What Part of an Eminent Domain Award Should Belong to a Tenant?

Print
Print Friendly

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.”

Print

Comments

  1. Ira,

    Nice analysis and something I will try to use in future negotiations. The problem here in Massachusetts (and probably most places) is that the likelihood of a taking is so remote most of the time that the parties are unwilling to spend serious time considering and negotiating a fair resolution that takes the true valuation of the tenant’s loss into account. And even if they did, the landlord will typically not want to muck up any negotiations with the taking authorities by having the tenant participate, either directly or indirectly.

    Michael Kraft

  2. Scott Young says:

    Ira,

    Thanks for the very relevant post. I’m in-house real estate counsel for a large restaurant owner and operator, and we have had 8 condemnations (or threats) in 4 jurisdictions in the last 6 or 8 months. We are grappling with this very issue with little success. I would be very interested in hearing your suggested provisions for landlord/tenant allocation and mortgagees.

    Best,

    Scott Young

  3. Ira:

    I’m not sure I understand why, in your example, you think the tenant created this “bonus” value. If the space were vacant, wouldn’t the taking authority value the space based on the $20 market value? The tenant’s $10 lease didn’t create this bonus amount, the market did. I agree that the difference between the $10 the tenant is paying and the $20 market value is called the “leasehold value”, I just don’t agree that the tenant is entitled to same because it “created” it with its $10 lease.

  4. Alan Betus says:

    Ira, another good post as always. Using your example, and in the State of General, is the tenant getting shortchanged by agreeing to language that allows the tenant to pursue any award for the value of its leasehold estate [or the pursuit of anything really] provided that such award does not reduce Landlord’s award?

    • Alan, the short answer is yes for two reasons. First, in most jurisdictions (the State of General being a prime example), the tenant has no claim because the fee is being taken and, if you read the lease, upon a taking, the lease is terminated. Thus, there is no taking of the tenant’s leasehold interest (and it isn’t the owner of record) because it didn’t exist in the hands of the tenant upon the taking. Essentially, the bonus value “returned” to the landlord. The landlord “picked up” the “bargain” element of the rent (assuming a below market rent situation). And, it didn’t pay for it. In a possible consensual scenario where a landlord wants to “buy back” the lease, it would pay its tenant for that “bonus, below market rent situation.” [By the way, from a landlord’s perspective, for maximum clarity, the lease should be terminated the day before the taking so that there is no argument about whether there was any real property interest held by the tenant on the day of the taking). The second reason is that the notion that “but not if it would reduce the Landlord’s award” essentially eliminates any possible “eminent domain” award to a tenant because the whole bundle of sticks has a single price. The leasehold value is part of that price. if that “stick” was bought from the tenant, the landlord would have fewer sticks to sell.

  5. Chris Lombardi says:

    Among other concepts, I have developed 200 coin laundries, so as you might imagine we located in areas that were more susceptible then many to eminent domain. As mentioned in the earlier notes,- to discuss in detail could take awhile – I minimum provision I insisted on all leases-and always got- I get the right at my own cost to challenge the award of the “taking” solely for loss of business or the relocation of the business. In many jurisdictions this is separate from the ‘land value” discussion. I was very successful in Chicago and Philadelphia in particular with this – I was awarded on average $100K per location.

    • Becky Smith says:

      And I, at a Pet retailer based throughout the Southeastern US, have also been successful in always insisting that I have the right to challenge, at my own cost, the award and obtain remuneration for loss of business, leasehold improvements, relocation of business as well because I learned from the best . . . Chris Lombardi. I never agree to the “so long as it doesn’t reduce Landlord’s award” language. If I don’t get this language, I move on to the next deal.

  6. Lee SIngleton says:

    It seems to me that the tenant simply has the right to be made whole. This includes the costs related to relocation and whatever it takes to get him up and operating at essentially the same level. The landlord has made an investment that carries a value which is based on the capitalized NOI. That value should be based on market rents. The tenant doesn’t deserve any of that valu in my opinion because the tenant can be replaced by another tenant at the same rate.

    That being said, the actual terms of the lease can potentially however add or subtract value if the tenant is paying something different than market. Therefore, if market is $20/ft and he is paying $10 per foot and must now go out and pay $20 elsewhere there is a loss of the capitalized value of $10/ foot and he should be reimbursed. If on the other hand if he is paying $30/ft and gets out of a bad lease and finds an alternative space for $20 he should feel like the luckiest guy around and hope nobody notices.

  7. Sigit Haryo says:

    Nice article! Although it seems a bit hard to find the resemblance with what is happening in the Indonesian land market. I think it is because we were not in that “sophisticated” stage as other countries such as USA, or even India. In here, The Government of Indonesia definitely has a different policies on its land market and also in the way they acquiring land (of which i wrote as one point of my theses in 2011). Those differences nullified (or at least weakened) the validity of what you called as the “eminent domain award”.

  8. Randall Gunn says:

    Ira: Nice article but, it may be a Florida law thing, you have not dealt with a partial taking. In Florida, if there is a partial taking, there is a right to business damages. If there is a total taking, there is NO award of business damages. The “business” that has the potential to be damaged at a leased location is the Tenant. The rental income can not be the “business” since that is a part of determining fair market value of the real estate. Only the Tenant has a business that would be capable of receiving a business damage award. Why should the Landlord be entitled to something that he has NO way of receiving?

Leave a Reply