Entrepreneur Insight

Before You Buy Property, Dig into Environmental Issues

Protect yourself and conduct an environmental review before buying or selling CRE.

Thinking about buying or selling a piece of commercial real estate property that's currently in use as a shopping center, apartment building or warehouse? Before proceeding much further, a deep-dive review of environmental issues is in order.

It could be the difference between dealing with a minor roadblock now, or a king-sized headache later. In the worst-case scenario, the omission of an environmental assessment could torpedo the entire deal.

While that may sound harsh, it's a warning against the line of thinking that what you don't know doesn't hurt you. The message from many experts in the fields of banking, law and engineering is the same: Find out if your property has issues now, before it becomes a bigger problem.

CRE environmental review step by step

For many banks that finance commercial real estate transactions, a review of environmental risks is required for any deal, says Tom Mounteer, an environmental partner at Paul Hastings, a law firm with offices throughout the United States and Asia. It's a way for the bank to protect itself, he says.

“A review informs the bank about the real property condition and if there have been any releases of hazardous substances on the property,” says Mounteer, who advises buyers and sellers on environmental liabilities in real estate transactions.

But environmental reviews are not the law of the land. A hodgepodge of federal and state laws applies at various points in the environmental-review process. And it's not required by law to pay an environmental professional to perform an assessment, Mounteer says.

Since a legal mandate doesn't exist, many banks have established procedures for conducting an environmental review, says Kurt Easthouse, a principal geologist of environmental services at EHS-International Inc. in Seattle, which has completed more than 1,000 environmental investigations, hazardous material abatement, and construction management projects. A first step is usually the ordering of an Environmental Data Record, which is essentially a list of publicly available information on a specific lot.

If the EDR turns up something that warrants further review, the next step is usually a Phase I Environmental Site Assessment. This process is guided, although not legally regulated, by federal Environmental Protection Agency standards, Mounteer says. An ESA goes into more detail than an EDR, but typically does not involve the collection or testing of groundwater, soil or air samples.

However, the ESA stage is when things can get serious. If the ESA reveals issues, advisers on a deal will typically order a Phase II assessment, Easthouse says. That's an even-deeper investigation of the site's environmental conditions and includes steps such as collecting groundwater samples. If measurements of those samples reveal contamination that exceeds certain levels, the owner may be required to report the data to federal authorities.

An EDR report costs about $500, says Kimberly Rice, a commercial lending relationship manager for East West Bank. A full Phase I ESA runs between $1,500 and $5,000. A Phase II report can cost thousands of dollars more.

How it protects CRE buyers and sellers

Experienced real estate professionals are mindful that these sometimes-costly steps are an integral part of any transaction. But not every buyer or seller of commercial real estate is savvy about this process, Easthouse says.

Consider this case study: Easthouse once had a couple as a client who wanted to sell their ranch, which was near Seattle, and pass along the proceeds as an inheritance to their children. However, when the family had bought the property 15 years earlier, they paid cash. That means an environmental risk assessment wasn't performed at the time, and the family didn't know the ranch once contained a gas station, which had a leaking tank.

“They're now responsible to clean it up, even though they didn't cause the contamination,” Easthouse says.

Cleanup costs can vary widely, but can run into the hundreds of thousands of dollars.

Another reason for conducting a thorough environmental-risk assessment is that it can help a buyer or seller protect their own interests when it comes to the transfer of liability. Although the buyer usually assumes liability in a CRE deal, the terms of the liability transfer are unquestionably a “creature of the contract,” Mounteer says. For example, a Phase I study is required for a buyer to secure a liability defense to a federal hazardous substance release liability.

It's also simply a good idea to know what you're getting into, Mounteer says.

“Buyers want to know what was on the property before the current site use,” Mounteer says.

Plan ahead

Some types of properties are more likely to cause problems than others. Lots where a hotel stands or once stood are typically clean. The current or former sites of dry cleaners, gas stations and automobile repair shops are another story, Easthouse says.

A final word of advice: Plan ahead. Actually, plan very far in advance.

In King County, Wash., where Easthouse works, it can take six to eight weeks just to get an appointment with a county inspector to review the files of a pending transaction.

“They are so underfunded and understaffed,” Easthouse says.

Speaking of government, a private individual contemplating a property sale doesn't need to worry about any kind of immunity granted to local or state entities. At least in that respect, private landowners are playing on a level playing field in any CRE deal, no matter what bank or financial institution is involved and no matter where the property is, Rice says.

“There are no exemptions for a government agency,” she says. “It doesn't matter who the borrower is – all properties that are secured by a loan must go through the due diligence.”

This was the featured topic at an East West Bank workshop in Seattle, Wash. Upcoming topics include estate planning and project management. See details on upcoming workshops.