One of the areas of F&R’s environmental practice is transactional due diligence support – helping our clients manage the environmental risk associated with real property. Some of that work is performed for lenders whose purpose is to provide their clients with financial resources to reach their goals. When times are good it’s rewarding to be part of team that helps someone start up a small business, redevelop a distressed site, or expand an existing manufacturing facility.
However, when a recession hits our lender clients are faced with a wave of potential foreclosures that they never wanted and may be unprepared to handle. It’s been over a decade since the Great Recession and memories can be short, so we thought it would be a good idea to touch on some of the ways that foreclosure changes the potential environmental risks CRE can present to a lender.
ENVIRONMENTAL CHALLENGES WITH TROUBLED ASSETS…Preparing for Pandemic-Driven Foreclosures
In the US we are over four months into this pandemic and as I’m sure is true all of you, F&R’s primary concern has been the health and safety of family, loved ones, colleagues, and clients. However, we have also been concerned about the economic impacts of the pandemic. Increases in unemployment, major restrictions in global trade, and a reduction in consumer spending have created the sharpest recession in US history. Many businesses that have been shut down in the interests of public safety have been especially hard hit, with higher possibility for permanent closure.
What Happens When a Lender Moves from Creditor to Owner?
One of the areas of F&R’s environmental practice is transactional due diligence support – helping our clients manage the environmental risk associated with real property. Sadly, for the commercial real estate lending sector that means an increase in foreclosures. Any lender will be the first to tell you they are built to service their client’s financial needs, not to own or manage property. Most lenders have established policies and designated personnel to handle distressed assets, with the first goal to work with borrowers to prevent foreclosures and then to handle foreclosure if necessary. Lenders typically have a process of managing and selling any properties acquired through foreclosure which is referred to as Real Estate Owned (REO). However as we saw with the tidal wave of foreclosures related to the Great Recession in the late 2000s, even the best prepared lenders were overwhelmed with the volume of sites and the complexity of what was required as they suddenly owned thousands of properties they didn’t want. Over a couple years lenders eventually got their hands around the situation and slowly disposed of the properties, and in doing so equipped a generation of lending professionals with the experience needed to tackle the current situation. However, many of those professionals moved on in their careers as needs diminished and there is a danger that the hard-earned experience has been lost. In addition, not all lenders have specialized environmental risk management (ERM) departments, which have experience navigating environmental regulatory and liability challenges presented during foreclosures.
Whether a lender has in-house ERM, outsource partners, or relies on the expertise of their consultants foreclosing on a property increases the potential risk a property can present to the lender. Being prepared gives you the best chance of managing what can be a bad situation. There are a whole host of risks presented by owning real property that are not present when lending on real property. In general, lenders have protections from liability from environmental issues related to real property in most environmental laws and regulations. However, if a lender steps into the chain of title for a property or even participates actively in that properties management those protections can be rendered void.
A Lender’s Guide to Environmental Issues with Distressed Properties
Know your policy and the provisions of the loan documents. Policies are usually shaped by incorporating lessons learned from past experiences, many of which may not be mistakes you want to make again. You have to know your environmental policy to ensure you are following it.
Evaluate your existing due diligence, but don’t rely on old information: If the property in question has existing environmental due diligence documentation it can be helpful for initial evaluations or as a resource to be used in preparing an updated report. However, do not rely on old reports or reports prepared for others. Condition at a property can change quickly and you as a lender are moving from a creditor to an owner.
Put together the right team: Obviously we are a little biased here, but we think it’s important to have a knowledgeable, reputable environmental consultant on your side. However, something you may not have considered is the potential importance of an environmental attorney. Any good real estate attorney knows the basics of transactional due diligence, but if significant environmental challenges are uncovered on a property it’s typical to call in an environmental attorney experienced with the regulations of the state in which the property is located. You should also have a plan in place in the event the pre-foreclosure and REO work volume overwhelms the existing resources. During the Great Recession lenders employed approaches including re-tasking existing employees, outsource partners, or new hires.
