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Environmental Due Diligence in the Commercial Real Estate Transaction: How to Protect Your Client Without Killing the Deal.

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Environmental Due Diligence in the Commercial Real Estate Transaction: How to Protect Your Client Without Killing the Deal

Environmental Due Diligence in the Commercial Real Estate Transaction: How to Protect Your Client Without Killing the Deal

There are many ways to kill a real estate deal, but environmental due diligence shouldn’t be one of them. The first step in protecting your client is to assemble a team of professional allies who will help you and your client reach the ultimate goal: to purchase or sell commercial property.

Once you and your client have made the decision to buy or sell a commercial property, consider adding a qualified attorney to your team. Why? Because the starting point of every commercial transaction is the purchase and sale agreement (PSA). As with any contract, the terms in the PSA are negotiable. At these early stages of the transaction, you have the first opportunity to protect your client. For example, the CCIM PSA contains the following:

NO OTHER REPRESENTATIONS AND WARRANTIES. Except as expressly set forth in this PSA or in an Addendum or Counteroffer: (a) Buyer is purchasing the Property, and the Property shall be conveyed and transferred to Buyer, “AS IS, WHERE IS, AND WITH ALL FAULTS” and specifically and expressly without any warranties, representations or guarantees, either express or implied, of any kind, nature or type whatsoever from or on behalf of Seller…

The “AS IS” language is favorable to a Seller because it allows the Seller to offer the property without warranties, which shifts the bulk of the risk to the Buyer. If you represent the Buyer, you should negotiate to remove the “AS IS” language altogether or negotiate exceptions into the PSA. One way to do this is to modify the standard Seller’s Disclosures to include a property condition disclosure requiring the Seller to disclose any known violation of any laws or restrictive covenants affecting the property. Inclusion of the following language could be helpful: “To the Knowledge of the Seller, the Property is in compliance with Applicable Law,” and “To the Knowledge of the Seller and except as disclosed by environmental reports provided to Buyer, no Hazardous Material is present in, on or under the Property.” You can also modify the Seller’s Disclosures to require the Seller to provide copies of all studies and reports that have been performed in connection with the property at issue, including prior Phase I Environmental Site Assessments (Phase I).[1] Finally, you can add environmental Indemnification into the body of the PSA as follows:

Environmental Indemnification. From and after the date of execution hereof, and forever thereafter, Seller agrees to indemnify, reimburse, compensate and hold harmless Buyer from and against any and all costs, claims, losses, cleanup expenses, or liability whatsoever, for environmental remediation necessitated by the release, discharge, refining, dumping, production, processing, manufacture, generation, treatment, handling, storage, transportation or disposal of Hazardous materials during or before Seller’s ownership of the Property.

After you negotiate the PSA and all addenda, the next step in your environmental due diligence process is to hire a qualified environmental consultant to conduct the Phase I which can usually be completed in about two weeks, depending on the environmental consultant’s schedule. It is best to get the Phase I completed early in the due diligence period to allow ample time to complete additional work that may arise. Provided the Phase I does not identify any recognized environmental conditions (REC)[2], controlled recognized environmental conditions (CREC), or historically recognized environmental conditions (HREC), both Buyer and Seller can move forward with the remainder of the transaction.

However, if the Phase I indicates there are environmental concerns, it’s important to come up with an appropriate plan of action to address them. Typically, the Phase I will provide a punch list of additional environmental work, sometimes referred to as a Phase II; this may, and usually does, suggest subsurface sampling of the commercial property. While a subsurface investigation may be required depending on the environmental issues identified, there are many times the issues can be addressed and resolved quickly and inexpensively while still protecting your client’s interests.

For example, floor drains are commonly found in industrial and commercial spaces. When floor drains are not connected to the sanitary sewer system, they become an REC because historically floor drains are commonly used to dispose of nearly everything, including spent chemicals. If the floor drain is not connected to the sanitary sewer and it has been a chemical disposal site for years, a costly cleanup may be required. Before conducting a subsurface investigation, however, it is possible to resolve the issue with a simple dye test coordinated with the local sewer agency. A dye test will tell you for certain whether the floor drain is connected to the sanitary sewer. If the floor drain is connected, and there are no records of hazardous waste discharge, there’s no need for further investigation. Instead of a costly subsurface investigation, the matter gets resolved for a few hundred dollars.

