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Some Considerations of Condemnation Clauses

Most leases used today are form leases containing “boiler plate” clauses. Although they are reviewed when attorneys are involved, our observation, based upon the almost universal nonchanges in standard condemnation clauses, is that they generally are accepted as written. The inference must be that they are either so expertly drawn that they anticipate all situations or are so little understood that most do not know what to do with them. Where, however, leases are drawn to order, one can find a variety of condemnation clauses, some done quite well, others less so. Some are drawn so inexpertly, that we wonder if either party had enough basic knowledge to know how to structure such clauses.

Drafting a Specialty

The condemnation clause is one that requires special knowledge and understanding. In drafting such a clause, one must understand why it is necessary, what it is supposed to accomplish and how it impacts on a tenant’s rights as against the landlord in a condemnation proceeding.

A tenant with a leasehold estate has a grant of an interest in the real estate, the extent of that estate being measured by the leasehold instrument. In the usual lease, there is a grant for a term of years (or a specific lifetime which can be equated to a term of years based upon life expectancy tables) in exchange for the payment of rent. There is a benefit to a tenant when the value of his leasehold exceeds the amount of rent that he is paying. Absent any contrary contractual arrangement (the condemnation clause) the tenant is entitled to have any benefit from that leasehold estate compensated for if it is condemned. A tenant who has a five-year remaining term to his lease under which he has a rent obligation of $1,000 a year but which space is worth $2,000 a year has the benefit of $1,000 per year for five years.

Under this example, the value of the space is measured by the rental of $2,000 per year, of which the landlord receives but $1,000 and the tenant the other $1,000. Each would be entitled to compensation for his respective interest. As the property may not be worth more than 100 percent of its value and as the tenant has been granted an interest in that property, any compensation the tenant receives is carved out of the value of the property as a whole.

Ruling in A&P Cases

As was said in Great Atlantic & Pacific Tea Co. v. State of N.Y., 22 N.Y. 2d 75, 84, 291 N.Y.S. 2d 299, 305 (1968):

“Generally speaking, where there are two or more interests or estates in a condemned parcel, the proper mode of assessing damages is to ascertain first the damage to the fee as if it were unencumbered, and then to apportion that amount among all of the estates and interest which are held in the property. . . . . In computing the value of the leasehold, the court must first ascertain the fair rental value of the premises and then deduct therefrom the actual rent reserved for the remaining period or term of the lease.”

How this rent disparity comes about very often determines the position of the parties as to whether the tenant should be entitled to compensation for loss of the lease. Most landlords, with cause, take the position of why should I give the tenant any part of the compensation for my property if he did nothing but be there when values increased, either from inflation, an increase in neighborhood values or just a miscalculation of values in making the lease?

However, the increase in rental value may come about by an expenditure by the tenant for the improvement to the property. This runs a gamut from the improvement of an “as is” building to a substantial structural alterations or additions to the erection of an entire structure under a ground lease. Obviously, when this occurs, the tenant assumes he will receive the benefits of those improvements, not only over the full term of the lease but through his option periods as well. Such expenditures not only increase the value of the property but are deemed prepaid rent by the tenant. (In re Water Street, 19 A.D. 2d 44, 24, 241 N.Y.S. 2d 44 (1963)).

One must be careful, however, in differentiation between those tenant improvements which became part of the real estate either under common law doctrines or the “alterations and improvements” clause in standard leases which reflect it and those installations which are tenants’ trade fixtures for which the tenant is entitled to additional and separate compensation (Matter of City of N.Y. [Allen Street], 256 N.Y. 236 (1931)) and which do not add to the rental value of the property, not becoming part of the landlord’s estate.

It is when the tenant has added to the value of his landlord’s estate by improvements, the enjoyment of which over the term of the lease is cut off by condemnation, that he seriously bargains for a share of that condemnation award. That share may be determined in any way the parties may agree, and the Courts, in apportioning a condemnation award, will be bound by the terms of that agreement (Traendly v. State of N.Y., 51 A.D. 2d 489, 382 N.Y.S. 2d 365 (1976)).

Many Approaches Used

Many approaches to such an agreement have been used. The basic approach is to let the measure of compensation be the difference between rent reserved and higher rental value over the term of the lease, including tenant option periods, discounted to present value based upon market rates of risk and return for leaseholds. When this happens, there are in essence three estates to be valued, making up 100 percent of the value: the landlord’s estate based upon the rent reserved in the lease, the tenant’s estate which is based upon the additional rental value over the rent reserved for the term of the lease and the landlord’s reversionary interest after the expiration of the lease. If properly valued, these three together should equal 100 percent. Because the property is most times valued by a capitalization of income and the leasehold is valued in accordance with tables on the present value of a future flow of income which mathematically do not work out the same, there is often a disparity, which is particularly egregious in longer term leases.

The drafter of a condemnation clause should be aware of the problem and attempt to treat it in his lease clause. One suggestion is to provide that in no circumstance may the owner of the fee estate receive less than the value of the lease rent capitalized plus the reversion with the tenant receiving the present worth of his rent bonus as long as it does not reduce the landlord’s award below that figure.

Very often, where improvements are made to the real estate which add to its value, the means chosen to compensate the tenant is to separate real property from trade fixtures, specifically enumerating them, and provide for an amortization of the cost of the improvements over the term of the lease. The problem is in differentiating between trade fixtures and improvements and assuming that the real estate value is increased dollar for dollar with the cost of the improvements. Probably, this is the best compromise approach, considering the alternatives, but it appears to us that the trade fixture award, if and when made, should be factored into the computations.

Where there is a land lease, with the tenant constructing the building, two approaches have been used, one the typical common laws case approach and the other a provision that the land value goes to the fee owner and the building to the tenant. There are, however, practical problems.

An Example

As an example, take a building which, when built, conformed to the maximum that could be built under the zoning regulations. Subsequently, the zoning is changed to permit more intensive use of the land resulting in an increase in value. If the land were valued only consistent with what was built on it, it has one value. If valued in accordance with its highest and best use, i.e., what could now be build on it, it has a higher value. But the property still produces income only in accordance with how it is built and produces a value based upon it. Yet the rule of law in condemnation proceedings provides for a value in accordance with highest and best use. If one first values the land based on highest and best use the building value is decreased. If one takes either current building value (assuming it could independently be fixed) or land value based upon the building as built, the land value, in terms of its value if freed from the lease, suffers. The problem has led to protracted negotiations where the problem has been recognized.

It has been suggested that there are at least two answers to the problem. First, increase in land value increases the rental value which, in any event, will increase total value. But, it does not handle the problem of an increase in value by reason of a zoning change. The second answer is probably the correct one. Buildings only have such value as they add to the land. As the land becomes increasingly more valuable and the building is less and less an adequate improvement, for whatever the reason, it becomes more and more obsolete until the land value, freed of the building, is in excess of the land as improved with that building, at which time, it would be demolished. Thus, it is the land which must first be valued at its highest and best use with the residual value between it and total value attributable to the building.

Whatever the answer, however the parties arrive at it, it must be considered in terms of knowledge of the economics of real property valuation and how the clause will work in that context. Note that we have not begun to discuss partial takings and the special problems inherent in them, in terms of apportionment of rent, reconstruction, allocation of values, etc. We reserve that for another column.

Reprinted with permission from the April 7, 1982 edition of the New York Law Journal © 2010 Incisive Media Properties, Inc. All rights reserved. Further duplication without permission is prohibited.