Enhanced pre-foreclosure due diligence: Prior to foreclosure most lenders have a Phase I Environmental Site Assessment (Phase I ESA) prepared for the site by a reputable firm. Ensure that the report is prepared in accordance with the most recent ASTM Standard, which as of July 2020 is E1527-13. Work with the consulting firm to ensure you complete your obligations during the process so that the report is compliant with the EPA All Available Inquiries (AAI) standard which provides liability protection from CERCLA, which is commonly known as the Superfund Act.
Business Environmental Risks (BERs): Phase I ESAs prepared to the ASTM Standard are limited to the risks presented by petroleum products and a group of contaminants identified by the EPA which include solvents and heavy metals. You should consider having your consultant evaluate some of the following environmental risks which could impact real property: asbestos, lead-based paint, lead in drinking water, radon.
Active construction sites: There are additional risks specific to active construction sites. As an example, on construction sites as the owner you may become liable for compliance with erosion and sediment control regulations with potential fines of thousands of dollars per day. We’d recommend including this as a BER on any active construction site, especially single family sites which may have less regulatory oversight.
Industrial sites: Industrial properties may have an elevated risk of contamination to the site soil or groundwater from past operation. However, there are other risks to evaluate prior to foreclosure including decommissioning of process equipment, disposal of unused chemicals or waste, and compliance with on-going regulatory obligations. Actively engage your legal counsel to assist you in managing and addressing these risks and determine from the loan documents the responsibilities of the borrower, if solvent. There is a strong incentive for the lender to work with the borrower to ensure that they address as much of the decommissioning effort as possible. Costs to decommission a mid-sized manufacturing facility could be in the six to seven figure range, and without the cooperation of the borrower, the lender may have to list themselves or a Special Purpose Entity (SPE) as the generator and assume cradle to grave responsibility for the ultimate fate of the waste.
Allow plenty of time, and prepare for a slow process: It will come as no surprise that some borrowers are not cooperative in facilitating due diligence by the agent of the lender if they are concerned with foreclosure. Arranging access can be a lengthy process, and you may need to work with your legal counsel to obtain a court order.
Prepare for a mess: Unfortunately, foreclosure sites are not always in the best condition. Material handling and storage procedures get sloppy; waste materials build up on site to avoid disposal costs, and significant amounts of trash, debris, and unwanted material can be left on-site. Budget additional time and effort for someone to identify and quantify the materials present and have a cost estimate prepared for their removal and proper disposal.
Deferred Maintenance: If the improvements contribute significantly to the value of the property you should consider a Property Condition Assessment (PCA), which will evaluate the general condition of the structures and identify deferred maintenance issues. If the borrower has put off the performance of maintenance to increase short term cash flow or profits, then the improvements may be worth less than the appraised value. This is fairly common, especially with family-owned businesses and mid to lower market multi-family properties. Roofing on a large industrial or commercial warehouse can run into the six figures.
Avoid dark building syndrome: If a building sits vacant and without power after foreclosure it can cause significant damage to the asset. A finished building is designed and built to have an HVAC system actively controlling the temperature and humidity. Uncontrolled temperature and humidity can allow for mold growth in the summer, and pipes can freeze and break in the winter. If unmonitored a small leak can cause thousands of dollars of damage over time. Additionally vacant buildings are inviting targets for vandals, which may cause significant damage and violations or fines from the locality. Have a plan in place when taking possession to the building to keep power on, secure the building, and provide routine observations or security. Property management companies can be an asset for these considerations.
What’s your Exit Strategy?: The lender took title to the property in order to recoup resources lost when a loan defaulted. What is your process going to be to maximize the return on that property? Do you have partners such as a commercial real estate agent identified to help you explore improving a property for sale? Will you sell as is, or will you improve the property? – The cost estimate for removal and disposal of trash and debris you had the foresight to obtain prior to foreclosure will be asset at this point in the process.
Most estimates we’ve seen are forecasting foreclosure volume to ramp up beginning in Q3 2020 and stay high throughout 2021. It is not too late to prepare for the influx of foreclosure activity that is coming. Review and update your foreclosure policy, get your list of consultants and attorneys list up to date, and put a plan in place on how to service the additional REO volume. If you want to talk through any of these points or you have additional questions, please give us a call.
Prepared by Zachary Parker, Senior Client Manager, Due Diligence