In our last blogpost, we determined that after the completion of an EDR LoanCheck, you can take a few simple steps to avoid a costly Phase I Assessment. In this case study, we’ll talk about a Phase I that recommends additional testing.

In one recent case, a Phase I was completed for a commercial retail property situated in a commercial/light industrial suburban area. The report concluded that Phase II testing was necessary, including the advancement of soil borings and the installation of groundwater monitoring wells. The rational for testing was based solely on the presence of a 50-gallon gasoline UST as depicted at the subject collateral on a 1932 Sanborn Fire Insurance Map.

Was a Phase II really necessary? Not nessesarily. Let’s further review the details:

The UST represented on the Sanborn map was likely used to fuel vehicles at a former nursing home that improved the site, and was not associated with additional USTs and not used for retail sales. The UST is not depicted on any additional maps after 1932; the area of the former UST was excavated down to at least 15-feet to support site redevelopment into a retail strip mall with a subterranean parking garage in 1955; and the site is not situated in a groundwater protection area or in a residential neighborhood.

Using these mitigating factors and a little logic — such as the size of the UST and the likelihood that it was removed more than 50 years ago — PVC made a reasonable determination that a Phase II was not necessary. It was extremely unlikely that this gasoline UST remained on-site, nor was it likely to have significantly impacted soil and groundwater conditions on the property. It’s noted that the author of the Phase I Assessment was unwilling to opine on these mitigating factors.

In this example, the client was able to forgo a costly and time-intensive Phase II by relying upon PVC and using some common sense.

Next time, we’ll consider what to do when your subject collateral is listed as a spill site.

During the last tutorial – one in a series dedicated to answering your most common environmental questions – we addressed what environmental due diligence product is right for your deal. But should you always strictly adhere to a report’s recommendations if they seem overly aggressive and conservative? And what if there is no clear recommendation, leaving you to decide whether additional action is necessary?

More often that not, unpopular and expensive recommendations are wholly appropriate; other times, not so much. This is one of the reasons I started PVC – to take the guesswork out of the equation for lenders, and help you make educated, risk-based decisions. I’ll provide two examples, one in this post and one in the next, that illustrate this point.

Let’s assume you’ve ordered an EDR LoanCheck report for what is considered a low risk property – say, a multi-family residence in an urban area. The LoanCheck concludes the environmental risk posed to your collateral is “Elevated” because of the presence of a state-listed spill site (a former gasoline station) on a property situated approximately 250-feet from your collateral. The LoanCheck suggests a Phase I Assessment would be needed to further assess this condition.

So is a Phase I really needed? Maybe not, and it may take just a few relatively simple steps and short dollars to confirm that.

First, a check of available online records confirms that the collateral is not subject to conservative groundwater protection standards and that area topography appears to place the former gasoline station downgradient of the collateral.

Second, files available on the Massachusetts DEP’s website confirm that while a permanent solution has yet to be achieved for the spill site, extensive testing and groundwater flow data suggest the gasoline plume is migrating in the opposite direction of your collateral, as was anticipated by the area topography.

Based on this information, it’s logical to conclude that a Phase I is not necessary as a result of the release at the former gasoline station. Rather, some relatively limited online research was completed for a fraction of the cost and time it would have taken to complete a Phase I.

Next time we’ll present a case that involves a non-conclusive Phase I report, something that probably seems all to familiar to you.

As 2012 draws to a close, I want to share three important themes that seemed prominent throughout the course of the year. I hope they will help guide your business in 2013.

1. Using an escrow to get the deal done

2. The pros and cons of SBA deals with high-risk collateral

3. AULs…Don’t forget to maintain them!

Using an escrow to get the deal done

In the not too distant past, an environmental issue requiring remediation would often spell the end of a deal, especially if it required bank financing. As the industry has evolved, so has lenders’ understanding of issues involving contamination and their risk tolerance. To that end, I’ve noticed an abundance of contaminated properties being transferred this year — and lent upon — with outstanding environmental issues.

The first ingredient in making these deals happen — and sleeping well at night — is making sure that the property owner (or party responsible for the cleanup) has a qualified consultant that fully delineates the source and extent of contamination in soil, groundwater and indoor air (as applicable). Second, the consultant must accurately predict the cost and time frame to take a property to permanent regulatory closure.

