After a careful search, you’ve found a commercial property you feel is right for your business or as an investment. Your next step will be a process of due diligence to minimize risk and ensure the building or property is a sound venture. Assessment of the physical condition, researching liens and obligations, review of prior insurance claims, surveys and improvements, and, in some cases, evaluation of current tenants will comprise the standard due diligence process.
In many cases, a contemplated purchase should also consider the environmental condition of the property. Many properties have environmental issues, and without conducting environmental due diligence, parties to the transaction risk loss of property value or liability for remediation costs. An environmental review protects the buyer, the seller and the lender from surprises. In some states, title companies require certain levels of due diligence as well.
Scope of environmental due diligence may vary.
The characteristics of the property and the nature of the transaction will usually determine the need for environmental due diligence. Properly designed and executed environmental due diligence allows each party in the transaction to identify and quantify environmental concerns and, in doing so, make risk-based decisions that are mutually acceptable.
The purchaser should tailor its environmental due diligence to satisfy its operational and liability concerns. In many cases, a tool developed by the American Society for Testing and Materials (ASTM) can be used to do a preliminary assessment on a tract of land with or without structures. The Transaction Screen Process (TSP) is an ASTM copyrighted questionnaire that provides a snapshot of the environmental condition of a real estate property. It may be used to determine whether or not a more comprehensive Environmental Site Assessment (ESA) – i.e., Investigation (Phase 1), Sampling and Analysis (Phase 2) or Cleanup (Phase 3) – is necessary.
Unlike the ESA, a TSP does not require an environmental professional's judgment. The questionnaire is the basis for the entire assessment. All of the questions are answered yes, no or unknown. The questions are self-explanatory and direct. Should further investigation by ESA be warranted, time considerations and fees for assessment and remediation should be factored into the transaction and advisability of the purchase. In complicated real property transactions and/or properties with a prior history of uses that may involve contaminants, it is best to have an environmental consultant and/or attorney review the ESA. Prevention and caution in this field is very important as remediation usually runs in the millions of dollars.
Some entities are more likely at risk than others.
Not all commercial transactions require environmental due diligence, and the decision whether to perform due diligence can be guided by several factors, including the characteristics of the real property, type of transaction, past uses of the land, the buyer’s planned use of the property and a lender’s risk tolerance. Lenders may require an ESA and other environmental due diligence in connection with any commercial real estate loan in order to assess any risks involved with using the property as collateral for a loan and to properly evaluate the loan-to-value ratio of the property.
The most common environmental and regulatory exposures encountered by real estate entities include:
- Contaminants from known and unknown historical usage/operations or neighboring properties, including illegal drug manufacture/distribution.
- Regional soil and groundwater contamination.
- Air emissions from ammonia-based refrigeration systems.
- Construction debris containing hazardous materials (e.g., paint cans, tars, etc.)
- Sick Building Syndrome (i.e., carbon monoxide, mold or bacterial air releases from faulty heating, ventilation or air conditioning systems).
- Hazardous chemical storage, including laboratory chemicals, medical wastes from doctor and dentist offices, dry cleaning solvents, pesticides and herbicides used both indoors and outdoors, etc.
- Inadequate containment at loading/unloading areas.
- Inadequate containment for hazardous materials, waste and process areas.
- Lead, asbestos, PCBs and radioactive material.
- Methane contamination from buried tree stumps and construction debris.
- "Midnight dumping" on vacant land parcels.
- Past landfills, lagoons and other solid waste disposal areas.
EPA Superfund’s “innocent landowner” exemption may apply.
Entities that acquire property and had no knowledge of the contamination at the time of purchase may be eligible for the "innocent landowner" (ILO) defense to Superfund liability if they conducted all appropriate inquiries (AAI) prior to purchase and complied with other pre- and post-purchase requirements. Under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA or Superfund Act), a purchaser who “did not know or had no reason to know” of contamination would not be liable as a CERCLA owner or operator. To establish that s/he had no reason to know of the contamination, a landowner must demonstrate that s/he took “all appropriate inquiries into the previous ownership and uses of the facility in accordance with generally accepted good commercial and customary standards and practices.” Bear in mind that there are exceptions and it can be difficult to qualify for this exemption.
Some common cases of environmental claims – no scarcity of examples
Environmental issues can surface long after the property is purchased and therefore require ongoing monitoring and due diligence. As the claims examples below illustrate, there are a variety of ways you can be liable for environmental issues at your property.
