This article discusses improvements made by tenants on leased property and the landlord’s rights to these improvements.
A retail business owner, as a tenant, enters into a nonresidential lease agreement for commercial space. The leased premises does not contain tenant improvements since the building is nothing more than a shell.
In the lease, the tenant agrees to make all the tenant improvements necessary for him to occupy the premises and operate his business (i.e., interior walls, flooring, carpeting, lighting, plumbing, telephone and electronic wiring, etc.). The tenant will also install trade fixtures on the premises.
The lease agreement provides for the property will be delivered to the landlord on expiration of the lease “in the condition the tenant received it” less normal wear and tear.
However, no other provision in the lease addresses whether:
· improvements made by the tenant will remain with the property; or
· the property will be restored to its original condition when the lease expires.
On expiration of the lease, the tenant strips the premises of all the improvements he made and vacates. The building is returned to the landlord in its original condition, a shell, less wear and tear. The landlord replaces nearly all the tenant improvements removed in order to relet the space and make a demand on the tenant for their replacement costs.
Is the tenant liable for the landlord’s costs to replace the tenant improvements for the next tenant?
Yes! Improvements made by a tenant which are permanently affixed to real estate become fixtures, part of the real estate to which they are attached. Fixtures are to remain with the property on expiration of the tenancy, unless the landlord and the tenant agree to the contrary in the lease agreement. [Calif. Civil Code §1013]
With the exception of trade fixtures, improvements attached to the building become part of the real estate. [CC §660]
However, the landlord’s right to the improvements is conditioned on:
· the permanent or temporary nature of the improvements made by the tenant (i.e., built-in or free standing); and
· any lease provisions relating to the tenant removal of improvements or the restoration of the premises.
Examples of improvements which become part of the real estate include:
· built-ins (i.e., central air conditioning or heating, cabinets and stairwells);
· fixtures (i.e., electrical and plumbing);
· walls, doors and dropped ceilings; and
· flooring which is attached (i.e., carpeting, tile or linoleum).
On expiration of the lease, the landlord is entitled to property improvements and alterations made by the tenant, unless agreed to the contrary.
Leasehold improvement provisions
Nonresidential leases do or should contain a further- improvement provision allowing the landlord to either retain tenant improvements and alterations made by the tenant or require restoration of the property to its original condition on expiration of the lease. [See first tuesday Form 552 §9]
The further-improvement provision usually includes clauses regarding:
· who will make the improvements (landlord or tenant);
· who will pay for the improvements (landlord or tenant);
· the landlord’s consent is required before the tenant makes improvements;
· any mechanic’s liens due to improvements contracted by the tenant will be removed;
· the condition of the premises on expiration; and
· whether the improvements are to remain or be removed on expiration of the lease.
Failure to make improvements
Consider a landlord who obligates himself under a lease to make improvements. Once agreed to, the landlord must complete the improvements in a timely manner so the tenant may use them or the lease may be terminated by the tenant.
For example, a landlord agrees to make all the improvements necessary to convert a ranch into a dairy farm for a tenant who operates a dairy.
The landlord is to construct a barn and several sheds which are essential to the operation of the tenant’s dairy business.
The tenant moves into the property before the improvements begin. Several months pass and the landlord does not start construction on the promised improvements. The tenant vacates the property since it is impossible to conduct his dairy business without the barn and sheds.
In this example, the landlord’s failure to make the promised improvements is a breach of the lease agreement.
Since the landlord has breached an essential provision of the lease, the tenant may vacate the property and terminate the lease without any obligation to pay further rent. [Souza v. Joseph (1913) 22 CA 179]
Now consider a landlord who agrees to construct the shell of a building for a tenant. The tenant agrees to install all other improvements and fixtures required to occupy and use the property.
However, before the building is completed by the landlord, the building code is changed to require the installation of a sprinkler system. The tenant demands the landlord pay the cost of installing the sprinkler system since he cannot occupy the premises without the sprinkler system.
The landlord refuses to pay the additional cost to install the sprinkler system claiming the lease agreement calls for him to build the structure, not to make it ready for occupancy.
Is the tenant responsible for the cost of the sprinkler system?
Yes! It is the tenant’s responsibility to make the alterations or improvements required to bring the building into compliance with use (occupancy) ordinances since the tenant agreed to make all improvements to the structure needed in order to take occupancy. [Wong v. DiGrazia (1963) 60 C2d 525]
Alternatively, lease provisions can obligate a tenant to improve vacant, unimproved property, such as occurs with ground lease arrangements.
