Environmental risk screening: A prudent risk management practice for lenders

RMA Journal, The, June, 2003 by Anthony J. Buonicore

The goal of environmental analysis is to ascertain the value of a CRE property and to protect the lender from loss. Due diligence can cost anywhere from nothing to $2,500, depending on the amount of risk the bank is willing to assume. This article includes seven levels of due diligence and 11 questions often asked by lending institutions.

The risk of environmental exposure today has become a common due-diligence consideration for financial institutions involved in financings for which commercial real estate is used as collateral. A recent survey of national, super-regional, regional, and community banks in the U.S. revealed that more than 80% of these institutions have a formal environmental policy. (1) This was not surprising considering that 10% of the banks surveyed also indicated they faced losses attributable to environmental problems in each of the past three years.

The same survey indicated that almost 75% of all GRE loans today receive some level of environmental investigation during due diligence. This trend has closely followed the availability of third-party, property-specific environmental information on-line. While the primary purpose of environmental due diligence is to assess any impact on the value of the collateral, the presence of environmental contamination on a property may have other negative impacts on the bank. For example, environmental contamination may increase the likelihood of loan default or involve the bank in unnecessary litigation. Under a worst-case scenario, it may even expose the bank to direct liability for cleanup costs. (2)

Environmental Risk

Environmental risk can exist in any of the following banking business areas:

* Commercial lending, where properry serves as collateral for new loans and refinancings.

* Workout, where a financial institution may assume "too active a management role."

* GREG (other real estate owned), where the financial institution owns the property, e.g., bank branches, foreclosed property, etc.

* Trust, where financial institutions may assume ownership and/or control positions as part of their fiduciary responsibility.

To minimize such exposure, the specific risks that financial institutions must consider include:

1. Loss in the collateral's value.

2. The risk of having to write off the loan balance because pursuing foreclosure on the property used as collateral is not possible (for example, due to the presence of environmental contamination).

3. The risk that a borrower required to undertake an environmental cleanup on the property may not be able to repay the loan or make timely payments.

4. The risk that a mortgage loan may lose priority to an environmental cleanup lien ("superlien") imposed under certain state laws--for example, in Massachusetts, Michigan, New Hampshire, Arkansas, Tennessee, and New Jersey.

5. The risk that a borrower may not maintain property with potential environmental contamination in a sound manner.

6. The risk of personal injury and property damage suits, aside from statutory liability.

7. The risk of reduced property value after discovery and remediation of environmental contamination (stigma impact).

8. The risk of direct liability for cleanup costs (which could exceed the value of the property) if the financial institution participates in the management of the facility. (3)

9. The risk of litigation with beneficiaries for property held in trust (for example, litigation over responsibility for cleanup of contamination).

Environmental Due Diligence

Environmental due-diligence alternatives may range from doing nothing, to a very minimal level of screening, to the ASTM Transaction Screen process, to a full Phase I environmental site assessment (see Table 1). In general, large cap loans (greater than approximately $1 million) collateralized by commercial real estate virtually always have a Phase I conducted during due diligence. Small cap loans, on the other hand, have a wide variety of environmental screenings performed, depending upon, among other things, the perceived risk of the property, the type of property, the size of the loan, and the loan structure. The survey mentioned earlier found that more than 50% of financial institutions today are conducting some level of environmental screening on these small cap loans. Five years ago, most of these loans received no environmental review during due diligence. Of course, the more extensive the due diligence, the higher the cost. The typical cost of each of these various due diligence alternatives is summar ized in Table 1.

Fundamentally, the goal of performing any level of environmental investigation is to identify the presence or likely presence of environmental conditions associated with the property that may impact its value. Some common questions lenders use to identify potential environmental conditions that may impact a commercial property's value are presented in Table Z. In general, an affirmative response to any of these questions generally warrants further investigation by an environmental professional.