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When a tenant commissions construction work, it creates a complex mechanics lien situation. Mechanics lien claims, after all, are filed against the property itself. The result is that the property owner would get penalized for a tenant’s contractual default.

States handles this situation differently (of course).  While there are ways to file a claim against the property owner’s interest in many states, claimants are almost always allowed to file a mechanics lien claim against the tenant’s “leasehold interest” in the property.  This limited encumbrance on the property can be problematic for tenants, property owners, lenders and others, but what exactly does it mean?  How is it foreclosed upon?  And, what happens when the tenant’s lease is terminated?

How The Leasehold Estate Became An Issue in Wang Electric v Smoke Tree Resort

Funny thing about this case is that this situation could have been avoided entirely if this one particular subcontractor had filed a mechanics lien against the property owner’s interest in the property.  This Wang Electric Inc. v. Smoke Tree Resort case addresses the validity of multiple subcontractor liens. Most of the subcontractors filed full liens against the owner’s interest properly because the tenant was ruled to be an “agent” of the owner, but one claimant only filed and foreclosed against the leasehold estate.

Trouble for that contractor is that the tenant’s lease was terminated. What’s the use of a lien against a leasehold estate that doesn’t exist?

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Leasehold Estate Doesn’t Exist…But What About The Tenant Improvements Left Behind?

The leasehold estate ceased to exist with the lease was terminated in the the Wang Electric case, but the subcontractor claimant argued that it still had a right to claim a lien against the improvements the tenant left behind.

The liening subcontractor – Adobe Drywall LLC – relied on a case from 1968 (Hayward Lumber & Investment v. Graham) to support its position.  In that case, a mechanics lien claim against the leasehold estate was foreclosed upon against the improvements the tenant left behind. There were a lot of distinguishing factors in that decision, however, as: (1) The tenant only leased the land from the landlord and all the improvements were the tenant’s own; and (2) There wasn’t a contractual provision, found in many modern leases, that all tenant improvements retroactively become the property of the owner at lease termination.

The Hayward court adopted decisions from courts in California and Oregon, which construed lien statutes similar to Arizona’s, to conclude that “when improvements are made to property solely at the instance of a tenant, Laborers may impose liens on the improvements even though they may not impose liens on the underlying realty.”

The Wang Electric appeals court even acknowledged that the situations in this case were different from any precedent in Arizona, including the Hayward case:

Hayward Lumber is distinguishable because it involved construction of a building entirely at the tenant’s instance…The court did not address the viability of a lien on improvements made within a structure owned by a landlord who did not order the improvements.

The court looked at Hayward Lumber and other precedent in Arizona to derive the following legal principles applicable to these tenant leasehold mechanics lien situations:

First, a Laborer’s mechanic’s lien imposed solely against a tenant’s interest in improvements made to leased premises survives termination of the lease if the landlord has no ownership interest in the improvements…Second, the lien extinguishes if imposed against improvements in which a landlord has an ownership interest unless the tenant acted as the landlord’s agent or the landlord is estopped from denying the agency.

What did this mean for the instant situation?  Here, the court is really confusing.  The result is clear enough, as the court appears to have reversed the trial courts and upheld the Adobe Drywall lien.  Since the lien is only against the leasehold estate, the result appears to be that there is some utility in the lien even under these circumstances.  What exact utility is unclear:

Applying these principles to this case, we decide Adobe’s lien survived REM’s lease termination because, as previously explained, see supra…REM served as Smoke Tree’s agent for the purposes of the lien statutes. Because REM’s leasehold estate no longer exists, however, Adobe’s lien necessarily is one against Smoke Tree’s interests…

Lessons for Mechanics Lien Claimants in Arizona

If you are filing a mechanics lien claim in Arizona and the construction work was initiated by a tenant, your best case scenario is that the tenant be considered an “agent” of the property owner. In this case, you could file the lien against the owner and the tenant. If you cannot, however, the Wang Elec Inc v. Smoke Tree Resort LLC case is a source of optimism.

Liens against a leasehold estate can be foreclosed upon and have some utility when the leasehold estate still exists.  That much is obvious.  Now, however, claimants also have some room for recovery even when a leasehold estate is terminated before the foreclosure.  The details, unfortunately, are still unclear.

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