Improvements promised by the tenant
A tenant must complete the improvements he has agreed to construct or install on the leased premises within the time period agreed to in the lease or in a timely manner if no commencement or completion date for construction is agreed to in the lease. [CC §1657]
However, if the tenant fails to make or complete mandated improvements prior to expiration of the lease and the improvements were to remain with the property on expiration of the lease, the tenant is liable to the landlord for the cost incurred to complete the agreed-to improvements.
For example, a tenant agrees to construct additional buildings on leased property in lieu of paying rent for a one-year period. When the lease expires, the improvements will remain with the property.
The tenant fails to construct the buildings during the term of the lease. The tenant claims the lease provision calling for construction is permissive, not mandatory, since he only had to build if he needed to do so for the operation of his business.
However, the improvements were agreed to in exchange for rent. The tenant is obligated to make the improvements since the landlord bargained for them in the lease agreement. Thus, the landlord is entitled to recover an amount equal to the cost of the improvements the tenant failed to construct. [Simen v. Sam Aftergut Co. (1915) 26 CA 361]
Additionally, if the tenant agrees to and does not complete the construction of improvements which are to remain with the property on expiration of the lease, the landlord may complete the improvements. The tenant is then responsible for the landlord’s expenditures to construct the improvements he agreed to construct. [Sprague v. Fauver (1945) 71 CA2d 333]
The landlord is also entitled to recover lost rent and expenses incurred after the expiration of a lease resulting from the tenant’s failure to construct the promised improvements.
Consider a landlord who enters into a lease and agrees to construct a building for the tenant. However, after the foundation is laid, the landlord and tenant orally modify the construction arrangement. The tenant agrees to finish construction of the building in exchange for the landlord relinquishing his construction profit.
The tenant breaches the oral modification of the written lease by failing to complete the construction of the building. The breach places the landlord in financial jeopardy since he now must complete the building himself and relet it. The landlord terminates the lease, evicts the tenant and completes the construction promised by the tenant.
In this example, the tenant is not only responsible for the landlord’s costs of construction, he is also liable for lost future rents and any expenses the landlord incurs to relet the property. [Sanders Construction Company, Inc. v. San Joaquin First Federal Savings and Loan Association (1982) 136 CA3d 387]
Landlord’s consent to improvements
Lease provisions often allow a tenant to make improvements to the leased premises. However, further-improvement provisions typically call for the landlord to approve the planned improvements before construction is started.
For example, a tenant wishes to add a room to his leased premises to operate his business. The tenant begins construction without the landlord’s prior approval as called for in the lease. The addition is located in space outside the area described in the lease as the leased premises, resulting in an encroachment on other land owned by the landlord.
In the past, the landlord has approved other improvements made by the tenant. However, this time the landlord refuses to give consent and complains about the tenant’s construction and the encroachment.
The landlord continues to accept rent while he negotiates with the tenant regarding the approval of the addition and the modification of the lease to include the area subject to the encroachment.
Ultimately, after a few years of negotiations without a resolution, the landlord declares a forfeiture of the lease based on both the breach of the provision requiring his prior consent to construction and the encroachment of the unapproved improvements.
The tenant claims the landlord has waived his right to declare a forfeiture of the lease since the landlord continued to accept the rental payments after the breach and encroachment.
However, a landlord does not waive his right to consent to additional improvements by accepting rent from the tenant as long as negotiations to resolve the breach continue. [Thriftimart, Inc. v. Me & Tex (1981) 123 CA3d 751]
Likewise, when a tenant with an option to buy makes improvements with the expectation he will ultimately become the owner of the property, the landlord’s consent to improvements called for in the lease is needed before any improvements can be made.
Further, the tenant is not entitled to reimbursement for the cost of improvements, whether or not the landlord consents to the improvements. The improvements will not become the tenant’s unless he exercises his option to buy. [Whipple v. Haberle (1963) 223 CA2d 477]
Permissive improvements by the tenant
Some lease provisions allow a tenant to make improvements, but do not specifically mandate that he do so. In the prior example, the tenant was not obligated to make the improvements, but was merely authorized to do so without the need for further consent from the landlord.
For instance, a landlord and tenant sign a long-term lease. A lease provision authorizes the tenant to demolish an existing building located on the property and construct a new one in its place without obtaining the landlord’s prior consent. The rent is based on the current value of the premises.
However, the lease provision does not state a specific time period for demolition or construction.
