Retail Property Values and Land Use Regulation: Judicial Approaches to Measuring Diminution of Value and Legal Strategies to Redress Loss of Property Value

The U.S. Supreme Court's takings decisions have articulated various “tests” for determining whether or not a regulation effects a taking, but the Court has not adopted a single theory of valuation as a constitutional requirement for establishing a fair rate of return. See Walter, “Appraisal Methodology and Regulatory Takings: New Directions for Appraisers, Judges, and Economists,” The Appraisal Journal (July 1995). In fact, generally speaking, neither the takings decisions by the courts nor takings literature focus on economic and financial methodologies. At the same time, in takings cases, economists and appraisers are asked to provide expert opinion using economic and financial methodologies for measuring the economic impact of regulation. There are two Supreme Court takings tests that are increasingly relevant to measuring the impact of restrictive regulations on property value and economic viability of a shopping center.

The Multifactor Takings Test

In 1978, Justice William J. Brennan, Jr., writing the majority opinion for the U.S. Supreme Court in Penn Central Transportation Co. v. City of New York, 438 U.S. 104 (1978), acknowledged that the Court “quite simply, has been unable to develop any 'set formula' for determining when 'justice and fairness' require that economic injuries caused by public action demand compensation.” The case involved a challenge to an historic landmark designation designed to prevent construction of a high-rise office tower over Grand Central Station. The Penn Central owners did not dispute that they could earn a reasonable return on the existing terminal. Rather, they argued that the restriction on Penn Central's use of the air rights above the terminal required compensation. In order to address this question, the Court adopted a multifactor balancing test that today remains the “default” test that should be applied when a landowner makes a takings claim involving a regulation that neither deprives the landowner of all economically beneficial use of its property nor entails a permanent physical occupation.

In order to measure a regulatory taking that falls short of total deprivation of value and does not involve a permanent physical occupation, the Court identified three factors, stating:

The economic impact of the regulation on the claimant and, particularly, the extent to which the regulation has interfered with distinct investment-backed ex-pectations are, of course, relevant considerations. [Citation omitted]. So, too, is the character of the governmental action.

With regard to the first factor, economic impact, the Court found that by Penn Central's own admission, a reasonable return could be earned from the existing facility. The Court did not define the second factor, distinct investment-backed expectations. However, it noted that Penn Central had not established a taking “simply by showing that they have been denied the ability to exploit a property interest that they heretofore had believed was available for development.” He also stated that only a landowner's primary expectation in the use of its property was protected. The Court explained the third factor, character of the government action, by pointing out that a taking is more likely to be found when the government's interference with the private property is a physical invasion, as opposed to interference that “arises from some public program adjusting the benefits and burdens of economic life to promote the common good.”

1) The Economic Impact of the Regulation. This factor involves a judicial inquiry into the effect the regulation has on one or more measurements of economic impact: typically, economic uses of the property, fair market value and rate of return. Just as in Penn Central, where the Court focused on the “reasonable return” that could be earned from the existing terminal, in Keystone Bituminous Coal Ass'n v. DeBenedictus, 480 U.S. 470 (1987), the Court found that a state law requiring that the coal companies leave 50% percent of the coal in the ground to prevent subsidence did not result in a taking of property, because the record did not demonstrate that the requirement made the companies' mines unprofitable.

With respect to the effect of the regulation on the property's economic value, whether measured by remaining economic uses or fair market value, lower courts generally have interpreted the U.S. Supreme Court's pronunciations to require that the regulation result in all, or nearly all, of the property's economic use in order to find a taking. However, in Palazzolo v. Rhode Island, 533 U.S. 606 (2001), and then a year later in Tahoe-Sierra Preservation Council, Inc. v. Tahoe Regional Planning Agency, 535 U.S. 302 (2002), the Supreme Court indicated that where regulation of property causes less than a total deprivation of value, such a partial regulatory taking may be compensable under the multifactor test outlined in Penn Central.

2) Distinct Investment-Backed Expectations. This second regulatory takings factor under Penn Central ' the extent to which the challenged regulation interferes with the private property owner's distinct investment-backed expectations ' has become one of the most important of the Penn Central factors. The Supreme Court had indicated in Ruckelshaus v. Monsanto Co., 467 U.S. 986, 1005-1006 (1984), that such expectations must be reasonable and that failure to prove investment-backed expectations can defeat a takings claim. In rejecting the takings claim in Ruckelshaus, the Court emphasized that the company knew about the property restriction in advance of its claim.