Finally, the lender should retain their own Environmental Professional to review the scope and anticipated costs of remediation, and either escrow (for example) 150% of anticipated costs or obtain environmental cap-coverage insurance, until regulatory closure is achieved.

The pros and cons of SBA deals with high-risk collateral

With the consolidation of the petroleum industry in the last 10 years, many redundant services stations were put on the market and purchased by existing operators. The SBA 504 program offers a great opportunity for borrowers to put less money down while providing lenders with less capital exposure.

The catch, however, is that SBA has a pretty exacting environmental policy and requires certain assurances from consultants (e.g. Reliance Letters that some consultants refuse to sign due to liability language). These requirements may not otherwise be needed on a traditional commercial mortgage, and I’ve encountered a number of borrowers who struggle with the decision. More often than not, however, while it may cost the borrower more upfront money in due diligence expense, it seems that the favorable aspects of the SBA program outweigh the negatives. Plus, if the borrower is also purchasing the property — rather than a refinance — it behooves the borrower to be all the more conservative.

AULs…Don’t forget to maintain them!

Most CRE lenders have probably been involved with properties that maintain an Activity and Use Limitation (AUL), which may limit certain future use of the property, unless more extensive remediation is conducted. What’s often lost in translation, however, is some of the more benign requirements of an AUL.

For example, an old industrial property used for many years as a plating facility was remediated. While the lion’s share of soil and groundwater contamination was removed, elevated levels of heavy metals and petroleum were left in soil in order to significantly limit the cleanup costs — once it was determined that the requirements of an AUL would adequately protect human health and the environment. Everyone involved in the transaction understood that certain future uses were prohibited, such as residences, daycare facilities, etc. However, as the contaminated soil was located underneath a paved parking lot, the AUL also required that a suitable barrier (pavement in this instance) be well maintained and inspected annually.

In this example, three years after the AUL was filed, three violations occurred: 1) The pavement was not annually inspected; 2) The pavement became worn and no longer provided an adequate barrier to the contaminated soil; and 3) A contractor hired to plant trees along a walk way was not made aware of the AUL and excavated and improperly disposed of contaminated soil off-site. The DEP subsequently fined the owner and may scrutinize this property in the future.

In short, as a lender, know all the requirements of the AUL and bind your borrower to adhere to them throughout the duration of the loan.

Welcome to the second in a series of brief tutorials on environmental due diligence.

During the first tutorial, we talked about how using preexisting environmental documents is a good starting point in your quest for appropriate environmental due diligence. But what if previous reports aren’t available and you need to start from scratch?

Here’s a brief overview of three environmental due diligence products to consider, and how to make the best choice for your individual deal.

NOTE: If the video is blocked by an internet firewall, you can download the video transcript.

Environmental Due Diligence tutorial series

This past summer, we asked our clients to tell us about the environmental issues and concerns that are most affecting their real estate transactions. Inspired by your responses, we are producing a series of brief tutorials to help illuminate some of these issues — from a general overview on how to get started, to more specific discussions on reports, contamination and the nuances associated with different property types. Watch this space for more tutorials.

Welcome to the first in a series of brief tutorials on environmental due diligence.

At the onset of a commercial real estate transaction, do you find yourself wondering if an environmental investigation is even necessary — and if so, what level of due diligence is appropriate? Watch this two-minute tutorial to learn about the three simple steps that can get you moving in the right direction.

Environmental Due Diligence tutorial series

This past summer, we asked our clients to tell us about the environmental issues and concerns that are most affecting their real estate transactions. Inspired by your responses, we are producing a series of two-minute tutorials to help illuminate some of these issues — from a general overview on how to get started, to more specific discussions on reports, contamination and the nuances associated with different property types. Watch this space for more tutorials.

1. A longtime dry cleaner on a septic system in a rural area

A longtime dry cleaner can be a significant hazard in any setting, but add in a septic system in a rural setting and it nearly always spells trouble. While dry-cleaning solvents, namely perchloroethylene (“perc”), have a nasty habit of penetrating concrete and can be released to sub-surface soils via minor spills, more widespread issues tend to occur when there’s an opportunity for perc to enter a leach field, via sinks, toilets or floor drains…whether by accident or not.

The heightened risk in a rural setting is related to the likelihood of a property requiring a potable well, or that the site is located in a groundwater protection area even if serviced by municipal water. These situations have a very low threshold for contaminants — it doesn’t take much of a problem to become a big one.

