THE CONDEMNATION CLAUSE

By Tom Flynn of
International Amalgamated Group, Inc.

The condemnation clause in a lease can do one of three things:  (1) clarify, (2) ignore or (3) confuse.  There have been instances when the clause has managed to do all three.  We will attempt to provide some insights in the problems caused by unclear drafting.  Ignoring the potential for condemnation potentially leads to additional litigation between the landlord and tenant as they fight the government and each other to maximize the award each hopes to obtain.

Part I - Landlord – Tenant Splits:

Absent a condemnation clause, the tenant usually will be awarded the “bonus value” of the leasehold.  The bonus value is described as the difference between the market lease rate and. the contract rate in the lease, present valued for the remaining term of the lease.  The market lease rate is that rate charged for similar property as of the date of value in the condemnation case.  The contract rate is the rate currently charged the tenant as stated in the lease for the property.  In most states, any award to the tenant decreases the amount of the award to the property owners.  The amount of the bonus value becomes an issue for the real estate appraisers.

When the tenant is allowed to seek the bonus value, the landlord and tenant become adversaries as the owner attempts to maximize his award from the government.  When dealing with the government, the owner needs to provide proof of the highest possible market rental rate to prove the highest market value for the property.  However, this higher market rental rate helps the tenant as it maximizes the spread between the market rate and the contract rate.  In this instance, the owner is assisting the tenant to prove a higher bonus value for the tenant without strengthening his own position.

Disagreements between the landlord and tenant tend to favor the government and reduce the award to one or both of the parties.  By law, there is no opportunity for either the tenant or the landlord to initiate a separate lawsuit to deal with this issue.  They must resolve this issue within the condemnation case filed by the government.  The government takes the position that the property has one value and they are unconcerned as to how it is split between the landlord and tenant.

Often, the clause calls for the tenant to receive the unamortized value of the tenant improvements.  This is unclear and begs several questions.  Does this mean amortized over the life of the lease?  Would the improvements be completely amortized before a lease extension took effect?  Or, should they be amortized over the useful life?  Or, could they be amortized per the schedule on the income tax returns?  All of these possibilities exist and should be made clear in the lease before a condemnation taking forces litigation between the parties to resolve this issue. 

Often the parties include specifics in the clause which call for the tenant to be reimbursed for fixtures, equipment, leasehold improvements or other property plus moving expenses.  Unless specified, it will be unclear as to whether or not the payment will come from the condemnation award.  Issues are left unresolved:  Should the tenant be reimbursed for the initial cost; should the reimbursement be based on the current market value or on the tenant’s book value?  Again, if the language is unclear, it leads to additional litigation expense and risk in the litigation.    

If the language in the clause states that the tenant may recover the value of fixtures, equipment or tenant improvement from the condemnation award, the tenant may be able to double dip.  If there is a total taking or a partial taking that takes a substantial amount of a building, the tenant may also be eligible for relocation benefits.  These benefits, although the condemnation gives rise to the payment, are separate from the condemnation award which typically deals with real estate only.  Relocation benefits help pay to move fixtures and equipment, the expense to uninstall and reinstall the fixtures and equipment, plus there is a payment for various moving expenses.  In some instances, leasehold improvements, if they are specialized, may also be included for payment within the relocation benefits.  Except for some minor payments for a site search for a replacement site, the owner receives no relocation payments.  If the language in the lease calls for the tenant to receive the value of fixtures, equipment or tenant improvements as a part of the condemnation award, the additional payment of relocation benefits to the tenant for the same items may result in a double dip for the tenant and the landlord is financially hurt by poor language in the condemnation lease clause.

Part II -  Total Takings vs. Partial Takings:

In order to properly protect an owner or tenant, the clause should spell out the split of the award including all aspects of potential damage caused by a taking.  The person drafting the clause should anticipate the possibility of a partial taking that may take only a portion of landscaping, drainage retention, parking, driveways, or perhaps a portion of the building.  Ideally, the language should be site specific rather than relying on stock or boilerplate language that attempts to cover all situations in an overly broad way. 

Anticipating all the possibilities of a partial taking is somewhere between difficult and impossible.  Often for a street widening, a portion of the property is taken that does not involve a taking of any portion of the building.  This type of taking may look like the area impacted is only the landscaping.  However, a taking that looks minor may impact the driveways, parking lot or drainage retention areas.  In turn, this minor impact may have a major impact on the business conducted on the property.  A loss of business is not compensable in the vast majority of states.  In this instance the tenant faces a loss of business but will not be paid for this loss by the government.  However, the impact on the real estate is reflected in the rental rate that can be charged for the property.  This directly impacts the value of the property and the damage to the real estate is fully compensable to those who may collect as reflected in the condemnation clause. 

