In today’s competitive commercial real estate market, your investor clients are under pressure to control costs, including the expense of doing environmental due diligence on a property. Almost all commercial mortgage deals require an initial environmental screening.
Not all commercial property, however, may warrant a Phase I environmental site assessment, which is the accepted industry standard for the initial inquiry. Three other levels of environmental screening studies can be safe and acceptable options for some deals, and they can save your clients time and money.
Although an environmental study is part of nearly every commercial real estate deal, some mortgage brokers struggle to give basic advice on the appropriate level of environmental due diligence. With certain deals, your clients may not need to complete a formal Phase I environmental site assessment (ESA). Sometimes properties require less-involved studies that include only portions of the full Phase I ESA.
The Phase I ESA is undoubtedly the most familiar study to mortgage brokers as it has been the gold standard for due diligence since the 1990s. In many cases, the Phase I study will be mandatory. Many lenders, as well as the government-sponsored enterprises Fannie Mae and Freddie Mac, require a Phase I ESA as a condition of closing a loan.
Lenders primarily want to avoid the legal liability for the cost of a cleanup should contaminants later be found on the property. The owner and lender can be exempted from liability if they have undergone the appropriate environmental inquiries prior to the property changing hands. A Phase I ESA can satisfy this requirement.
The Phase I ESA, however, may lead to an even deeper Phase II environmental study, which can involve soil, water and air testing in areas identified as potential risks by the Phase I process. In other commercial mortgage deals, however, the environmental due-diligence study need not be so involved. A Phase I study may not even be necessary.
With that in mind, the question becomes, “When can I consider more limited due diligence and still feel comfortable with my property?” The scope of the study often depends on the property type, the size of the deal, the risk tolerance of the parties involved, the marketability of the asset and the environmental policies of the eventual end use of the property. With these factors in mind, let’s take a closer look at the varying levels of due diligence used as alternatives to Phase I ESAs and determine when they may be a logical fit.
Keep in mind that an environmental database is only as good as the data entered by state agencies.
The first level of due diligence is to search for any past records in environmental databases. Any given consultant will have its own name for this report. The common denominator, however, is that the study is completed from the desk with no site inspection. Furthermore, there is typically little or no historical research done on the property and its surrounding area.
These reports should be used sparingly, but they do have their uses. The typical fit is a low-risk property where the history of both the site itself and the surrounding area is well known. Properties located in commercially developed zones typically require a deeper assessment. For properties in these zones, a lack of historical research can result in overlooking important risks relevant to the real estate.
Also, keep in mind that an environmental database is only as good as the data entered by state agencies. If an issue of environmental interest has been reported or if a site has been registered with the state as a hazardous-waste generator, for example, it will theoretically be identified within the database records. Many sites, however, were contaminated long before state agencies kept records of them. Assessments that are limited to a review of environmental database records commonly gloss over potential environmental risks.
A basic screening of database records is most often used with vacant rural land that has no historical use. It also can be suitable for some apartment complexes located within residential neighborhoods. It also is common to see this option used on smaller deals where the potential exposure to the lender is limited.
A Records Search with Risk Assessment (RSRA), as it is referred to by the U.S. Small Business Administration, is the next step up in environmental due diligence. These studies are undertaken to determine the past uses of the property. The scope of the historical research can vary significantly and the studies are often called by different names. A consultant will typically use many sources, including city directory records, fire-insurance maps and aerial photographs.
This level of study could be sufficient in cases where the property hasn’t changed hands often, the presumed environmental risks are low and the deal size is not too high. This option is often used on low-risk sites containing benign commercial operations where environmental risks are not anticipated but where the history of the site and the surrounding area is not precisely known by the interested parties.
A quality environmental consultant should be able to produce a reasonably in-depth, useful report from their desktop. Your client, however, should insist that the report be completed by an environmental professional and not by a consultant’s trainee.
The next step up is an environmental transaction screen assessment (TSA). This study is, in essence, a watered-down version of a Phase I ESA. The study typically includes a site inspection, interviews with key site personnel, and a review of environmental database records and various historical records. The key difference is that the transaction screen assessment won’t give the investor or lender the same legal protection from liability as the Phase I ESA.
TSAs can be a good option for assessing a site while saving the additional expense of a Phase I ESA. These studies are often used in situations where something more involved than a desktop report is warranted. This may be due to the size of the deal, the potential environmental risks, timing or other factors.
Sometimes, an investor or property owner will do a TSA after identifying a risk through historical research at the desktop level. If, for example, a desktop assessment reveals that a given property has been used for automotive repair in the recent past, the property likely should be inspected. At that point, the investor or owner would have to decide whether to proceed with a TSA or a full Phase I ESA. In the above example, this might depend on when the property was used for auto repairs.
The site-inspection component of a TSA enables the consultant to gauge the overall risk. TSA reports also are a good option when the environmental risks are low but the property size and value is too high for a simple desktop study. The site inspection is designed to reassure the interested parties.
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A qualified consultant can walk you through the nuances of each option and how to find the best fit for a given situation. In a perfect world, a Phase I environmental study would be conducted as part of every commercial real estate deal. The reality, however, is that competition and other market factors often necessitate quicker and more frugal solutions.