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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   February 2008

Hidden Problems, Nasty Consequences

Environmental contamination isn’t confined to industrial properties

c_2008-02_Ezovski_spotA site in New Jersey tainted by an adjacent property’s oil spill. A Florida building constructed near a former bombing range. A Texas property built on a former oil-and-gas field with elevated levels of carcinogenic chemicals in the soil.

These recent headline-making examples have something in common: On-site contamination is compromising human health and driving down real estate values. What’s more, the properties mentioned in these examples all contain residences.

Surprised? Don’t be. Environmental contamination doesn’t only affect industrial properties. Apartments, condominiums and even single-family neighborhoods are not immune to pollution’s effects. Considering that many housing developments are built on recycled land that once had industrial, commercial or agricultural uses, environmental issues regularly arise.

When it comes to environmental contamination, however, many commercial lenders and investors assume that single- and multifamily developments contain no threats. As a result, undeveloped and vacant properties and multifamily properties often comprise the greatest percentage of real estate on which no environmental due diligence is performed.

Further, many brokers in these transactions mistakenly believe environmental risk is proportional to the asset value of the real estate. They believe low-dollar-value properties carry little environmental risk and little cleanup costs.

But cleanup costs sometimes exceed the value of the property. The prior presence of a gas station, dry cleaner or other common polluter, however, can spell big trouble for a property-owner.

As such, it is a mistake for borrowers on multifamily properties not to conduct environmental due diligence. You should encourage any property-buyer to conduct environmental due diligence no matter what the value of the deal or the perceived risk of the property. The few-hundred dollars spent upfront on environmental due diligence might save thousands in cleanup costs in the long run.

The Phase I and CERCLA protection

When contamination does occur, it can compromise human health, drive down property values and stigmatize entire neighborhoods -- especially when it draws media coverage. In extreme cases, property-owners can be held responsible for cleanup. This can cost thousands of dollars and compromise their ability to pay their mortgages.

With apartment buildings, condos and other multifamily dwellings, investors can lose rental income, be forced to pay for costly remediation or face litigation from fearful tenants. Contamination can also stigmatize the property, making it difficult to find tenants. These circumstances can all lead to loan default.

High-risk properties built on or adjacent to former or existing dry cleaners, gas stations, auto-repair facilities and the like should always receive a Phase I environmental site assessment, as should deals when Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) liability is a concern.

The Phase I is a due-diligence tool that an environmental professional uses to determine if any recognized environmental conditions exist at a given property. It includes a site visit; interviews with past and present owners and others knowledgeable about the property; a review of government records and historical sources; and a report of the findings.

This thorough due-diligence tool can help qualify a property-purchaser for cleanup-liability protection under CERCLA when it is conducted in accordance with appropriate regulatory standards.

For investors of multifamily properties, a Phase I is often warranted. Results of the site assessment will show not only the quality of the real estate, which can be used to analyze the business risk of the deal, but they can also be used to take advantage of the protections afforded under CERCLA if contamination is discovered later.

Note that common environmental concerns such as lead-based paint, asbestos, mold and radon fall outside the scope of a Phase I. A reputable environmental consultant can offer your clients advice as to whether assessments for these non-scope conditions are necessary in the Phase I.

Other due-diligence tools

Although property values have little to do with the degree of contamination, cost considerations for environmental due diligence are an issue for investors. With Phase I assessments costing at least $2,500, it’s not practical to have one for every transaction.

Rather than skipping environmental due diligence altogether, investors looking at transactions that aren’t considered high-risk should look at an alternate form of assessment -- one that can help them make an informed business decision about the environmental health of the property in question.

If the time or cost involved in a Phase I aren’t feasible for your clients, there are other options that are quick and cost-effective. After the Phase I, there are three main levels of environmental due diligence:

  1. Transaction screen: For lower-dollar transactions (those below the bank’s Phase I threshold) with no known environmental risk, this kind of assessment can be a good bet. Generally, for approximately $800 to $1,000, an environmental consultant will conduct a database review and a site inspection of the property and present the results in about 10 days.

  2. Government-records check: A commercial environmental-information vendor will provide reports about the target property and surrounding area based on information found in federal, state, local and tribal databases. The reports will outline the environmental findings, and maps typically show site-elevation data, Superfund-site boundaries, wetlands data, flood zones, waterways and roadways.

    Although this method doesn’t involve the expertise of an environmental professional, the reports are easy to interpret and can include historical information, if requested. They are quick -- turnaround is typically one business day with online delivery -- and inexpensive. A basic report costs just a few-hundred dollars. And should the reports reveal red flags, the lender can turn them over to an environmental professional for further investigation. 

  3. Environmental questionnaire: Lenders often won’t rely solely on the environmental questionnaire to determine whether the property is clean. This is because the accuracy of the questionnaire depends on the knowledge, skill and responsiveness of the individual supplying the answers -- typically the lender, buyer or seller. 

    The questionnaire can be used to supplement other forms of environmental due diligence such as a site visit and government-records check, however. A bonus to your clients is that this tool is free.

Each tool provides a measure of confidence about the environmental health of the property and is far better than doing nothing. These tools are good choices for small-balance multifamily properties where historically no environmental due diligence would have been done.

And should any of these screens raise red flags, lenders and borrowers can consult with an environmental professional for recommendations on how to proceed. If a problem does exist, the lender may restructure or abandon the deal -- both better options than unknowingly taking title to tainted property.

•  •  •

When your clients are deciding on environmental due diligence, they should take a weighted approach that takes into consideration variables such as the loan amount and loan structure, the bank’s risk tolerance, client guarantees and the perceived risk of the property.

By using a combination of available environmental-due-diligence tools, when appropriate, investors can manage environmental risk on multifamily properties for a reasonable time and cost. Help them understand that they should choose a level of due diligence that they can live with -- one that best suits the needs of each particular deal -- rather than skipping environmental due diligence upfront and regretting it when it’s too late. 


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