What to do? Upfront due diligence — soil and groundwater testing — prior to purchase or extending credit will establish a baseline that contamination is not already present. Then, simple steps can help mitigate the risk of a future release: secondary containment storage for perc containers and dry cleaning machinery; closing unnecessary floor drains and sumps; posting signs warning that it’s illegal to dump perc down drains, sinks, etc.; and testing well water annually.

2. A residential improvement adjacent to a gasoline station in an urban area

Gas stations on postage-stamp lots in urban areas have spatial limitations…that’s easy to see. As a result, underground storage tanks (USTs) are often squeezed in between the service station building and property boundaries. If your collateral is a multi-family residence on an abutting lot, the building could be less than 10 feet from the USTs. Unlike gas stations in suburban locations, many urban stations haven’t been renovated. Older stations can mean older tanks and lines, and that can lead to a greater risk of a release.

Currently, one of the hot button issues at DEP is the potential for indoor air to be impacted by contaminates (e.g. vapors entering the basement of an apartment building from a gasoline release migrating in shallow groundwater).

What to do? Always check the regulatory status of nearby gasoline stations, especially those directly abutting your collateral. With new residential development, vapor barriers are often part of the construction process and can help mitigate the risk. With older, preexisting buildings, liquid boot or other basement-sealing technologies is a good, albeit expensive, solution.

3. A proposed development in filled land

In historically underutilized urban areas such as portions of South Boston (before the recent building boom) and cities such as Manchester, NH; Lawrence, MA; or Woonsocket, RI, redevelopment of vacant land or existing mills often means unearthing filled land to facilitate new building construction. Many of New England’s coastal and urban areas consist of former tidal flats or low-lying areas that were filled with soil that often contains ash, a byproduct of coal used to heat buildings prior to the introduction of petroleum in the 20th century.

The ash contains polynuclear aromatic hydrocarbons (PAHs) and heavy metals, and can be hazardous, even though state regulations may stipulate it is exempt from notification. When unearthed, this material needs to be properly disposed if it cannot be reused on-site, and the costs can be considerable.

What to do? Even if specific sources of contamination, such as tanks, drums, or leach pits, are not identified during a Phase I, consider soil analyses during geotechnical borings that are typically completed to assess the suitability of fill for new construction. The cost of soil disposal should be factored into development costs.

1. Former South Weymouth Naval Air Station: As noted in this Boston Globe article, portions of the former air station, which closed for military use in 1997, are contaminated with jet fuel, petroleum, solvents, and other hazardous materials. Clean-up efforts have been ongoing for more than ten years. Extensive residential construction will be a key component of the mixed-use development to be known as “Southfield,” so it’s critical that development guidelines for much of the property are unrestricted, as noted by several municipal officials.

In other words, Activity and Use Limitations (AULs) may not “fly” here — at least not those that specifically restrict residential use. The cost of this project will far exceed that of a straight commercial development with AULs in place. Given the EPA’s apparent allowance to limit the amount of remediation by the responsibility party (the Department of Defense), it looks as if a major tussle could ensue between the locals and the feds.

2. Rockport “Gift House”: This is an interesting tale of “damned if you do, damned if you don’t.” In 2001, the then-owner of a single-family residence gifted the home to the town rather than see it demolished to make way for a larger residence. The town accepted the proposal and moved the home to a piece of town-owned real estate in a predominantly residential area. Just one problem: The lot where the home was placed was historically used by the DPW for hazardous material and petroleum storage. While the foundation for the house was being excavated, contaminated soil was discovered.

Since 2002, the town has spent more than $500,000 on the remediation as well as the move itself and other unrelated repairs. The town is correct in saying that the site needed to be cleaned up anyway, and the most recent data suggests that it has been remediated to a level that meets residential criteria. But it would have been beneficial — not to mention more economical — to have tested the soil before the move, as echoed by a municipal employee in this Boston Globe piece. To date, the home remains on the market and has surely suffered from the stigma of its history, even if the land no longer presents a risk to its future owners.

3. Milton Mystery Contamination: File this one under “Never saw this coming….” Soil in the backyards of a number of residences along the Neponset River was found to contain elevated lead and arsenic concentrations. The testing was initiated by municipal officials concerned about elevated PCB concentrations at an adjacent parcel of state-owned land along the banks of the river. Testing on the state’s property lead to testing on the adjacent residential properties.

