During my 31-year career as an environmental consultant and licensed engineer, I’ve had the opportunity to consult and work with hundreds of lenders, bankers, brokers, and attorneys representing commercial real estate clients, who were uncertain about what exactly this thing called commercial real estate due diligence really is. If you fall into this category, you’re not alone, and I’ll do my best to demystify what’s involved in this incredibly important process.
The Basics of Due Diligence
If due diligence is “the care that a reasonable person exercises to avoid harm to other persons or their property” as defined by our friend, Merriam-Webster, then we can immediately clarify what we’re trying to avoid: harm.
In the CRE industry harm includes borrowers having to spend more money than they should have, would have, could have, or worse. Due diligence increases in importance the greater something costs or the more it is valued. When purchasing commercial real estate property, proper due diligence is of the utmost importance because it can make the difference between a business prospering or failing. Or, worse yet, whether the loan is defaulted upon and the bank takes over ownership as an REO, or Real estate owned.
When you take those all-important steps in completing your due diligence you can avoid situations that can ruin your day, like when the contamination of the property you own costs more to clean up than the property is worth.
In order to protect banks in such cases, and to encourage “Brownfield” development, the government protects the bank if they conduct proper “due diligence.” You definitely want to get ahead of the (due diligence) game, so you can look out for the buyer. In this way they’re protected under the “Innocent Landowner” defense. This means ALL commercial real estate transactions being financed by a bank have requirements to perform an environmental assessment on every commercial property being financed. You can see how thinking in terms of minimizing exposure is a strong strategy. The exposure of the bank is a combination of factors that may include the borrower’s collateral, the down payment amount, and the loan amount.
The Reports That Will Check Off Those Necessary Boxes
Typically, a property is assessed via an “Environmental Site Assessment” (ESA), one of which is the Phase I, but there are alternatives. This can also be accomplished with budget-friendly options like the Environmental Transaction Screen Site Assessment or even a Small Business Association (SBA) Records Search with Risk Assessment (RSRA) desktop evaluation.
If contamination, or the potential for contamination, is discovered at a property, it’s identified in the Phase I report as a “Recognized Environmental Condition” (REC). In such cases it’s likely a “Phase II” (or “Phase 2”) that’s recommended. A Phase II involves installation of soil borings at the suspect locations to check the soil and groundwater for contaminants. If the Phase II identifies contaminants, then further soil borings are likely required to better define the horizontal and vertical extent of the contamination. Government regulators become involved and they may require cleanup. Sometimes cleanup isn’t necessary, and the contamination is allowed to remain in the ground.
What Standards Apply to Performing Environmental Site Assessments (ESAs)?
The standards accepted by nearly every bank are specified by ASTM International (formerly known as American Society for Testing and Materials). It develops and publishes technical standards for a wide range of materials, products, systems, and services. The environmental assessment standards are found in document, ASTM E1527 – 13, Standard Practice for Environmental Site Assessments: Phase I Environmental Site Assessment Process.
Is the Expense for a Full Phase I Always Necessary?
A Phase I adds to the borrower’s out-of-pocket costs and can result in the borrower going elsewhere for the loan. Sometimes the on-site inspection of a Phase I doesn’t add significant value to the due diligence process. Therefore, sometimes a less costly evaluation, such as an RSRA desktop, could be an acceptable alternative.
Is a Phase I Necessary When It’s Known Up-Front a Phase II is Needed?
It depends. Sometimes a property is known to be on previously undeveloped property and it’s a foregone conclusion that a Phase II will be necessary (e.g., a suspect gas station). If so, then perhaps the Phase I expense is unnecessary and can be applied directly to a Phase II. On the other hand, if the property is known to be on previously developed property, there may be a concern the past development was a dry cleaner, machine shop, or some other potentially hazardous business, in which case a Phase I is very appropriate. I’ve seen banks go both ways on this.
As an environmental consultant, I’ve personally overseen the investigation and cleanup of hundreds of properties. The many causes of the contamination include: Improper equipment installation, equipment failure, operator error, corrosion, construction damage, tank overfills, dumping, vehicle crashes, and residual contamination from past practices and operations.
There are many ways in which contamination can be present on commercial real estate.