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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   March 2010

6 Trends in Environmental Due Diligence

Helping clients through the process starts with understanding lenders' approach

Amid today's shaky business climate and declining property values, mortgage lenders are finding it more important than ever to protect their bottom line. A disciplined due-diligence process helps them do that.

When it comes to financing commercial real estate, environmental contamination is a risk that can impair -- or even kill -- a deal.

Contaminated property securing a loan transaction can expose a lender to direct liability for cleanup costs as well as probable litigation. It also can cause buyers to default if they're forced to divert cash flow to pay for remediation. And in the case of foreclosure, it can leave the bank with property that may be difficult to sell.

To help protect themselves from unnecessary exposure, most commercial lenders conduct some type of environmental due diligence before extending credit -- usually tailored to the specifics of the deal, such as loan size, past use, planned use of the property or another factor.

It's important for commercial mortgage brokers to know not only why environmental contamination can be detrimental to borrowers and lenders but also how lenders' best practices in environmental risk management have evolved to where they are today. Armed with this knowledge, brokers can better determine whether a property will make a good deal for their clients and lending partners.

Although no two banks manage environmental risk quite the same way, the following six distinct trends have emerged in the past few years obligating lenders to address environmental due diligence proactively.

1. Regulatory pressure

In November 2006, the Federal Deposit Insurance Corp. (FDIC) updated its environmental guidelines for the first time in 13 years. It urged banks to address commercial real estate risk exposure proactively. Other agencies, including the Office of Thrift Supervision, the Office of the Comptroller of the Currency and the Federal Reserve Board, quickly followed suit.

This past September, after scrutinizing risk at the nation's largest banks, regulators expanded the net to include smaller banks. A month later, the FDIC issued guidance to assist banks with nonperforming loans. All of this adds up to a new normal: more government involvement in commercial real estate lending.

Challenged to demonstrate to examiners and regulators that they are complying with policy guidance, lenders are staying abreast of the latest regulatory changes and tools for assessing a property's environmental risk. Lenders that have not yet developed formal environmental policies are doing so. Others are updating existing policies to bring them in line with regulatory guidelines.

Lenders also are responding to the FDIC's prescribed initial risk analysis for all loans by pre-screening commercial real estate deals for environmental issues. This represents a significant change in environmental screening practices. Historically, environmental due diligence did not occur until near the end of the transaction -- or it was not conducted at all.

2. Pricing pressure

Although the Phase I environmental-site-assessment industry has always been price-sensitive, the recent recession has made it even more so. Many environmental consultants are reporting that they regularly lose jobs to underqualified, low-cost bidders. Low prices may seem like good news to mortgage brokers, lenders and borrowers, but quality can suffer.

Rather than automatically choosing whichever environmental consultancy offers the lowest price, lenders concerned with environmental risk are establishing relationships with a short list of preapproved consultants on which they can call when they require due-diligence services. Most lenders maintain a vendor list in-house and choose consultants based on reliability, qualifications and price.

3. Stricter underwriting

It's no secret that banks are tightening their underwriting, but brokers might not realize that this also translates into less tolerance for contamination on properties.

"A property's potential for contamination
doesn't necessarily correlate to loan size." 

Lenders are lowering their thresholds for Phase I environmental site assessments, which means that more loans are going through the process. Banks also are subjecting small-balance loans, or those of $5 million or less, to some type of environmental due diligence -- be it a Phase I environmental site assessment or a less intensive screen.

To help ferret out high-environmental-risk properties regardless of loan size, lenders are developing a tiered approach to environmental due diligence that considers not only loan value but also important factors such as a property's current and past use.

It's important to recognize that a property's potential for contamination doesn't necessarily correlate to loan size; a relatively small loan might be secured by a highly contaminated site. In some cases, cleanup costs could exceed the loan's value. Be prepared for lenders to require environmental screening on a greater number of loans -- even those that are less than $1 million.

4. Increased foreclosures

The past few years have seen a sharp deterioration in the quality of loans on banks' books as property prices continue to decline and a steep increase in the number of foreclosures, which are expected to escalate dramatically this year and beyond. Borrowers will have trouble refinancing loans taken out in 2007 -- believed to be the most toxic vintage.

Foreclosure turns lenders into owners, subjecting them to the same environmental liability that property-owners face under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA). As a result, regardless of whether they conducted environmental due diligence at origination, lenders are addressing it again before foreclosure. Usually, this is with a Phase I environmental site assessment performed in accordance with the U.S. Environmental Protection Agency's All Appropriate Inquiry (AAI) Rule guidelines or its equivalent, ASTM's E 1527-05 standard.

Banks are also brushing up on their knowledge of CERCLA's secured-creditor exemptions and are being careful to avoid "participating in management" of the business, which could cause them to lose these protections.

5. SBA's new protocol

When it issued its modernized standard operating procedure (SOP) No. 50-10(5) in 2008 -- a document it has updated several times since -- the U.S. Small Business Administration (SBA) effectively made its environmental policy more stringent and set a new precedent for environmental due diligence. The agency now requires certain property types to be screened with an AAI-compliant Phase I environmental site assessment and added a new level of due diligence to the lenders' due-diligence toolkit: the records search with risk assessment.

A notable change in the policy is that the SBA uses a property's current or past use as a trigger for requiring a Phase I environmental site assessment, rather than the more-traditional loan-size criteria. This change asserts that how a property was used has more impact on its inherent risk than loan size.

Although the SBA's revised SOP pertains only to its 7(a) and 504 loans, many lenders viewed the new policy as a catalyst for revising their entire due-diligence guidelines. After familiarizing themselves with the agency's new requirements, many lenders adopted the SBA's tiered approach to environmental due diligence based on property characteristics and loan value and have added the records search with risk assessment to their own policies, even for non-SBA loans.

6. Ongoing monitoring

Economic conditions have brought the importance of ongoing property monitoring to the forefront. Environmental due diligence does not stop at loan origination. Banks are monitoring properties for changes in environmental status over the life of the loan, as per FDIC recommendations. They also are adding language to loan documents to safeguard against environmental losses.

Some companies now offer services that alert lenders when a property in their portfolio is added to a federal or state environmental database such as the Comprehensive Environmental Response, Compensation and Liability Information System and lists of leaking underground-storage tanks.

•  •  •

In response to a mix of regulatory and market forces, banks' risk management has changed significantly since the start of the credit crunch. Commercial mortgage brokers who are aware of recent changes to lenders' environmental due-diligence practices will gain a competitive edge and will be prepared to navigate clients through the new world of environmental risk management.


 


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