The tenant does not make an effort to tear down the old building or erect a new one. Ultimately, the landlord claims the tenant has breached the lease for failure to demolish the existing building and construct a new one.
However, the tenant has not breached the lease. The tenant was not obligated to build since the lease contained no promise by the tenant to build. The tenant was merely authorized to build without the need for further consent.
Thus, the tenant was granted a privilege to make improvements. Further improvements on the tenant’s part were not mandatory, they were permissive. [Kusmark v. Montgomery Ward and Co. (1967) 249 CA2d 585]
Now consider a lease provision requiring that a tenant construct improvements on a vacant parcel he has leased. A date is not specified for completion of the improvements. Since construction of improvements is mandated to occur, the tenant must complete construction within a reasonable period of time.
For example, a landlord leases unimproved land to a tenant who is a developer. The tenant is obligated to build improvements, contingent upon his ability to obtain a construction loan. A time period is not set for commencement or completion of the construction. Also, no provision authorizes the landlord to terminate the lease if the required construction is not completed.
However, the lease gives the tenant the right to terminate the lease after one year if financing is not found to fund the construction.
The tenant does not find financing within the one-year period. However, the tenant does not exercise his right to cancel the lease and avoid the payment of future rents. Instead, the tenant continues his good faith effort to locate and qualify for construction financing. Ultimately, financing is not located and construction is not commenced.
A few years after commencement of the lease, the landlord claims the lease has been breached for lack of the promised construction.
The tenant claims the landlord cannot terminate the lease as long as the tenant continues his good faith effort to locate financing and remains solvent to qualify for the financing.
In this example, the tenant breached the lease. He failed to construct the intended improvements within a reasonable period of time. The original purpose of the lease was to have buildings erected without specifying a completion date. However, the landlord did give the tenant a reasonable amount of time — forty months — in which to procure financing for the transaction before terminating the lease.
A landlord cannot be forced to leave the property unimproved forever when the original intention under the lease was to develop the land. [City of Stockton v. Stockton Plaza Corporation (1968) 261 CA2d 639]
Surrender of improvements
All tenant improvements and alterations are to remain with the leased property on expiration or other termination of the lease, unless a lease provision exists permitting or mandating removal by the tenant.
Most leases merely provide for the property to be returned in good condition, less normal wear and tear for the years of the tenant’s occupancy.
Thus, the tenant is not required, much less allowed, to restore the property to the actual condition he received it in when he took possession. The covenant for ordinary care of the premises during the lease does not mean removal of tenant improvements or renovation to eliminate deterioration, obsolescence or wear and tear due to the use permitted to the tenant. [Kanner v. Globe Bottling Co. (1969) 273 CA2d 559]
Consider a landlord and tenant who enter into a lease of nonresidential property. The lease agreement contains a provision requiring the tenant, if the landlord at his option so demands, to restore the premises to the original condition received by the tenant, less normal wear and tear.
The tenant makes all the tenant improvements necessary to operate his business, such as installation of a concrete vault, the removal of partitions and a stairway, and the closing of two entrances into the premises.
On expiration of the lease, the tenant vacates the premises. The landlord exercises his right to require removal of tenant improvements by making a demand on the tenant to restore the premises, which the tenant rejects.
The landlord incurs costs to restore most of the premises to prepare it for reletting to a new tenant.
The landlord claims the tenant is liable for costs he incurred to restore the premises since the tenant’s improvements radically altered the premises and made it unrentable to others.
The tenant claims he is not liable for the landlord’s costs to remove the improvements and restore the premises to its original condition since the alterations are beneficial to the property.
Is the tenant liable for the landlord’s costs to restore the premises to a rentable condition?
Yes! On expiration of the lease, the tenant is obligated to restore the premises to its original condition, less normal wear and tear, since the lease provides for restoration by the tenant on a demand from the landlord. The tenant improvements made the premises less desirable and unsuitable for other occupants. On the tenant’s failure to restore the premises, the landlord was forced to incur restoration expenses to relet the premises. Thus, the tenant is liable for the landlord’s expenditures to restore the premises in order to relet it to a new tenant. [Masonic Temple Ass’n. of Sacramento v. Stockholders Auxiliary Corporation (1933) 130 CA 234]
In another example, a lease states a tenant will return the property in good repair and restore the premises to its original condition, less normal wear and tear.
The tenant modifies the premises to run his business. After the lease expires, the tenant moves out and leaves all his improvements and modifications on the property.
