Part 2: Environmental Due Diligence In Commercial Real Estate
Why should you worry about environmental issues?
When purchasing property in NYC (or anywhere in the USA), whether through a simple real estate purchase or large corporate deal, conducting an environmental due diligence investigation should be on top of the list. There are federal and state laws that impose significant liability both to governmental agencies and private third parties on owners and operators of properties with environmental contamination. Environmental issues also have major business and financial impacts: a property may decrease in value causing the property to be underwater on its loan; remediation may interfere with business operations on the property or result in an on-going expense; or there may be expensive litigation that lasts for many years.
In a commercial real estate acquisition the purchaser should have a Phase I Environmental Site Assessment (Phase I) completed by an environmental professional. A properly completed Phase I will allow a purchaser to say they carried out “all appropriate inquiries” and seek protection from the Comprehensive Environmental Response Compensation and Liability Act (“CERCLA”) as a “bona fide purchaser”. Although the bona fide purchaser protection from CERCLA liability is the cornerstone of proper environmental due diligence in acquiring commercial property it is important to note that there is a significant difference between being shielded from CERCLA and potential liability to private third parties or the public through tort actions. For example, if a not-for-profit that has a mandate to protect the nearby stream, or if the owner of the adjacent property or any other third party, is harmed by the contamination emanating from your site, they can sue you in a tort action – you cannot simply waive the Phase I and/or Phase II in front of the judge and expect to walk away. Moreover, owners of contaminated property can also be liable for the resulting health and safety impacts, for example, if the indoor air quality of a building harms employees of a tenant. The bottom line is that environmental issues can result in significant legal fees and damages no matter the amount of due diligence that is carried out. I say this not to discourage buyers from undertaking environmental due diligence – but to drive home the point of how important it is to take the process seriously to limit your risks as much as possible.
The Environmental Due Diligence Process
The Phase I Environmental Site Assessment
Any environmental due diligence should start with a Phase I Environmental Site Assessment. The Phase I ESA is essentially a review of all the records and documents applicable to the site backed up by a site visit by an appropriate environmental professional (i.e. “all appropriate inquiry”). Many buyers look for the cheapest Phase I that they can find – be very careful with that approach as you get what you pay for. The Phase I ESA must comply with the specific reporting requirements provided in 40 CFR §312.21 (Results of Inquiry by an Environmental Professional) and the ASTM Standards so make sure you hire a reputable consultant to do the work.
The Phase II Environmental Site Assessment
A Phase I ESA will identify whether there are any “Recognized Environmental Conditions” or “RECs”. If there are RECs present on the site, then the environmental professional will recommend that a Phase II Environmental Assessment should be completed. A Phase II investigates the RECs by doing intrusive testing. Holes are drilled into the soil (these holes can be outside of a building or even through the foundation to the soil underneath) and if necessary “monitoring wells” are installed into the holes to take groundwater samples. During the drilling the environmental professional takes soil samples and then submits them to the lab. They may also come back and use the monitoring well to sample the groundwater and submit those samples to the lab. The results will determine whether there is actual contamination. Phase IIs can also cover a variety of other testing, such as indoor air quality.
Depending on the level of contamination, the next phase would be remediation. The remediation process is beyond the scope of this article. Another aspect of environmental law that is beyond the scope of this article, but worthy of mention for any purchaser considering a new development is the State Environmental Quality Review Act (known SEQR). Although SEQR is not technically a part of the due diligence in acquiring a piece of property, it can make or break a new development deal. Any time a NYS agency or local governments must approve or issue permits for a new development, an environmental impact assessment must be completed and depending on the project it can range from being quite simple to very complicated and costly. Bottom line is if you are looking to acquire property for a new development, in additional to conducting standard due diligence make sure that you also seek advice on the likely SEQR path your project will take prior to consummating the deal (or even signing the contract).
Environmental liability in commercial real estate can undermine any deal and may result in additional liability to the buyer beyond even the value of the property. In acquiring property the basic, age-old concept is referred to as “caveat emptor” or “buyer beware”. In other words, if you are a buyer and do not spend the time and money to investigate the condition of the property you are going to purchase (whether environmental or otherwise), once you close on the deal, all the environmental issues could become yours to keep. Although nothing substitutes carrying out actual environmental due diligence, there are ways to shift environmental risk between parties through contract provisions. This can be accomplished in many ways, from having the seller make promises (or representations and warranties) that the seller is not aware of any environmental issues to having the seller agree to be responsible for cleaning up (or “remediating”) any environmental contamination found on the property.
- Make sure that the seller’s representations and warranties regarding the environmental condition of the property do not survive the closing or termination of the contract.
- Exclude any environmental issues that a prior owner or third party may have caused at the property from all seller’s representations.
- Sellers should be very careful if they believe that their property is contaminated – regulatory law requires environmental consultants to report contamination found during an environmental inspection (for example, when the Purchaser’s consultant takes soil samples during a Phase II). This means that environmental agencies will turn their eyes to the property you are trying to sell and the issues will likely become public knowledge.
- Hire a competent environmental consultant to conduct a thorough investigation of the environmental condition of the property.
- At the very least, have seller represent in the contract that the seller (nor its tenants) have done anything during seller’s ownership that could cause an environmental issue and try to have that representation survive the closing.
- If prior to the end of the due diligence period the environmental investigations reveal contamination, buyers should make sure to have a consultant provide an estimate of the cost of remediation.
- When environmental issues come up during the contract phase it can often kill a deal. One option rarely considered it to obtain environmental insurance. The parties should work together to determine what they are willing to be responsible for, and then obtain environmental insurance for the rest.
- Make sure consultants can get access to all parts of the seller’s property, even tenants’ space.
- Include an indemnity provision which makes the seller responsible for all existing conditions prior to the closing date. If you can get an environmental indemnity it is useless if it does not survive the closing.
- Be careful of definitions, for example there is significant differences between “Hazardous Waste” and “Hazardous Substances”.
- Require an appropriate contingency period. Thirty days is usually enough time if only a Phase I is needed. However, if a Phase II is required the typical 30-day due diligence contingency will not be nearly enough. In the alternative negotiate the right to extend the contingency period if the Phase I finds RECs and/or recommends a Phase II.
In the Concrete Jungle:
Phase I reports often do not carefully review asbestos issues with a building. In New York City, all building owners are required to have an “asbestos survey” on file – if you are purchasing a building (especially if it is an older building) make sure to request the asbestos survey and if the seller doesn’t have one, require them to conduct one now at their cost.
Lenders require Phase I’s on deals because they may be jointly and severally liable for cleanup costs in the event of loan default/foreclosure. However, as I mentioned in the first Article in this series in New York City many deals are done as “all-cash” with no lender involved. This means that in New York City there are often properties that have changed hands many times over a long period without a buyer ever being forced to conduct an environmental site assessment by a lender. This means the current owner of the property (i.e. the seller) may be able to provide you with a truthful representation that they don’t know of any environmental issues. In addition, the lack of historical investigations will likely mean that there are no obvious public records or environmental reports. The bottom line is that in New York City don’t assume that just because there is no information regarding an environmental problem on a property, that there is in fact none.
The EPA Website actually has a great resource for Phase I and Phase II ESAs – see link here.
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