Of course, there are RECs that can pose much larger, more expensive problems; common examples are hydraulic hoists and petroleum storage tanks. Both are found on commercial properties, and both are known to leak petroleum products into the environment. With respect to petroleum product releases, a little goes a long way, particularly where groundwater is impacted. According to the EPA, one gallon of released oil can contaminate one million gallons of water.[3] But before you embark on a subsurface investigation, your environmental consultant should review available records. Agencies and the current property occupant can be sources of records that could indicate whether there are any known problems. If product reconciliation logs do not suggest product loss over time, and there are no current agency investigations, there may be no need to investigate the subsurface. By simply reviewing the existing and available information, you save time, money and keep the deal moving forward.

Sometimes the records review will indicate either product loss or historic product loss, particularly in the case of tanks. For example, if your client is considering the purchase of a service station that has been in business for decades, it is likely that the underground tanks on the property have leaked. A leaking petroleum storage tank can present as an REC, a CREC or an HREC. If the records review of the tanks indicates an ongoing cleanup in progress, the release is categorized as an REC. If the release has been closed but contamination remains in place to a standard below unrestricted residential use, the release is categorized as a CREC. By reviewing the available records, the environmental consultant can determine the nature and extent of the remaining contamination as well as the approved use of the property. If the release has been closed and no further action is required, the release is considered an HREC and is no longer a concern. Again, a review of the records will give the Buyer and Seller the information necessary to move forward, renegotiate the purchase price, or reconsider the transaction, including but not limited to: escrowing funds to complete any cleanup, delaying the Closing pending satisfactory cleanup, or opting not to Close on the property.

In addition to the environmental issues addressed above, there are some common issues of concern that fall outside the scope of a Phase I because they pose human health rather than environmental risks. These issues include asbestos-containing building materials, lead-based paint, and radon gas. Your environmental consultant should be able to inspect and test for these potential health issues as well as perform the Phase I.

Asbestos is found in a variety of building materials, including joint compound, drywall, floor coverings, floor covering adhesive, ceiling tiles, spray-on ceiling material, and coatings under sinks and around pipes. The presence of asbestos-containing materials can be readily confirmed with an asbestos survey, which costs about $2,000 depending on the size of the project. If the survey identifies some asbestos-containing material, it can usually be removed or encapsulated relatively inexpensively.

Lead-based paint was commonly used in homes and commercial property prior to the 1950s. In poor condition, lead-based paint can easily be reduced to a dust, making it more prone to ingestion. If a person ingests too much lead from lead-based paint, lead poisoning results. Your environmental consultant can sample and test for lead in suspect surfaces. If lead-based paint is found, encapsulation is the most efficient and preferred method of ensuring that it no longer poses a health risk.

Radon, which is a naturally occurring, radioactive, colorless, odorless gas known to cause cancer in humans, is another non-Phase I environmental issue relatively common along the Wasatch Front. Your environmental consultant can test for radon by collecting samples from radon-prone areas such as subterranean basements and foundations. Remedial action is warranted where radon gas concentrations exceed the action level of 4 picocuries/l and there is a risk of human exposure. The most cost-effective remedy is to install ventilation to ensure radon gas is not allowed to concentrate in an area.

In conclusion, when you assemble a good team, negotiate the terms of the PSA to include disclosures and environmental indemnification up front, and understand there are many ways short of a subsurface investigation to resolve environmental issues. Don’t let environmental due diligence issues threaten your transaction.


 

[1] Phase I Environmental Site Assessment (Phase I) is a term defined by the American Society of Testing and Materials (ASTM) in Standard ASTM E1527. The purpose of the Standard is to set forth the minimum requirements of a Phase I, which includes a visual, non-destructive inspection of a commercial property as well as a public records review to determine whether sources of environmental concern exist at or in the vicinity of the commercial property in question. The Phase I satisfies a Buyer’s environmental due diligence requirements, giving the Buyer a safe harbor.

 

[2]  REC means there is an existing environmental condition on the property; CREC means there is an existing environmental condition on the property but that it is subject to some type of control or agency oversight; and HREC means there have been recognized environmental conditions in the past, but cleanup efforts allow the property to be used for unrestricted residential use.

 

[3] EPA Office of Water, Source Water Protection Bulletin: Managing Above Ground Storage Tanks to Prevent Contamination of Drinking Water (2010).

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