While PCBs were not found on the residential properties, dredging activities in the 1960s and/or historic use of spray pesticide are suspected to be possible sources for the lead and arsenic. The actual source may never be known. A property transfer on any of the single-family residences would not have included an environmental investigation, so there was little chance a prospective homeowner or lender would have known about this situation ahead of time. While the state is on the hook for the cleanup, the perception of a tainted property could linger well into the future.

No end-of-year message would be complete, however, without a “best of” list. After 20 years in the industry, I’ve noticed several common concerns that clients routinely seek help on. Here, then, are my top five Q&As of 2011:

1. Is this existing Phase I report too old?

That depends. Under any circumstance, a 20 year-old Phase I is going to be inadequate, but a report less than 10 years old might not be.

First, determining that the report was completed pursuant to industry standards and with a standard of care is a must. Second, some streamlined investigation can determine if anything of significance has changed at the property since the Phase I was completed (e.g., high-risk building occupants, new tanks, spills in the area, etc.). Means of answering these questions include updated borrower questionnaires and Database surveys. If nothing of consequence has changed, a new Phase I may be deemed unnecessary; the incurred fees of the streamlined investigation are a fraction of the cost of a new Phase I.

Note that some situations require a new Phase I regardless of mitigating factors (e.g., certain SBA 504 deals).

2. Should I rely upon a report (e.g., Phase I) that wasn’t prepared for the bank?

Maybe. First, determine if the report is of adequate quality and completed by a reputable firm. If so, ask the firm for a reliance letter and to be named as an additional insured on their insurance policy.

Lastly, see Question 1 above for information about the need for additional investigation.

3. If an RAO has recently been filed, why should I need anything else?

A Response Action Outcome (RAO) is used to close an open spill condition with the Massachusetts DEP. The key word here is condition…not site.

Example: An RAO is filed at a gas station for a spill of waste oil that was released from a failed underground storage tank. The tank is removed, contaminated soil is excavated, and the condition is closed.

Note, however, that none of the testing associated with this single condition has any relationship to other potential “recognized environmental conditions” on the property (e.g., gasoline tanks and pumps, hydraulic lifts and floor drains in the garage, or a fuel oil UST on the other side of the building). An RAO is a good sign that certain adverse conditions have been closed, but it’s only a piece of the puzzle.

4. Should I still be concerned about asbestos? It’s not as topical as it was in the 1990s.

To a certain degree…yes. However, one of the reasons asbestos isn’t front and center anymore is that so many building owners addressed the presence of asbestos during the renovation boom from the mid-1990s through mid-2000s.

Additionally, the FDIC had what some would consider an overemphasis on asbestos conditions in the early 1990s, when they were heavily involved in the New England commercial real estate market.

Some environmental firms still conduct cursory asbestos investigations (visual only) as part of a Phase I, while others clearly state that it is not part of the scope. Lenders should have their asbestos radar up on redevelopment deals or when considering foreclosure.

5. How detrimental is the existence of an AUL if I need to foreclose?

On some deals, an Activity and Use Limitation (AUL) will have little if any negative impact. On others, it can be more significant. For example, an AUL that simply limits access to subsurface soils at an industrial facility (in an industrial-zoned neighborhood) is unlikely to have any negative impact on value.

However, an AUL that prohibits residential development at a former suburban mill complex (in a mixed-use and mixed-zoned area) could limit the number of potential buyers and thus the resale value of the property, especially if it was otherwise an ideal candidate for redevelopment into an apartment complex.

Illustrating this point is the case of the Burgess Brothers Landfill site in Bennington, Vermont. While a former landfill and superfund site is not what a lender would consider a prime piece of collateral, it does emphasize one point in particular: Even a contaminated site that has been accounted for, in terms of remediation costs, can turn out to be much more of a financial burden than originally anticipated…and changes in groundwater flow direction can often be the culprit. Groundwater flow changes are caused by many factors, not the least of which is development — both in regards to changes in land use on the surface and greater strain of the groundwater supply, which tends to lower the groundwater table.

So what to do as a lender in a similar circumstance? When a substantial remedial effort has already been undertaken and it’s obvious that contamination is still present, consider one of many environmental insurance products, such as “cap coverage”, which will cover overruns in scope and related cost. Requiring a beefed-up escrow to cover the life of the loan would be an alternative to insurance.