The landlord is unable to relet the premises in the condition left by the tenant.
In this example, the tenant is liable for the reasonable costs incurred by the landlord to restore the premises to its original condition and for lost rental income for the period of time it takes to make the repairs.
Thus, lease provisions requiring restoration of the premises to its original condition require the tenant to restore the property to its original condition, minus any normal deterioration due to time and use of the premises as permitted. [Iverson v. Spang Industries (1975) 45 CA3d 303]
If a lease does not require the tenant to restore the property to the condition it was in when received, the tenant may only remove his personal improvements, called trade improvements or trade fixtures.
The tenant need only leave the property and tenant improvements in good condition. [Formosa Corp. v. Rogers (1951) 108 CA2d 397]
Reimbursement for tenant improvements on eviction
Compensation may be due to a tenant who has improved his property and is evicted prior to expiration of the lease.
A tenant who is evicted is entitled to the rental value of his improvements for the remainder of his unexpired lease term.
The tenant is not, however, entitled to reimbursement for the market value or cost of the improvements. Since reimbursement is not required, the landlord receives a windfall profit for his use of the tenant’s improvements until they revert to him on expiration of the original lease.
Thus, an evicted tenant is limited to collecting the reasonable value for the landlord’s use of the improvements during the remainder of the term on the original lease. [Asell v. Rodrigues (1973) 32 CA3d 817]
Real estate fixtures vs. trade fixtures
Two types of fixtures exist to distinguish improvements installed on buildings located on a parcel of real estate:
· real estate fixtures; and
· trade fixtures.
A real estate fixture is personal property which has become attached to the real estate. It becomes part of the real estate it is attached to and is conveyed with the property. [CC §§660, 1013]
In other words, if a tenant rents an office and builds bookshelves into the wall rather than merely anchoring them to the wall, the bookshelves become part of the improvements located on the real estate.
When the lease expires, real estate fixtures are the property of the landlord. The landlord takes possession of the real estate fixtures as part of the real estate surrendered to the landlord, unless the lease provides for restoration or permits removal of the improvements by the tenant. The passage of real estate fixtures from tenant to landlord on expiration of the lease is a conveyance called reversion. [City of Beverly Hills v. Albright (1960)184 CA2d 562]
However, trade fixtures do not revert to the landlord on expiration of the lease.
A trade fixture is an improvement which is attached to the real estate by the tenant that is peculiar to the operation of his business.
For example, a tenant leases property to operate a beauty salon. The tenant moves in work-related furnishings (i.e., mirrors, salon chairs, wash stations, dryers and the security system) which are needed to run the business. The items are attached to the floor, walls, plumbing and electrical leads.
On expiration of the lease, the tenant removes the fixtures which were used to render the services offered by the business. The landlord claims the fixtures are improvements to his property and cannot be removed since they have become part of the real estate.
However, furnishings which are unique to the operation of the business are considered trade fixtures even though the furnishings are attached and built into the structure. Thus, they are removable by the tenant.
A tenant may remove any trade fixtures at the end of or anytime during the lease term if the removal can be done without damaging the premises. [Beebe v. Richards (1953) 115 CA2d 589]
Fixtures that have become an integral part of the building structure due to the way they are attached or the general purpose they serve cannot be removed. Examples of fixtures not used to render services include toilets, air conditioners, vent conduits, sprinkler systems and lowered ceilings. [CC §1019]
Trade fixtures as security
Lease agreements often contain a default provision prohibiting a tenant from removing trade fixtures when he breaches the lease. The tenant (and a tenant’s unsecured creditors) no longer have a right to the trade fixtures under a default provision.
Consider a tenant who signs a commercial lease agreement to use the premises to operate a frozen packaging plant on the premises.
The lease states all fixtures, trade or leasehold, will belong to the landlord should the lease be terminated due to a breach by the tenant.
The tenant later encumbers his trade fixtures by borrowing money against them. The tenant later defaults on his lease payments.
While in default on the lease, the tenant surrenders the property to the landlord, including all trade fixtures.
Does the lender secured by the trade fixtures have a right to repossess them?
No! The tenant lost his ownership right to remove the trade fixtures under the lease. Any right to the fixtures held by the secured lender is similarly lost since the lender is junior in time and thus subordinate to the landlord’s interest in the fixtures under the lease.