Hospital – Mold:
A mechanical contractor was hired to perform HVAC repairs at a hospital. No medical procedures were performed during the actual renovation activities and proper measures were taken to ensure proper encapsulation. Despite the controls, one year after completion of the project, the contractor was notified that several aspergillus (a type of mold species) infections had occurred several months after valve replacement surgeries. Internal and governmental investigations identified the source as the hospital operating room shortly after the renovations. The hospital was sued by several of the patients sustaining secondary infections. The hospital and the contractor contributed to settle the claim.
Developer – Contaminated Soil:
New construction commenced on a previously undeveloped parcel of land. During excavation and dewatering activities, contaminated groundwater was discovered. The developer was required by State regulatory authorities to collect, test and treat groundwater pumped out during the excavation process. Contaminated soils were also discovered at the site. Construction delays and additional expenses totaling over $1M were incurred by the developer. It was eventually determined that the contamination had migrated from a nearby manufacturing facility that had gone into bankruptcy several years prior to the development project.
Manufacturing Facility – Solvent-Laced Wash Water:
A small paint manufacturing company performed routine drum washing operations over a severely compromised concrete containment pad. Over time, solvent-laced wash water migrated through cracks in the concrete and into the subsurface soils and groundwater. The plume of solvents traveled off site and contaminated a nearby municipal water supply well. The municipality filed suit for cleanup and property damage claims as the well had to be fitted with costly remedial technologies to provide safe drinking water for its customers.
Self-Storage Facility – Illicit Abandonment:
A self-storage facility repossessed a locker from a renter who had missed several payments. Upon gaining control of the rental space they found 12 drums of hazardous material. The renter could not be found, so the owner of the storage facility was required to pay for the disposal of the drums. In addition, soil and groundwater investigations were required due to staining on the floor of the unit, which resulted in the need to excavate several tons of impacted soils.
Manage pre- and post-transaction risk.
Generally, since contamination or hazardous substances on the property can greatly affect the value of the real estate, a buyer often includes in its purchase agreement an environmental inspection contingency. This allows the buyer to terminate the contract or renegotiate certain terms if the environmental conditions are not acceptable to the buyer. Because a cleanup operation may interfere with the purchaser’s business or operations on the property and its stream of income, potentially impairing its ability to repay the loan, a lender may make its loan commitment letter contingent on the acceptability of environmental findings from the due diligence period.
Purchasers should be wary of assuming there is no risk for non-obvious properties. Mold or toxic drug contamination, for example, can be an issue in ANY property – high-end hotel, school, apartment building, etc. Lease clauses and risk transfer mechanisms (insurance) need to be carefully considered; insurance protection is a key part of any environmental risk management plan.
There are two types of pollution policies:
- Site or premises pollution liability insurance provides coverage for bodily injury, property damage, legal expenses and clean-up costs resulting from pollution conditions arising from covered locations.
- Third-party pollution or contractor’s pollution liability insurance covers an environmental event resulting from work activities.
Policies are available either on a project or blanket program basis. Project policies provide coverage for all operations performed by the insured during the construction/work period and can include "tail" coverage to address an extended reporting period. A blanket program provides coverage on an annual basis for all defined covered operations taking place during the policy term. A typical policy can provide coverage while you are on the job as well as after your completed operations. Typically, contractor’s pollution is included in a combo policy with Contractors Errors & Omissions policies.
Prevention plays an important role.
In addition to providing protection against environmental exposures, having established standard operating procedures for environmental exposure prevention will influence underwriters favorably when determining coverage and rates. Insurance protection is a key part of any environmental risk management plan. General liability and property insurance typically do not provide protection for environmental exposures. Because there is no standard for environmental insurance coverage, the protection can vary greatly. It’s important to work with an insurance broker who has environmental expertise and can walk you through coverage applying to losses from property damage, cleanup expenses, bodily injury, defense expenses, business interruption and loss of income.
Commercial Real Estate and Contractual Risk Transfer. Savvy commercial real estate owners, developers, investors and property managers know that contractual risk transfer (CRT) is a key tool in managing commercial real estate operations and plays a substantial role in managing the total cost of risk.
If you have questions or comments about the issues discussed in this article, feel free to contact Erik Hansey (firstname.lastname@example.org, 816-945-5226) of CBIZ Insurance Services our touch base with our Infrastructure & Project Advisory Group (IPAG).
Published on November 15, 2018