This “notice rule” can be a factor in assessing whether the landowner's distinct investment-backed expectations are reasonable, but is not an absolute bar to a claim of investment-backed expectations under the Penn Central takings factors. It is important to note that Justice Sandra Day O'Connor, who wrote a separate opinion concurring with the majority opinion in the Palazzolo case, argued that in conducting a Penn Central multifactor analysis, courts should still consider the fact that a land use regulation existed at the time of the property owner's purchase. Justice O'Connor stated: “Today's holding [in Palazzolo] does not mean that the timing of the regulation's enactment relative to the acquisition of title is immaterial to the Penn Central analysis. Indeed, it would be just as much error to expunge this consideration from the takings inquiry as it would be to accord it exclusive significance. Our polestar instead remains the principles set forth in Penn Central itself and our other cases that govern partial regulatory takings. Under these cases, interference with investment-backed expectations is one of a number of factors that courts must examine. Further, the regulatory regime in place at the time the claimant acquires the property at issue helps to shape the reasonableness of those expectations.” Palazzolo v. State of Rhode Island, 533 U.S. 606, 633 (2001). With Justice O'Connor leaving the Court, it is unclear how much weight the notice issue will receive in the Court's takings analysis.

3) The Character of the Government Action. The Supreme Court in Penn Central explained that this factor means that a taking is more likely to be found when the government's interference with the private property is a physical invasion, as opposed to interference that “arises from some public program adjusting the benefits and burdens of economic life to promote the common good.” This factor raises the question: At what point does the character of government interference with private property in furtherance of a public program that adjusts the benefits and burdens of economic life for the general good go too far, and become a taking? To the extent that government regulation of private property has implications of physical interference, such as imposition of an easement that abrogates a landowner's right to exclude the public from its property, or of prohibition on development of private property in order to preserve it for open space or wildlife habitat for the benefit of the public, the “character” of these government actions will support a finding of a taking. On the other end of the spectrum is government regulation of private property where the character of the governmental interference falls within the traditional scope of the police power to protect health and safety or abate a nuisance, without the obligation to pay compensation.

Part two of this article will discuss the “whole parcel” rule announced in Penn Central as well as the two-part takings test established by Agins v. City of Tiburon, 447 U.S. 255 (1980) and suggest strategies to redress loss of property values due to regulations.

Part One of a Two-Part Series

Landlords and tenants who want to understand judicial methods for measuring diminution of property value resulting from land use regulation must first understand the U.S. Supreme Court's takings jurisprudence. Of course, federal takings standards only set the “floor” of constitutional protection. State constitutions may set a higher level of constitutional protection. Although state courts may find a taking in situations where a federal court would not, their approaches to valuation generally mirror the various approaches taken by the federal courts. This two-part article will discuss several Supreme Court takings tests and offer some legal strategies for dealing with them.

Supreme Court Takings Tests

The U.S. Supreme Court's takings decisions have articulated various “tests” for determining whether or not a regulation effects a taking, but the Court has not adopted a single theory of valuation as a constitutional requirement for establishing a fair rate of return. See Walter, “Appraisal Methodology and Regulatory Takings: New Directions for Appraisers, Judges, and Economists,” The Appraisal Journal (July 1995). In fact, generally speaking, neither the takings decisions by the courts nor takings literature focus on economic and financial methodologies. At the same time, in takings cases, economists and appraisers are asked to provide expert opinion using economic and financial methodologies for measuring the economic impact of regulation. There are two Supreme Court takings tests that are increasingly relevant to measuring the impact of restrictive regulations on property value and economic viability of a shopping center.

The Multifactor Takings Test

In 1978, Justice William J. Brennan, Jr., writing the majority opinion for the U.S. Supreme Court in Penn Central Transportation Co. v. City of New York , 438 U.S. 104 (1978), acknowledged that the Court “quite simply, has been unable to develop any 'set formula' for determining when 'justice and fairness' require that economic injuries caused by public action demand compensation.” The case involved a challenge to an historic landmark designation designed to prevent construction of a high-rise office tower over Grand Central Station. The Penn Central owners did not dispute that they could earn a reasonable return on the existing terminal. Rather, they argued that the restriction on Penn Central's use of the air rights above the terminal required compensation. In order to address this question, the Court adopted a multifactor balancing test that today remains the “default” test that should be applied when a landowner makes a takings claim involving a regulation that neither deprives the landowner of all economically beneficial use of its property nor entails a permanent physical occupation.

In order to measure a regulatory taking that falls short of total deprivation of value and does not involve a permanent physical occupation, the Court identified three factors, stating:

The economic impact of the regulation on the claimant and, particularly, the extent to which the regulation has interfered with distinct investment-backed ex-pectations are, of course, relevant considerations. [Citation omitted]. So, too, is the character of the governmental action.