Often, it is the partial taking which looks relatively small and harmless that can reek havoc.  Two examples I have seen in my 30 years of experience working for property owners illustrate how a somewhat minor taking can have a major impact.     

In an actual case, the government offered the property owner the value of a small area of land and the value of the landscaping in that area.  The property was used as a mini-storage facility and the taking was between the fence surrounding the improvements on the property and the street right of way.  The government didn’t realize that the area taken included 50% of the on-site drainage retention area.  Without the ability to direct storm water into this retention area, water would back up into many of the storage units potentially damaging thousands of dollars of property in those units.  The solution was to use what little landscaped area that was left and create an underground drainage storage area at a cost of over $500,000!  All of a sudden this seeming minor taking became a major problem.

In another actual case, the site was used for a drive-through fast food operation.  A taking occurred where neither parking nor any portion of the building was taken but effectively moved the street closer to the building.  The taking reduced the stacking distance for customers already served at the drive-in window. Those customers waiting to pull out onto the street were effectively blocking other customers from being able to advance to the drive-in window.  Obviously this made the site less desirable for the intended use.  The owner was only able to resolve the problem by tearing down the existing facility and rebuilding the building farther back on the property.  This type of problem is rarely specifically addressed in the condemnation clause.  Perhaps only a clause which allows a tenant to vacate if the premises are no longer satisfactory for the tenants continue business would address this issue.  However, in such an instance, the landlord is almost at the mercy of the tenant.  Unless the landlord is willing to allow the tenant to direct his fate, the landlord needs to protect his  rights in the condemnation clause from possible instances such as this.

Another example would be a taking of less than 10% of the parking (a typical standard found in leases).  If the spaces taken are near the front door, this may make the remaining parking inconvenient for retail customers and result in a less desirable business location.  However, if the parking taken is near the back of the site where employees typically park and the site is part of a larger shopping center with a reciprocal parking agreement, the employees may park off-site with little impact on the business conducted on the premises. 

Often the loss of 10% or less of a parking lot will not trigger the loss of a tenant per the condemnation clause.  However, the value of the site may be reduced.  If the taking renders the site non-conforming per the local zoning authority, and if there is a casualty loss, the improvements cannot be rebuilt to the same size.  The reduction in available parking will reduce the size of the allowable building that can be built and may not conform to the needs of the existing tenant.

Once the taking impacts the driveways, parking lot or drainage retention areas, the impact on the building may be major or minor.  Usually preparing for the worst case will cover the takings with less of an impact. 

In another scenario in which the impact was initially unforeseen was a simple taking for a road widening.  It may not seem at first glance that losing some landscaping is threatening but the area was used for drainage retention, there might have been a major impact on the big box retailer on the property.  Depending on how the site was contoured for drainage, the loss of the retention area could have caused ponding in the parking lot or perhaps directed storm water into the building.  In this scenario, we negotiated with the government who agreed, as a part of a settlement, to allow the on-site drainage to flow into the City’s storm water facilities.  If the lease clause only addresses takings which physically take either a portion of the parking lot or the building, it will not address this type of problem.  Luckily in this instance the City accepted the problem relieving both the landlord and tenant from solving the problem.

The examples cited above happen more often than you may realize.  Therefore those drafting or reviewing condemnation clauses in leases need to take into consideration how the site was developed and the damages that might occur if there was a condemnation as well as the case law in a particular jurisdiction.

Part III - Land Leases: 

Land leases are subject to the same potential damages experienced by owner occupied property when a condemnation occurs.  Unfortunately, there are additional problems caused by separate ownership of the land and the building in a condemnation.  The language in the condemnation clause must be more precise in defining terms and articulating the rights of the parties.

Typically, the fee owner owns the present worth of the income stream provided in the lease plus the reversion of the land at the end of the lease plus the reversionary value in any improvements that are to remain at the end of the lease provided the tenant is not allowed to retain them or required to remove them.

In instances where vacant land is leased to a tenant who erects any improvements on the site, the language needs to address issues in a slightly different way.  If the condemnation clause is ignored, the tenant may be awarded the bonus value (if any) of the lease.  The bonus value is described as the difference between the market lease rate and. the contract rate in the lease, present valued for the remaining term of the lease.  The market lease rate is that rate charged for similar property as of the date of value in the condemnation case.  The contract rate is the rate currently charged the tenant as stated in the lease for the property.  For the real estate appraisers who are involved, obtaining data on land leases is very difficult.  Therefore, a determination of a true market lease rate will be difficult.

When drafting a condemnation clause for vacant land, the parties should be aware that the method used by the real estate appraisers who appraise the condemned land will be to value the property at its highest and best use.  The highest and best use of the property is clearly defined in condemnation law.  It is: “the reasonable probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value.  The four criteria the highest and best use must meet are legal permissibility, physical possibility, financial feasibility, and maximum profitability. (The Dictionary of Real Estate Appraisal, Third Edition)

The appraisal should address the value of the land, as if vacant, at its highest and best use as well as the value of the whole property as improved.  There are times when the value of the land, as vacant, at its highest and best use is different than the value of the land as a component of an improved property.

