Owner’s Liability for Tenant Improvements in Commerical Leasing

By Renee Gerstman

Most commercial leases allow for tenant improvements. Some leases provide for complete owner control of the process, including, design, construction and payment for the improvements. Other leases place the burden of construction entirely on the tenant with no control by the owner. However, most contract provisions fall between these two opposing points on the spectrum and allow for owner approval of the tenant’s designs and plans with each party bearing some of the cost of the improvements. The rationale for mixed responsibility makes sense. Owners want input on the structural and aesthetic changes to their property while tenants want to have control over the functional layout of the space that will bring out their business personality.

The combined responsibility for construction of tenant improvements can give rise to complex legal issues when the contractor and subcontractors are not paid and liens are imposed against the property. These legal issues were brought to the forefront in the case of Wang Electric, Inc. v. Smoke Tree Resort, LLC, 230 Ariz. 314, 283 P.3d 45 (App. 2012). In Wang, the court addressed whether the landlord could be held responsible under a theory of unjust enrichment for improvements made by the tenant and whether the mechanic’s liens attached to the landlord’s interest or only the tenant’s leasehold interest in the property.

Unjust Enrichment

The court of appeals resolved the unjust enrichment claim in favor of the landlord, holding “that a contractor hired by a tenant to make improvements to leasehold premises, or subcontractors retained by that contractor, can recover unpaid monies only when that owner has engaged in improper conduct.” The court rejected the contractor’s argument that the owner’s retention of the right to approve plans was improper as it was a right typically retained by a property owner.  A key factor in the court’s decision was the fact that the contractor was retained by the tenant and not the owner. The owner’s right to approve the plans and obligation to reimburse the tenant for a significant portion of those improvements did not alter that result.

Mechanic’s Liens

The court took a different approach when it came to the extent of the mechanic’s lien and held that a mechanic’s lien can apply not only to the leasehold interest but also to the owner’s interest in the property.   In reaching its decision, the court looked at prior case law interpreting Arizona’s mechanic liens statutes which held that the terms of the lease may create statutory agency relationship binding the owner’s interest in addition to the leasehold interest as security for the work. Language that requires a tenant to make improvements or provides extensive control by the owner over the construction creates such an agency. The practice of including self- serving language in a lease  negating the existence of an agency or limiting the ability of a workman performing work for a tenant to assert a lien against the owner’s interest in the property was disapproved by the court.

A distinction remains after Wang for those circumstances where the tenant improvements are done solely at the instance of the tenant and not required by the owner or subject to significant control by the owner. In those instances, it may still be possible for the owner to avoid both liability under the theory of unjust enrichment and imposition of a lien against its interest.

Lessons to be learned from Wang

Owners may not rely on lease provisions with their tenants to avoid a lien attaching against their interest in the property. Rather, owners must put practical safeguards in place to ensure that any tenant improvements are timely paid by the tenant, take security for the improvements, require the posting of a bond or letter of credit.

Renee Gerstman is a partner with the Phoenix law firm of Jaburg Wilk. Renee can be reached at 602.248.1049 or email rbg@jaburgwilk.com.

This article is not intended to provide legal advice and it only relates to Arizona law. It does not consider the scope of law in the states other than Arizona. Always consult an attorney for legal advice concerning your particular situation.