However, if the trade fixtures installed by the tenant are owned by a third party, or if a third party had a lien on them at the time of their installation, the landlord has no more right to them than the tenant. [Goldie v. Bauchet Properties (1975) 15 C3d 307]
Notice of Nonresponsibility
A landlord may find himself paying for improvements made by the tenant if he does not post a notice on the premises of his intention not to be responsible for the improvements, called a Notice of Nonresponsibility, and record the notice with the county recorder.
Tenants occasionally contract for improvements to be constructed on the premises they have leased. Any mechanic’s lien by a contractor for nonpayment initially attaches to the tenant’s leasehold interest in the property. [CC §3128]
However, the mechanic’s lien for unpaid labor and materials may also attach to the fee simple interest held by the landlord if the landlord or his property manager:
· acquires knowledge the construction is taking place; and
· fails to post and record a Notice of Nonresponsibility.
A Notice of Nonresponsibility is a written notice which must be:
· posted in a conspicuous place on the premises within ten days after the landlord or his property manager first has knowledge of the construction; and
· recorded with the county recorder’s office within the same ten-day period. [CC §3094]
However, the landlord who becomes aware of the construction and fails to post and record the nonresponsibility notice is not personally liable to the contractor. Rather, the contractor can only lien the landlord’s interest in the real estate and then foreclose on his lien to collect for unpaid labor and materials delivered to improve the property under contract with the tenant. [Peterson v. Freiermuth (1911) 17 CA 609]
Further, a mechanic’s lien can attach to the landlord’s interest even when he has posted and recorded a Notice of Nonresponsibility if the lease requires the tenant to make improvements.
For example, a lease states the tenant is to make certain improvements as a condition of renting the property. Since the improvements are not permissive, the tenant is deemed to be the landlord’s agent when he contracts for the construction of the mandated improvements.
Thus, the mechanic’s lien incurred by the tenant will attach to both the tenant’s and the landlord’s interest in the property despite any posting and recording of a Notice of Nonresponsibility. The lease mandated the tenant to construct improvements. [Los Banos Gravel Company v. Freeman (1976) 58 CA3d 785]
Had the lease merely authorized the tenant to make nonmandatory (permissive) improvements or make improvements subject to or without the landlord’s prior consent, the tenant is not then acting as an agent for the landlord. Thus, the landlord’s interest in the property will not be subject to a mechanic’s lien if the Notice of Nonresponsibility is timely posted and recorded on discovery of the tenant improvements. [Baker v. Hubbard (1980) 101 CA3d 226]
Additionally, a mechanic’s lien cannot be recorded against the landlord if the improvements are removed by the contractor recording the lien.
For example, a tenant contracts to have air conditioning installed in his building. The contractor sells the equipment to the tenant under a conditional sales contract. The contractor retains title to the equipment as security until the sales contract debt is paid.
The landlord’s consent to the improvements is not obtained by the tenant, but the landlord has knowledge the work has commenced. The landlord does not post a Notice of Nonresponsibility.
Later, after the air conditioning units are installed, the tenant vacates the property.
The contractor is not paid and files a mechanic’s lien against the landlord’s fee interest in the property. Further, the contractor repossesses the air conditioning units and resells them at a loss, which he now seeks to recover under his lien.
However, by his election to repossess the units, the contractor waived his right to pursue the mechanic’s lien to foreclosure.
Whether the air conditioning units are considered a removable fixture due to the financing, or a property improvement permitting the recording of a mechanic’s lien, is no longer an issue after their removal.
The contractor removed the air conditioning units as authorized by the conditional sales contract and chose to treat the units as personal property, not real estate fixtures. Thus, the contractor lost his lien rights for nonpayment. [Cornell v. Sennes (1971) 18 CA3d 126]
Consider the tenant who leases a property containing tanks for holding gasoline. The tenant negotiates a reduced rental payment in exchange for installing fuel pumps free of any liens.
The tenant purchases the pumps on credit and the pumps are installed. The supplier of the pumps does not receive a Uniform Commercial Code (UCC-1) financing statement from the tenant, and thus does not file a UCC-1 with the Secretary of State, a requisite to perfecting the supplier’s lien on the pumps.
Later, the pump supplier claims title to the pumps due to the unpaid installation debt and seeks to repossess them.
However, the landlord owns the pumps as fixtures which became part of the real estate. He gave consideration in the form of reduced rent to acquire the pumps. More importantly, the pump supplier failed to perfect its lien on installation of the pumps. [Southland Corp. v. Emerald Oil Company (9th Cir. 1986) 789 F2d 1441]