For example, assume vacant land is under a long term lease to a scrap metal dealer on a twenty year lease.  If there is industrial development in the area surrounding the property after the lease begins and if a condemnation occurs in year 10 of the lease, the value of the land at its highest and best use probably would be for industrial development.  Now, encumbered by the lease, an industrial development is not possible and the land may have a lower market value. 

Consider another example, in which vacant land is on a 99 year lease for an office building and a condemnation occurs during the lease.  The rent adjustment clause, if any, will become critical.  Further assume that the lease has a condemnation clause which gives the value of the land to the land owner and the value of the building to the tenant.  In this instance the clause is too simple.  Is the value of the land to be its value as if unencumbered and at its highest and best use?  Or alternatively, is its value as encumbered by the lease where the owner is entitled to the present value of the existing and anticipated cash flow present valued to the current date plus the residual value of the property at the end of the lease.  The parties to a lease of this nature need to articulate the value they intend to split.

If the office land lease described above is fairly old, the lease could well be below market.  Older leases often have fixed periodic rent increases which have not kept up with inflation or the market.  In the event of a condemnation, the tenant may well have an interest in the value of the land due to a “bonus value” lease situation where the contract rate is less than the market rate.  Properties in this situation are sometimes more at risk for a condemnation due to cities desiring to redevelop older areas of their city.  Parties involved with these older properties may want to review their leases.  Given the potentially large financial impact, property owners trapped with a bad condemnation lease clause such as this may find that the best alternative for them in case of a condemnation is to fight the attempted taking.

Many leases allow the tenant to recover the unamortized value of their improvements in the event of a condemnation.  However, what is the definition of unamortized?  It could be the value found in the tenant’s tax return.  It may be the value of those improvements as if amortized over their useful life.  Should it be the value amortized over the initial term of the lease if any options to renew are not automatic?  If the parties fail to define their terms, they may find themselves relying on real estate appraisers.  Because typically the appraisers for the government do not deal with issues of the unamortized values of tenant improvements, both the landlord and the tenant will need to hire an appraiser and fight it out in court.  Therefore, the better the parties define their terms up front, the better the chance to avoid additional litigation.

Another problem which often develops with land leases is establishing the value of the land in case of a condemnation.  While the lease clause may clearly spell out which party is entitled to what part of a potential award, the establishment of the land value comes down to the opinion of the various real estate appraisers involved.  In valuing improved commercial property, most appraisers attempt to use all three approaches to value – market, income and cost.  Both the market and income approaches do not break down the value of the components.   Often appraisers will attempt to avoid the cost approach due to problems determining depreciation.  However, the cost approach is the only one of the three which addresses the value of the land independently. If the appraisers hired by the government do not do a cost approach, it may be up to the parties to retain appraisers to determine the value of the land independently.  Even in this instance, they need to be given direction on the land value to be determined – as encumbered by the lease or free of encumbrances. (If the land is valued free and clear of encumbrances, it will be the highest and best use of vacant land.  If valued as encumbered by a lease, the value is limited by the rental rate in the lease.  If this is a land lease, the rental rate will probably just be capitalized.  If the landlord built the building and leases an improved property, the appraiser would probably calculate a return on the cost to build the improvements and subtract that return from the overall rental rate.  The balance would then be the rental rate attributable to the land and if there is a “market” rate of return, dividing the rent by the return would give you the value of the land as encumbered by the lease.) In these instances, the parties can provide a clarification in the condemnation clause which binds them on the method of determining the value of each party’s interest which should not impact the amount of compensation to be ultimately obtained from the government.

Part IV - Condemnation Takings v. Police Powers:

At times, the condemnation clause attempts to redefine condemnation to include other governmental actions generally known as “police powers.”   Clauses that allow the tenant to vacate the property for any change in driveways, traffic patterns, and new street medians address the government’s police powers, not the condemnation power.  .  These governmental actions are not a condemnation as defined in Lease Enhancement policies and therefore, are not insured under these various policies.

Although certain governmental actions may have an impact on the ability of the tenant to do business, they may not be compensable under condemnation law (or any other claim).  Properties have a right to reasonable access to the adjacent street system but do not have a right to the traffic flow on that street.  Therefore, when the Interstate Highway System came into being, many cities were by-passed.  Older U.S. Highways which were once lined with motels, service stations and other businesses catering to the traveling motorist found themselves now on secondary roads.  As new businesses sprung up adjacent to the Interstate Highways, the older businesses simply failed and the properties often changed their use.  There was no compensation paid to the property owners on the abandoned highways.  It is under this same theory that the placing of a median on a city street is allowed without compensation to property owners who are affected. 

