When developers and their investors contemplate acquiring a site that is compromised with environmental contamination, there are important guidelines they would do well to follow in order to properly evaluate the risk, determine what may be done to mitigate that risk, and inform both the decision on whether to proceed and the adjustments needed to appropriately factor the risk into the terms of the acquisition.
It is vital the site be comprehensively evaluated to determine the extent to which the contamination might expose the site buyer to cleanup liability, delay development, prevent use of the site for the purposes intended or limit the features of the product type contemplated. Depending on the nature and extent of the contamination, each of these considerations can rise to the level of a deal breaker.
There was a time when some developers did the minimal amount of site assessment they could get away with on the theory that ignorance is bliss. That is a losing strategy in today’s environment (forgive the pun). Debt and equity capital sources alike require a thorough inquiry into the environmental status of properties presented for loans or investment, to identify all issues and potential issues, to assess the likelihood remedial action will be required and to determine the impact of any remedial plan on project costs, schedule and product. The information obtained will permit worst case scenarios to be determined along with the relative probabilities of different scenarios, leading to the ultimate determination as to whether the site is feasible for the development planned, and what mitigations are needed (including adjustments to the terms of land acquisition) to contain the risk of proceeding to acquire and develop the site. To the greatest extent possible the risk should be quantified and factored into the construction budget for the proposed improvements.
In general, there is strict liability for property owners of contaminated sites. There are exceptions allowing lenders to avoid potential liabilities, but those protections are available only if certain conditions are satisfied. While those conditions are largely within the lender’s control, avoiding responsibility can be tricky if the contamination is ongoing. Though lender liability limitations are helpful, they don’t protect against diminution in value wrought by environmental issues. Similarly, there are innocent landowner defenses, but those too are of limited value. There are hurdles to overcome to gain the protection of such rules, including conducting “all appropriate inquiries,” and the protections don’t apply to all claims or potential liabilities. There is simply no suitable alternative to thoroughly diligencing compromised sites and understanding at a deep level the environmental issues presented.
It is worth noting that there are brownfield programs intended to encourage the development of brownfield sites. These programs vary by state, but are worth exploring as it may be that the incentives offered allow potential environmental liability to be managed in an acceptable way.
Another tool that may be a difference maker is the availability of pollution liability insurance. The negotiation between land seller and buyer where there is a compromised site may, especially where the seller is the party responsible for contaminating the site, lead to the polluting landowner undertaking to remediate the contamination at its expense and to be responsible for any ongoing monitoring or testing that is required. Alternatively, there may be a price adjustment sufficient to allow the seller a walk away, or the negotiated outcome may land somewhere in between and involve shared responsibilities. In the not uncommon case where there is a gap—the maximum price reduction the seller will accept yields a price higher than the buyer is willing to pay—the gap may be closed through the purchase of insurance.
Pollution liability insurance policies will not cover known issues, but known issues can be quantified and will generally lead the market to an appropriate risk-adjusted land purchase price. The gap arises where the buyer needs protection against the unknown and the seller is not interested in discounting value based on what-ifs. This will be especially true where the selling owner is not the party that contaminated the site. Pollution liability insurance may be the perfect solution and the only means of closing the negotiation gap.
It is increasingly common that redevelopment is proposed for sites with polluting prior uses. The real estate investment community can participate in such redevelopment as long as the risks are properly boxed. The nature and extent of the contamination needs to be known based on extensive site characterization, the impacts on the proposed project must be carefully determined, and the risks of proceeding must be mitigated through appropriate deal terms and, where useful, the procurement of environmental insurance.
Marv Pearlstein is a partner at Manatt, Phelps & Phillips in the firm’s San Francisco office. Pearlstein represents some of the most successful and active real estate development companies and financial institutions in their acquisition, disposition, development, construction, financing, leasing and management of real property.