value of its lease. What is that? If you don’t know already, you’ll have to start scrolling.
Ruminations is sure there must be a spreadsheet with a state-by-state comparison of eminent domain rules, but we don’t have such a reference source in our office. So, we’re going to create the “State of General” and it will have rules common to most, if not all, jurisdictions. Here are the relevant ones. First, to take someone’s property for a public purpose obligates the taking authority to pay just compensation, and such payments are made in a single award to the record fee owner. In the most common case, that of a total taking, the award is to pay for the entire “bundle of sticks,” i.e., every element of the real property. Next, even though some (but few) jurisdictions allow a tenant to participate in condemnation proceedings, usually those dealing with valuation, any portion of the award that would go the tenant is a product of the lease’s language, not the law. Yes, the landlord gets all of the money and then would, by contract, pay some of it to its tenant. [In some jurisdictions, the condemnation courts will allocate awards based on the lease, but that doesn't mean that there is direct compensation to the tenant, only that the related consensual "split" be we heard by the court.] There may be some payments directly available to a tenant related to loss of goodwill, relocation expense or personal property, but those are statutory and not part of “just compensation” because they are not components of “real property.” They do not come out of the fee owner’s award. The last rule in the State of General is that the eminent domain taking awards are based on the highest and best use for the property.
It is this last rule that gives rise to a tenant’s entitlement to a piece of the award. “Highest and best” valuation is different than “what would a willing buyer pay for the property.” To make this simple, let’s assume that the highest and best use of a given property then being used as a retail shopping center is as a retail shopping center, not as a garden apartment complex or a high rise office building. Now, we can give a stark example of the difference between what a taking authority must pay and what an unrelated, arms-length buyer would pay for the shopping center on the same given day.
Here is our example. First, pretend there is only one tenant. Next, assume that the tenant has 20 years to go on its lease and is paying ten dollars per square foot of floor area whereas the fair market rent has risen to twenty dollars per square foot. An arms-length buyer will value the property based on only receiving rent at the ten dollar rate for the next 20 years at which time the rent would go to “market.” The taking authority, on the other hand, has to value the same shopping center at its highest and best value, i.e., at the market rent of twenty dollars per square foot. That’s a lot more money. If the tenant had been paying market rent, the arms-length buyer and the taking authority would be paying the same amount. But, that’s not what happens in our example.
So, what is the basis for this extra money – this “bonus”? Answer – it comes from the tenant’s hide. It is the tenant that has created the “bonus” by negotiating for what turned out to be a below market rent. If the rent had been “above market,” the highest and best value would have been based on the above market rent because that is high and better than market. The “takings” price would be the same as an arms-length buyer would have to pay. Yes, if a tenant is paying market rent or higher, the eminent domain award will equal the usual purchase price in a typical sale. That, in fact, is all a property owner is entitled “as its own.” If a forced sale (i.e., a taking) results in a higher price (award) than a consensual market-based sale made at the same time, the “extra” had to come from someplace or someone else.
To see why it comes from the “tenant,” just think about what the tenant will experience. In our example, the tenant will be tossed out of its space at a time when replacement space costs twenty dollars a square foot. That’s ten dollars a square foot more than it was going to pay for the next 20 years. That’s the same ten dollars a square foot that created the “bonus” part of the eminent domain award. In accounting parlance, that’s called “leasehold value” and leasehold value belongs to the tenant. It is what the tenant needs to “pay for” or “cover” the extra rent it will have over the next 20 years in its new space.
When a landlord pays the leasehold value “component” of an eminent domain award to its tenant, it isn’t losing anything it had because, absent the taking, it would never have seen the “bonus.” To the tenant, however, failing to get the leasehold value (one of the sticks in the bundle of real property rights), deprives it of the benefit of the bargain it earned when it obtained a below market rent. Of course, if a tenant’s rent is at or above market, the tenant does not generate a “bonus” and its landlord receives nothing more than it would have received had it made a market rate sale.
There is a lot to say as to whether a tenant should be entitled to reimbursement from its landlord for leasehold improvements made by that tenant if those improvements “enhanced” the eminent domain award, but that’s too long a subject to take up today.
The details of how to craft a lease provision wherein the amount of “bonus” value can be determined and paid over are beyond this week’s assignment, as is the issue of dealing with mortgagees. Ruminations may deal with those issues sometime down the road, but for now we are building our bomb shelter for protection against expected attacks from those who are stuck with the mantra – “tenant may have such awards as do not reduce landlord’s award.”