Lenders Should Contract for the Right to Recover Lost Goodwill Proceeds when Commercial Property is taken in Eminent Domain

Business Goodwill Generally

In California, the “goodwill” of a business “consists of the benefits that accrue to a business as a result of its location, reputation for dependability, skill or quality, and any other circumstances resulting in probable retention of old or acquisition of new patronage.” Cal. Code Civ. Proc. § 1263.510(b). Put another way: “Goodwill is the amount by which a business’s overall value exceeds the value of its constituent assets, often due to a recognizable brand name, a sterling reputation, or an ideal location. Regardless of the cause, however, goodwill almost always translates into a business’s profitability.” People ex rel. Dept. of Transp. v. Dry Canyon Enterprises, LLC (2012) 211 Cal.App.4th 486, 493–94 (internal citation omitted).

Under California Eminent Domain Law, only the owner of a business conducted on condemned property may claim compensation for lost business goodwill. Cal. Code Civ. Proc. § 1263.510 (providing that upon proof of certain facts, “[t]he owner of a business conducted on the property taken . . . shall be compensated for loss of goodwill . . .”).

Lenders Can Contract for the Right to Recover Lost Goodwill

Despite the general rule that only the owner of a business is entitled to recover lost goodwill, courts have held that parties can contract for the assignment of business goodwill proceeds in an eminent domain action. See e.g., Redevelopment Agency v. International House of Pancakes, Inc. (1992) 9 Cal.App.4th 1343, 1348 (acknowledging that parties can contract for the assignment of an award for loss of business goodwill); Chhour v. Community Redevelopment (1996) 46 Cal.App.4th 273, 282–83 (holding “[a] tenant and landlord may apportion a condemnation award any way they see fit, [] and a tenant may assign his rights in a condemnation award”).

Applying Chhour’s apportionment rule, the court in Galardi Group Franchise & Leasing, LLC v. City of El Cajon (2011) 196 Cal.App.4th 280, 282, upheld an assignment of any condemnation award from the lessee-restaurant operator to the lessor as entitling the lessor to lost goodwill damages. After the city condemned the land on which the restaurant operated, the lessor sued the condemning city for inverse condemnation, seeking damages for lost goodwill based on a waiver of rights to any condemnation award by the lessee-restaurant operator in the operating agreement, as well as a subsequent explicit assignment of any right to lost goodwill. Id. at 283. The trial court entered judgment for the city after finding the waiver clause in the operating agreement constituted a waiver as to any right to recover from a condemning agency, and that the subsequent assignment was “ineffectual” because the lessee no longer had any interest to assign because of the earlier wavier.  Id. at 283–84.  The Court of Appeal reversed, holding “the parties intended the waiver clause to define their respective rights to goodwill damages vis-à-vis one another.”  Id. at 287.

The lessor in Galardi was a franchisor that had entered into an operating agreement with the lessee to operate a limited franchise.  Id. at 283.  The operating agreement between the lessor and lessee contained a waiver clause stating “[i]f all or any part of the premises is condemned for public or quasi-public use, [lessee] waives all right to or interest in any condemnation award or settlement.”  Id. at 286.  After the city condemned the property, the lessor and lessee executed an assignment whereby the lessee-restaurant operator specifically assigned any claim it had for lost goodwill compensation to the lessor.  Id. at 283.  The condemning city argued the lessee-restaurant operator was the owner entitled to lost goodwill, and that, alternatively, the waiver in the operating agreement made the later assignment ineffectual because the lessee no longer had any interest to assign.  Id.  The court rejected these arguments, reiterating the rule that a tenant may assign his rights in a condemnation award, and concluding the parties intended the waiver clause to constitute an assignment of the lessee-restaurant operator’s right to lost goodwill.  Id. at 287–88 (citing Chhour).

Conclusion and Take Away Points

Lenders use a variety of appraisal methods when valuing commercial real property in the context of making lending decisions. Sometimes the property is tenant-occupied, and the lender can rely on a rent roll to capitalize the income of the property and determine its value. In other cases, the real estate has an owner-operated business on the property, allowing the lender to capitalize the income of the owner’s business. Regardless, the collateral package relied upon by the lender in making lending decisions often includes some component of business goodwill attributable to the business operated on the property.

Because the California Eminent Domain Law only compensates the owner of a business operated on property that is condemned for lost goodwill, lenders should be cognizant of whether any appraisal method used includes any component of business goodwill. To ensure that the lender is adequately protected in these situations, the lender’s operative deed of trust should include an assignment of and lien on all condemnation proceeds, including any lost business goodwill.