There's Dignity (and Profit!) in Hard Work:
Court Allows Landlord Who Takes Back Abandoned Retail Property to Keep Profits from Business Operations and Full Non-Discounted Breach of Lease Claim Against Abandoning Tenant

In a significant victory for commercial landlords, the California Court of Appeals for the Second District recently ruled that notwithstanding a landlord's ability to profitably run a business on premises abandoned by a tenant, the landlord continued to be entitled to seek recovery of the full undiscounted unpaid rents and other damages under the lease.

In Lu v. Grewal (2005) 130 Cal. App. 4th 841, the tenant entered into a 10-year lease in 1993 to operate a gas station and convenience store in Los Angeles. Shortly after executing the lease, the tenant assigned its interest under the lease to Mepco Oil, Inc.. The assignment, however, did not release the original tenant from the lease obligations. The lease required the tenant to maintain the property in good condition and to repair and indemnify the landlord from any and all claims and expenses relative to the use of the property. The lease also provided that the tenant would assume the risk of damages to the improvements located on the premises.

Lu, the successor to the original landlord under the lease, purchased the property and assumed the lease in August of 2000 and thereafter received only a single monthly installment of rent from Mepco Oil. In October of 2000, the landlord discovered that Mepco Oil had abandoned the property and that all of the gas pumps and equipment within the convenience store had been removed. The landlord decided to make repairs and improvements necessary for the operation of a gas station and convenience store on the property. After laboring seven days a week for over three months "practically sleeping at the gas station," the landlord was finally able to run the business at a profit. The landlord continued to run the business while listing the property for sale or lease.

After two years of operating the business, but having no success with either leasing or selling the property, the landlord filed an action against the original tenant for breach of lease seeking unpaid rent, late charges, and damages resulting from the removal of the gas pumps and other equipment from the property. The tenant asserted that the landlord should not recover any damages from the tenant if the landlord received more revenue from operating the gas station and convenience store business than the landlord would have received in future rent payments under the lease. The trial court ruled in favor of the tenant, adopting the tenant's argument that the landlord had fully mitigated its damages by deriving a profit from the operation of the business exceeding the amount of the unpaid rent. The trial court also awarded the tenant over $200,000 in legal fees and costs as the "prevailing party" under the lease.

The landlord appealed the decision to the California Court of Appeals, arguing, among other things, that (i) the purpose of Civil Code section 1951.2 is to encourage productive use of vacant commercial property after abandonment and (ii) the statute contemplates mitigation only in terms of efforts to relet the vacant premises.

In reversing the decision of the trial court, the appellate court noted that pursuant to Civil Code section 1951.2, abandonment of a lease by a tenant constitutes an automatic termination of the lease and converts a landlord's continuing right to rent under the lease into a claim for damages based on lost rents. The Court also noted that under the statute, the landlord may recover damages only to the extent unpaid rent exceeds the "amount of such rental loss that the tenant proves could have been reasonably avoided." A landlord has an obligation to mitigate its damages by undertaking reasonable and good faith efforts to re-let the property, but the burden is on the tenant to prove whether or not the landlord has done so. In this particular case, the evidence established that the landlord had repeatedly attempted to re-let or sell the property without success.

While the landlord took the position that the fair market rental value of the property was the appropriate measure of mitigation under section 1951.2, the tenant asserted that mitigation should be based on either (a) the profits of the new business operated by the landlord or (b) the increased value realized by a sale of the property together with a profitable business. The court rejected the tenant's position, determining that the tenant should not be entitled to benefit from the landlord's "hard work and capital in making the property productive… nor should the [landlord] be punished for bringing the property back to life." As the court further noted: "[a] tenant has an interest neither in the value of the land, nor in the value of the landowner's business ventures."

Even if a sale of the property had been completed, any profit realized by the landlord as a result of the sale would not reduce the tenant's liability for unpaid rent. A breaching tenant, according to the court, "cannot claim an interest in the value of the property itself - a value its lease never entitled it to profit from." In addition to the lost rent, the landlord was also entitled to recover other damages caused by the tenant's breach of the lease by way of abandonment. As the lease required the tenant to assume the risk of damage to the premises (ostensibly, an insurable risk), the landlord could recover the reasonable expenses incurred in retaking possession of the property and making necessary repairs, such as purchasing and installing new gas pumps and related equipment and restocking the convenience store, and in preparing the property for re-letting.

The Court of Appeals sent the case back to the trial court for a determination of the amount of lost rent reasonably suffered by the landlord, irrespective of any profit realized in operating the gas station and convenience store.

The Lu decision confirms that as long as a commercial landlord takes reasonable action to mitigate its lost rent damages by attempting to re-let the property in the event of an abandonment, no other profitable activities undertaken by the landlord relative to the operation of the property will offset the landlord's right to lost rents and other damages specified by the lease.

If you have any questions regarding any real estate legal matter, in San Diego please contact Brian Frasch, Esq. (litigation) at bfrasch@gordonrees.com or Eric Young, Esq. (transactions) at eyoung@gordonrees.com or call us at (619) 696-6700. In San Francisco, please contact Phillip Wang at pwang@gordonrees.com or call him at (415) 986-5900.