Include Five Protections in Lease Condemnation Clause

Although just about every lease has one, the condemnation clause is often overlooked. That’s understandable. After all, when landlords and tenants sit down to negotiate a lease, the possibility that the property will be condemned during the lease term is probably the furthest thing from their minds. But every once in a while, it does actually happen. And on those occasions, the parties are usually taken by surprise. Only upon receiving notice of condemnation do they wake up to the massive dollars and business implications involved. That’s why it’s so important to vet the condemnation clause in your own leases to ensure it properly protects your interests.

What Is Condemnation?

Condemnation, a.k.a. “eminent domain,” is the power of federal, state, and local governments to take private property for public use—for example, condemning an office building to build a school. The catch: The government must provide fair compensation to the owners of the property it takes.

Tenants’ Condemnation Rights

Of course, the landlord/owner is in line for such compensation. But what some landlords may not recognize is that tenants are also entitled to claim a share of the condemnation award to compensate them for loss of business value and leasehold rights such as:

• “Bonus value”—that is, the difference between the lease rent and market rents (when the latter is higher);
• Damages if a partial condemnation leaves the lease intact but renders it less valuable;
• Improvements the tenant has constructed on the property (even when the tenant is required to remove those improvements at the end of the lease);
• Loss of goodwill resulting from the taking; and
• Relocation costs.

The way it usually works: The government pays a lump-sum award to the landlord covering the entire property. Then, the tenants can file claims for a portion of that award. Bottom line: The tenants’ compensation may come out of the landlord’s pocket.

The Importance of the Lease

The good news for landlords is that tenants can waive their rights to compensation. And because they’re typically drafted by landlords, standard leases often include condemnation clauses entitling the landlord to the entire condemnation award and waiving the tenants’ right to assert claims for its own losses. But as with any other lease clauses favoring the landlord, courts scrutinize condemnation waivers carefully and won’t enforce them unless they’re clear and unambiguous. Consider the following two cases, both from California:  

Landlord wins. In 2001, tenants leased property for use as a gas station and minimart. Four years later, they assigned the lease on the same terms and conditions to a new tenant. When the State of California condemned the property to widen the adjacent highway in 2016, the assignee/tenant claimed it was entitled to a portion of the condemnation award. But the court said no dice. Luckily for the landlord, it had the foresight to include the following clause in the original lease:

LESSEE hereby irrevocably assigns to LESSOR any right to compensation or damages to which LESSEE may become entitled by reason for the condemnation of all or a part of the demised premises.

The language was clear and enforceable, the California court reasoned. And because the 2005 assignment maintained the original lease terms, it was enforceable against the new tenant [People ex rel. DOT v. Hawara, 2019 Cal. App. Unpub. LEXIS 7098, 2019 WL 5445552].

Landlord loses. After condemning property leased for restaurant use, California awarded compensation of $12.3 million, including $6.2 million for lost property interests and $6.1 million for lost leasehold value, including goodwill. The restaurant tenant put in a claim for the latter, and the landlord objected, citing the condemnation waiver in the lease. But this time the tenant won. The difference was the lease language:

All awards for the taking of any part of the Premises or any payment made under the threat of the exercise of the power of eminent domain shall be the property of the Landlord, whether made as compensation for the diminution of the value of the leasehold or for the taking of the fee or as severance damages.

According to the California high court, the waiver applied only to the property losses and didn’t say anything about goodwill, which is “separate and apart” from the parties’ interest in the property taken. Result: The tenant had a legitimate claim to the $6.1 million award for lost leasehold value [Thee Aguila v. Century Law Group, Case No. B289452, Cal. Ct. App., July 2, 2019].

The Five Issues to Consider

Relying on boilerplate condemnation clauses is a perilous proposition that could cost you a great deal of money. So, pay attention to the clause and ensure that your clause, like our Model Lease Clause: Establish Ground Rules in Case Leased Property Is Condemned, addresses the following five key issues.

1. Who gets the money? As we’ve seen, tenants are entitled to condemnation compensation but may also waive those rights. First choice: Require the tenant to waive 100 percent of the condemnation award, including both the property and business losses. The Thee Aguila case above is an illustration of the need to expressly spell out the waiver’s inclusion of goodwill and other business-related losses the tenant incurs as a result of the condemnation. Of course, the tenant is apt to bristle at waiving right to compensation for lost goodwill, improvements it paid for, relocation expenses, and other business losses. So, unless you’re in a strong bargaining position, you’ll probably have to compromise the way our Model Clause does [Clause, par. 3].

2. What happens if entire property is condemned? Condemnation may affect some or all of the property, so your lease needs to address both contingencies. First, explain what happens if the entire property is condemned. In most cases, total condemnation is treated as a terminating event relieving both parties of further responsibilities under the lease. After all, once the property is condemned, there’s nothing left to lease [Clause, par. 1].

3. What happens if only part of property is condemned? Things get trickier when the condemnation affects only part of the property. Key question: Does the condemnation defeat the tenant’s purpose in leasing the property? If the answer is yes, the tenant should have the right to terminate the lease just as if the entire property was condemned [Clause, par. 1].

4. What happens if partial condemnation doesn’t render premises untenantable? The tenant should not have termination rights if it can still reasonably operate its business after the condemnation. To avoid post-condemnation termination disputes, clarify what kind (or extent) of a condemnation would cross the line and make it impossible for the tenant to operate its business in terms of either percentage of or portion of the property condemned [Clause, par. 1].

5. What is landlord’s obligation to restore after partial condemnation? One way to keep a tenant in place after a partial condemnation is by promising to make immediate and reasonable efforts to restore the property to as close to its pre-condemnation value as possible. Restoration will have to be at your expense, although you may be able to require the tenant to contribute. In the meantime, you’ll probably have to grant the tenant a prorated rent reduction until the restoration is complete [Clause, par. 2]. Another option may be to make any other property you own available to the tenant after the condemnation.