Environmental due diligence is an unavoidable part of a commercial real estate transaction. But how much diligence is enough? How long will the process take? How much will it cost? Finding answers begins with understanding the details of your transaction.
Steve Price, CHMM, admits that when it comes to due diligence, he and his colleagues often sound like a broken record. “Whether we’re sitting down with a new client or a repeat customer, a first-time developer or a seasoned professional, we always start the conversation the same way – by zeroing in on the specifics of their real estate transaction.”
Price, a principal and vice president at PM Environmental, specializes in transactional due diligence. Having written and implemented environmental policies for more than 60 local and regional lending institutions with combined assets in excess of $160 billion, he knows exactly which questions to ask first:
- What is the transaction type? Is it a new purchase or a refinance for the borrower? If for the lender – is it a foreclosure?
- What are your plans for the property?
- Who is the lender?
- Will the deal involve governmental financing such as Small Business Administration (SBA) loans?
- What is the use of the property? Any known current or previous high risk operations?
We asked Price to walk us through how transaction details like these drive environmental due diligence requirements, and to suggest a few tips to help property owners manage expectations and navigate the process.
Purchasing a commercial property
Prior to purchasing a commercial property, buyers have a window of opportunity they won’t see again. “This is the only point when a buyer can claim what are known as innocent landowner protections against liability for any actual or potential environmental contamination identified at the site,” explains Price.
The only way to lock in these protections is to conduct a Phase I Environmental Site Assessment (ESA). A Phase I ESA report, completed in accordance with the American Society for Testing and Materials (ASTM) Standard E1527-2013, is an independent professional opinion about the environmental condition of the property. It identifies Recognized Environmental Conditions (RECs) associated with the property, and whether additional investigation is warranted.
“This is the only time a purchaser can obtain these protections,” says Price. “It’s a very cost effective insurance policy.”
Refinancing an existing property
If a borrower already owns a property and wants to refinance, the due diligence requirements are largely determined by the lender. Several factors come in to play when determining what needs to be done, including property use, loan amount, and whether it is a new loan versus existing collateral. Some lenders may require a full Phase I ESAs while others may only require a more limited type of environmental review.
Redeveloping or rehabilitating an existing property
When borrowing in order to modify a property other specific due diligence steps may be required, depending on the particulars of the project. For example, if part of a building is being torn down and replaced with an addition, a pre-asbestos demolition survey may be required.
“It’s important to note that due diligence isn’t just about finding problems that need fixing,” Price says. “It can also help identify opportunities where PM can assist clients in redeveloping a property.” Redevelopment projects that create jobs or improve blighted communities, for instance, may qualify for federal or state economic incentives. “At PM Environmental, we see our role as helping the client make the most of those opportunities as well. We have an entire team of professionals who assist clients in finding and securing these incentives to help pay for environmental and other redevelopment costs, many of which our clients didn’t even know existed.”
A transaction involving the Small Business Administration (SBA)
The SBA has its own Standard Operating Procedure (SOP) which must also be met along with the lender’s environmental policy. The SOP is generally risk driven and will require a Phase I ESA for any high risk property. Low risk properties can start with either an Environmental Questionnaire (if the SBA’s portion is less than $150,000) or a Records Search with Risk Assessment (RSRA) if over $150,000. If any concerns are found, a Phase II ESA will most likely be required. If any contamination is discovered, the borrower must satisfy one of the mitigating factors in the SOP prior to SBA funding the loan. This can take time and increase costs. Price always advises clients considering an SBA loan for a high risk property, that it’s important to fully understand what could be necessary to close the loan, before undertaking the project.
A transaction involving property with known environmental risks
When contamination is identified on a property in Michigan, a Baseline Environmental Assessment report (BEA) is needed to provide the buyer with liability protection. The BEA documents the results of the Phase I and Phase II ESAs and is disclosed to the Michigan Department of Environmental Quality (MDEQ). While BEAs and similar programs in other states provide cleanup liability protections, owners/operators are required to meet certain Due Care obligations that ensure the property is safe to occupy, including but not limited to eliminating unacceptable exposures and providing proper notifications to those who could potentially become exposed to the known contamination.
Just because there is known contamination, it doesn’t necessarily mean that a loan cannot be made on a property. “It is important to fully understand the condition of the property, and what affects (if any) that contamination has on the use of the property, and what Due Care obligations the owner/operator may have,” says Price.
A transaction involving a property in foreclosure
When a lender forecloses on a property, they are considered a “new purchaser”, and can obtain the same innocent landowner defenses as any other party. To do this, they must follow the same processes as discussed above (i.e. Phase I, II ESAs and BEA as necessary), even if their borrower completed those steps at loan origination. If the Phase I ESA is more than a year old, a new one must be completed. However, if the conditions on the property have not changed since the previous Phase II, it may not be necessary to duplicate these efforts, and a BEA can be completed using the existing Phase II data. BEAs are not transferrable and a lender must complete their own in order to be protected.
4 Due Diligence Survival Tips
1. Put time on your side.
“Build environmental due diligence into the financing timeline,” says Price. “The most important piece of advice I give clients is to start early. Don’t wait for the appraisal to be completed before you call us. By then, it may be too late to address the issues that sometimes arise and closings can be delayed.”
Generally speaking, it takes three to four weeks to complete a Phase I ESA that meets the ASTM standard. A Transaction Screen or other limited reports can usually be completed in about two weeks, and in some cases, when ample information and/or previous reports are available, desktop reviews can be completed in even less time.
And remember that due diligence is a stepped process. When a required report generates no action items, the process is complete. But if a REC is identified, additional steps – and additional time – might be required.
2. Don’t underestimate the power of the past.
While it’s understandable to want to focus on the exciting plans for the future of the property, you can’t ignore the environmental effects of years past. Identifying, addressing and/or managing outstanding concerns are essential to financing a project. As Price reminds clients, “you’re not only buying the current use of the property – you’re buying its history.”
3. Get to know your lender’s environmental risk management policies.
“Different lenders have different requirements and risk tolerances,” says Price. “Inquire about the bank’s environmental policy needs as soon as possible to avoid surprises down the road.”
4. Put experience on your team.
When provided by experienced, credible environmental consultants, due diligence services bring clarity, confidence and compliance to property decisions, helping all parties manage environmental risk. But all consultants are not created equal. “Don’t be fooled by consultants who promise it faster and cheaper,” warns Price. “A report is no good if it is filled with holes or contains bad conclusions.”