With regard to the first factor, economic impact, the Court found that by Penn Central's own admission, a reasonable return could be earned from the existing facility. The Court did not define the second factor, distinct investment-backed expectations. However, it noted that Penn Central had not established a taking “simply by showing that they have been denied the ability to exploit a property interest that they heretofore had believed was available for development.” He also stated that only a landowner's primary expectation in the use of its property was protected. The Court explained the third factor, character of the government action, by pointing out that a taking is more likely to be found when the government's interference with the private property is a physical invasion, as opposed to interference that “arises from some public program adjusting the benefits and burdens of economic life to promote the common good.”

1) The Economic Impact of the Regulation. This factor involves a judicial inquiry into the effect the regulation has on one or more measurements of economic impact: typically, economic uses of the property, fair market value and rate of return. Just as in Penn Central , where the Court focused on the “reasonable return” that could be earned from the existing terminal, in Keystone Bituminous Coal Ass'n v. DeBenedictus , 480 U.S. 470 (1987), the Court found that a state law requiring that the coal companies leave 50% percent of the coal in the ground to prevent subsidence did not result in a taking of property, because the record did not demonstrate that the requirement made the companies' mines unprofitable.

With respect to the effect of the regulation on the property's economic value, whether measured by remaining economic uses or fair market value, lower courts generally have interpreted the U.S. Supreme Court's pronunciations to require that the regulation result in all, or nearly all, of the property's economic use in order to find a taking. However, in Palazzolo v. Rhode Island , 533 U.S. 606 (2001), and then a year later in Tahoe-Sierra Preservation Council, Inc. v. Tahoe Regional Planning Agency , 535 U.S. 302 (2002), the Supreme Court indicated that where regulation of property causes less than a total deprivation of value, such a partial regulatory taking may be compensable under the multifactor test outlined in Penn Central .

2) Distinct Investment-Backed Expectations. This second regulatory takings factor under Penn Central ' the extent to which the challenged regulation interferes with the private property owner's distinct investment-backed expectations ' has become one of the most important of the Penn Central factors. The Supreme Court had indicated in Ruckelshaus v. Monsanto Co ., 467 U.S. 986, 1005-1006 (1984), that such expectations must be reasonable and that failure to prove investment-backed expectations can defeat a takings claim. In rejecting the takings claim in Ruckelshaus, the Court emphasized that the company knew about the property restriction in advance of its claim.

This “notice rule” can be a factor in assessing whether the landowner's distinct investment-backed expectations are reasonable, but is not an absolute bar to a claim of investment-backed expectations under the Penn Central takings factors. It is important to note that Justice Sandra Day O'Connor, who wrote a separate opinion concurring with the majority opinion in the Palazzolo case, argued that in conducting a Penn Central multifactor analysis, courts should still consider the fact that a land use regulation existed at the time of the property owner's purchase. Justice O'Connor stated: “Today's holding [in Palazzolo] does not mean that the timing of the regulation's enactment relative to the acquisition of title is immaterial to the Penn Central analysis. Indeed, it would be just as much error to expunge this consideration from the takings inquiry as it would be to accord it exclusive significance. Our polestar instead remains the principles set forth in Penn Central itself and our other cases that govern partial regulatory takings. Under these cases, interference with investment-backed expectations is one of a number of factors that courts must examine. Further, the regulatory regime in place at the time the claimant acquires the property at issue helps to shape the reasonableness of those expectations.” Palazzolo v. State of Rhode Island , 533 U.S. 606, 633 (2001). With Justice O'Connor leaving the Court, it is unclear how much weight the notice issue will receive in the Court's takings analysis.

3) The Character of the Government Action. The Supreme Court in Penn Central explained that this factor means that a taking is more likely to be found when the government's interference with the private property is a physical invasion, as opposed to interference that “arises from some public program adjusting the benefits and burdens of economic life to promote the common good.” This factor raises the question: At what point does the character of government interference with private property in furtherance of a public program that adjusts the benefits and burdens of economic life for the general good go too far, and become a taking? To the extent that government regulation of private property has implications of physical interference, such as imposition of an easement that abrogates a landowner's right to exclude the public from its property, or of prohibition on development of private property in order to preserve it for open space or wildlife habitat for the benefit of the public, the “character” of these government actions will support a finding of a taking. On the other end of the spectrum is government regulation of private property where the character of the governmental interference falls within the traditional scope of the police power to protect health and safety or abate a nuisance, without the obligation to pay compensation.

Part two of this article will discuss the “whole parcel” rule announced in Penn Central as well as the two-part takings test established by Agins v. City of Tiburon , 447 U.S. 255 (1980) and suggest strategies to redress loss of property values due to regulations.