While it is commonplace for major retailers to include language in the condemnation clause of their lease to deal with changes of traffic patterns, it may become a later fight with the property owner if the government causes a change of traffic pattern which comes without compensation.  It isn’t clear that the tenant can terminate a lease if a traffic pattern is changed when there is no condemnation.  If the parties want a clause to deal with a change in traffic patterns or access points, they would be better served putting this language elsewhere in the lease rather than in the condemnation clause. 

The parties should also understand that the property has the right of “reasonable ingress and egress.”  That doesn’t mean the owner gets as many driveways as he desires.  While the courts have rarely defined “reasonable,” the parties must recognize this and define their own version of reasonable if they want to avoid future litigation.

Inverse Condemnation:

Although unusual, government actions may result in an inverse condemnation, an action in which the landlord or tenant initiates a condemnation law suit against the government for damaging the property without paying compensation.  This action, in turn, may affect the landlord/tenant relationship.  Let’s say, for example, that the government changes the grade of an adjacent street without taking additional right of way.  If the grade changes results in unusable driveways, there may be a cause for inverse condemnation.  The problem may be cured by altering the driveway in which case the government should pay.  Most states allow for compensation for a change of grade that impacts the property.

It is rare to see a condemnation clause that deals with the issue of inverse condemnation for a case like this.  Even if the parties believe that the split of any award is covered by the condemnation award, there is the additional matter of the expenses involved to initiate such a lawsuit.

There also may be flooding caused by a change of grade.  If a property is below the grade of the adjacent street, a simple resurfacing of the street may cause an increase in the water flowing in the gutter which may flow into the property at a driveway.  Any damages caused may rise to the level to enable the parties to consider an inverse condemnation.

Both examples show the impact of condemnation although it is of the inverse variety.  It is extremely rare to find situations such as those cited above addressed in a condemnation clause.  It should be a relatively simple matter to include the possibility of an inverse condemnation when drafting the condemnation clause.

The Condemnation or Settlement Award:

If faced with a partial condemnation the parties should recognize that the monetary compensation paid to them is only one part of the issue.  With a partial taking, the government must outline exactly what they are going to do.  There are often right of way contracts which outlines what the government is going to do and when.  This becomes part of the consideration in the transaction. If the government fails to build the project which promoted the condemnation or settlement according to the contract or its plans which were furnished to the owner or tenant, there is an opportunity for a change of plans case against the government.  This allows the owner or tenant to recover additional damages based on the changes that had negative effect on the property.  Anyone involved in a condemnation should secure a right of way contract when negotiating with the government.  They should also obtain construction and right of way plans and save them in case there are meaningful changes.

As an example, a median break may be negotiated but unless it is in writing, getting compensated if the government closes the median may be impossible.  Let’s assume that as a part of compensation, the property owner is allowed to direct flood water from his property into an adjacent floodway which is part of freeway system.  If the government does anything to disrupt this flow, the property owner may be damaged.  This gives the owner the right to seek compensation against the government.

At times, the government’s project has several parts.  Some portion may not be built immediately and are projected for completion years in the future.  Although the general rule in a condemnation case is that you assume the project is complete on the date of value, unreasonable delays in a portion of the project  may benefit the property owner and give rise to what is known as delay damages.  Both the landlord and the tenant need to be aware of the timing of all aspects of a project and how it will impact the value of their interest in the property.  If a property is currently occupied by a tenant with 10 years remaining on a lease but the benefit of a portion of a project is not anticipated to occur for 12 years, is the existing tenant entitled to any portion of that benefit?  This is a question that we have rarely  seen addressed in a condemnation clause. 

MISC.

If there is a total taking, condemnation clauses often call for termination of the lease as of a specific date.  While this may be a good thing, it needs to be accurate.  If the federal government is the condemning agency, title passes to the government upon the declaration of taking which is typically when the case is filed.  Most condemnation clauses ignore this possibility.

The typical condemnation clause that addresses this issue calls for termination when the government takes possession of the property.  Unless the condemnation is a federal taking, this is probably the best time for all parties to terminate the lease.  If the termination is to take place when title passes, the tenant may be responsible for lease payments for years beyond when the property needs to be vacated as, in most states, title passes at the end of a case after payment is made by the government.  However, most condemning authorities have the right of immediate possession which effectively allows the government to take the right of the full use of the property other than bare title.  This usually occurs within 90 days of when a case is filed.  Often a tenant can negotiate to stay for a longer period of time but this needs to be either negotiated with the government or the tenant’s attorney needs to make a case in court for delayed possession due to extenuating circumstances.

©2010 International Amalgamated Group | Web Site Design by Lookit™ Design