Leasehold Improvements in the Philippines: Rights of Lessors and Lessees

When a business invests in renovating a leased space, a critical question arises: who owns those improvements when the lease ends? Philippine law provides a default rule, but as the Supreme Court clarified in Lhuillier v. Court of Appeals, a clear contractual stipulation can override that rule entirely. Understanding this distinction is essential for both lessors and lessees.

The Default Rule: Article 1678 of the Civil Code

Article 1678 of the Civil Code governs improvements made by a lessee. Under this provision, if a lessee makes useful improvements in good faith—improvements suitable to the intended use of the lease, without altering the form or substance of the property—the lessor must pay one-half of the value of those improvements upon termination of the lease. If the lessor refuses to reimburse, the lessee may remove the improvements, provided the removal does not cause more damage to the property than necessary.

For ornamental expenses, the lessee receives no reimbursement but may remove the ornamental objects if this causes no damage and the lessor does not choose to retain them by paying their value.

This rule, however, is not absolute. Article 1306 of the Civil Code enshrines the freedom to contract: parties may agree on stipulations they deem convenient, provided these are not contrary to law, morals, good customs, public order, or public policy. Courts have consistently upheld contractual terms that depart from the default rule of Article 1678.

The Case: Lhuillier v. Cebu Marijoy Realty Corp.

The dispute began with a 1980 lease agreement between Marguerite Lhuillier (lessee) and Cebu Marijoy Realty Corporation (lessor) for commercial units. The original contract contained a crucial clause: any permanent fixtures introduced by the lessee would become the exclusive property of the owner upon termination, without compensation to the lessee.

After the initial two-year term, the lease was renewed verbally several times, with only the rental rates and periods being adjusted. In 1993, Lhuillier sought permission to make improvements. Cebu Marijoy approved but proposed a new two-year contract with revised terms. Negotiations stalled, yet Lhuillier proceeded with the improvements anyway. When the lease neared expiry in 1994, the parties disagreed on the new rental rate, leading to litigation.

The Municipal Trial Court ruled in favor of Cebu Marijoy, ordering Lhuillier to vacate and pay back rentals. It also offered the lessor the option to reimburse half the improvement value or allow removal. The Regional Trial Court affirmed the order to vacate but removed the reimbursement option. The Court of Appeals upheld this, holding that the improvements belonged to Cebu Marijoy based on the original contract's stipulation.

The Supreme Court's Ruling

The Supreme Court affirmed the Court of Appeals. The Court reasoned that despite the verbal renewals, the core terms of the original 1980 contract—including the clause on improvements—remained in effect. Citing Ledesma v. Javellana, the Court noted that renewing a lease without specifying new terms implies the original terms are extended, except for rent and period.

The Court emphasized the binding nature of the stipulation: the parties agreed that all improvements introduced by the lessee would accrue to the owner at the end of the lease without reimbursement. This stipulation, not being contrary to law, morals, public order, or public policy, binds the parties and is the law between them.

Because of this explicit agreement, Article 1678 did not apply. The Court also rejected Lhuillier's claim of good faith, as the contractual agreement dictated the outcome regardless of good faith.

Practical Implications for Drafting and Renewing Leases

This case offers several lessons for both lessors and lessees.

First, clearly worded stipulations on improvements carry significant financial consequences. Lessees should be cautious about clauses that automatically transfer ownership of improvements to the lessor without reimbursement.

Second, when renewing a lease, parties must explicitly renegotiate terms they intend to change. Simply agreeing on a new rental rate does not alter other fundamental clauses. A formal written amendment or a new contract is advisable.

Third, while Article 1678 offers protection to lessees who make improvements in good faith, this protection can be waived through explicit contractual agreements. Understanding and negotiating these clauses before signing is crucial.

Practical Takeaways

• Contractual stipulations prevail over the default rule in Article 1678, provided they are not contrary to law or public policy.
• Review renewal terms carefully. Verbal renewals typically carry over original terms except for rent and period; any intended changes must be explicit.
• Negotiate improvement clauses before signing. Lessees should seek clarity on ownership and reimbursement for permanent fixtures.
• Document everything in writing. A written amendment or new contract is the safest way to modify improvement terms.
• Seek legal advice when drafting or renewing lease agreements to avoid costly disputes.

This article is general information and not legal advice. For your specific situation, consult a lawyer or ask ASG Legal AI.