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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   November 2015

Risk Is in the Air

Environmental problems with commercial properties can affect lending decisions and loan performance

Risk Is in the Air

Environmental testing and compliance assurance are no longer just the province of government regulators. Commercial mortgage originators now have to study borrowers’ environmental records and think more carefully about whether it’s wise to contaminate their portfolios with loans to polluters. For those making lending decisions, persistent environmental problems linked to a prospective borrower or property can signal trouble ahead, including the potential for costly bad publicity.

Many lenders have established risk-management programs that make use of the Phase I environmental-site assessments (ESAs) and  property-condition reviews to evaluate the environmental and physical condition of a property and to help establish the property’s value. Those basic assessments might seem sufficient, but in many cases they overlook significant environmental-compliance problems that can affect the value of the property and, ultimately, loan performance.

Many businesses cannot afford exposure to notices of violation, enforcement actions and civil penalties, and the fines that often accompany them. Following are some examples of environmental-compliance problems that were identified and remedied as a result of assessments that went beyond basic compliance testing.

  1. Checklist: A national bank sought a template-style environmental checklist to manage transaction-based risk in refinancing automobile dealerships. The checklist covered the major environmental compliance topics associated with those dealerships — such as stormwater, used oil and spill reporting.
  2. Environmental assessment: The owners of a 50-station retail-fuel operation commissioned an  environmental assessment that revealed significant compliance problems. The assessment showed that several stations were violating key petroleum bulk- storage regulations and needed significant capital  investment to comply with state standards. Thus, the stations had the potential to become nonperforming assets and jeopardize the overall business.
  3. Audit: A pre-acquisition audit of a Midwest metal- fabricating and manufacturing plant uncovered  significant violations of state stormwater-permitting regulations, which would cost $750,000 to remedy. The buyer used that information during purchase  negotiations and avoided taking on the liabilities.

Environmental risk management

So, as a commercial mortgage originator, where should you begin? The first step is to recognize the variables that affect the transaction risks, including the level of risk and the borrower’s environmental record and reputation, as well as the amount of equity that is at stake.

Automobile dealerships, quick-lube shops, dry cleaners and manufacturing businesses are among the property types with the highest levels of environmental noncompliance and, as a result, are among the greatest environmental risks to mortgage originators. That risk is compounded if the business in question has a record of noncompliance.

Repeated notices of environmental-compliance violations, enforcement actions, or a lack of key operating permits are indications of business-performance problems and higher loan-performance risk. If the  violations are well-publicized, they could affect a borrower’s reputation, making customers less likely to do business with them and, in turn, making the businesses less able to repay a loan.

More extensive compliance inspections or audits are necessary
with larger, more-complex commercial facilities.

The best way to manage environmental risk is through a tiered-approach that assesses risk associated with debt and equity financing.

The following is a helpful framework for such an assessment:

  • Tier 1: Lowest priority: Debt or equity financing of residential properties, including portfolios of multifamily properties, and many commercial facilities, generally would not present an environmental-compliance risk. In these instances, no additional compliance work is necessary.
  • Tier 2: Low priority: Restaurants, hotels, warehouses and retail properties may present a low risk of environmental problems. Mortgage originators should request a list of environmental permits and compliance records from these companies, which can be incorporated into the standard Phase I ESA process.
  • Tier 3: Moderate priority: Debt- financing deals for moderate-risk  commercial facilities — including retail- gas, dry-cleaning, quick-lube, auto- dealership and light-manufacturing facilities — should include a compliance check as part of the due-diligence process. The assessment should review permits and compliance filings, and also include a companion compliance check during the Phase I ESA site inspection. The compliance check would require a modest amount of additional time onsite for most property types and be somewhat more expensive than a typical Phase I ESA report.
  • Tier 4: Higher priority: More extensive compliance inspections or  audits are necessary with larger, more-complex commercial facilities,  including industrial properties, utilities and manufacturing plants. These audits should review all major federal- and state-regulatory programs to assure
    compliance, and the review should be conducted by a trained auditor. The inspection/audit can be either a companion part of the Phase I ESA or a stand-alone report.
    Although the costs can vary substantially, depending on the nature and complexity of the site inspection, such services typically start at about $1,000 per site.
  • Tier 5: Highest priority: Lenders should be more vigilant about measuring environmental compliance when they take an equity position in a company that includes significant stand-alone facilities or a portfolio of facilities that include the types of facilities covered in tiers 3 and 4. In these instances, the lender is effectively taking on an operational role and would have more exposure to environmental-compliance risks. In all cases, it is important for the lender to document the audit results to determine what actions are necessary to move the business into compliance and address any serious deficiencies. The review costs per facility would generally be in the same range as performing a Phase I ESA.

Systematic approach

This tier-framework approach allows mortgage originators to incorporate the measurement of environmental- compliance risk into their existing risk-management structure for commercial lending, without adding  unnecessary expenses.

Many properties would fall into the Tier 1 or Tier 2 categories and require little or no expense to assess for  environmental-compliance risk. Most importantly, the framework gives loan originators a systematic method of  quantifying risk for properties and businesses that are more problematic and pose a greater threat to property valuation — and the lender’s  balance sheet. 

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