By Gannon Roth
Environmentally Contaminated Commercial Real Estate
All parties involved face the standard hurdles in a contract process which many approach with trepidation from the start, however, retail purchase transactions with environmental issues present all parties with all new complications. As brokers, we’re not experts in liability, costs, and risks; however, with the right knowledge, persistence, and assistance from a reputable remediation expert, there’s hope to navigate the “dirty deal” to the closing table.
In the Denver metropolitan area, common discoveries are:
- Subsurface industrial solvents and gasoline
- Dry cleaner solvents (commonly tetrachloroethene or “perc” used in the cleaning process and disposed of irresponsibly).
Although these are most common, the spectrum of potential contamination issues are overwhelming, both above ground and subsurface, rare and exotic.
Discovery and Investigation
It is becoming a rarity to close a deal without some investigation into possible contamination and its full effect on the property. The first step is:
- A Phase I – Research past uses and recorded instances of contamination on or surrounding the property. This can cost $1,000 on the low side and reach upwards of $50,000 for more complex properties. If there are existing or discovered concerns, it is customary to follow with a Phase II. Fortunately, there is often an automatic extension for this incorporated in the contract and it is negotiated up front.
- A Phase II – Typically involves soil and ground water testing, air sampling, and/or sampling of building materials existing on the property. This process can take 30+ days and incurs a significant cost ranging from a few thousand dollars to well over $100,000. While there are no standards on how to proceed with a required Phase II and its costs it is never good news for the deal and is most frequently a deal killer. However, while the actual remediation can take years this is not necessarily the time to give up and there are often options available to those patient and committed to keeping their deal alive.
If a buyer moves forward following the discovery of environmental contamination the first step to is to look at whether the subject property or another nearby parcel was the responsible party or “RP”. If it is determined to be a result of the subject property the next step is to look at costs and the time involved in getting a no further action letter. The source of contamination will drastically affect this process as many subsurface issues have access to a state run superfund for both the management of the remediation process and costs if the responsible party cannot be found or does not have the funds/insurance. However, when dealing with other contaminants such as perc from dry cleaners there are fewer options as the operators responsible for the contamination seldom have funds to cover the remediation and it is rarely covered by insurance.
Finding the right lender
If the buyer has decided to move forward, a suitable lender needs to be matched with them. There are a few conventional banks that will lend on these properties, but they are few and far between; if they do not sell off their loan portfolios there may be a chance they are willing to accept the risk internally. The best bet is to focus on smaller, local banks and/or credit unions as the type of banks big enough to get a bailout are not going to bailout your deal. However, most Buyers and Sellers are forced to look for private lending in which unfavorable terms can be expected. To overcome the drastic change in interest rates and cleanup costs the Seller should expect a significant price reduction.
From a Listing broker’s perspective, whether contamination was a known complication at the time a property was listed, or discovered after, there is hope to get to the closing table. Marketing the property with the right terms and to the correct buyer pool is essential. While the Buyer pool has now been drastically reduced, with a patient Seller that is clearly coached in what to expect, most of these dirty deals can close in a decent market. The key here is to research lending options prior to receiving offers and coaching the Seller in what to expect in CAP rates for contaminated investment properties.
In my experience with contaminated investment properties, these CAP rates are usually .5% to 2% higher for comparable clean properties but every deal will be evaluated differently. Fortunately, there are also local companies and Buyers who focus on buying contaminated properties, although a larger discount than most other options can be expected as their profit is in the sale of the clean property following the risky cleanup investment that can often be higher than originally anticipated. When listing a contaminated property the best case scenario is to find a long-hold focused Buyer who is willing to accept the risks and the value-add cleanup process without a lender, whether that be cash or a 1031 tax exchange transaction.
The fact of the matter is with risk-adverse lending requirements on both investment and user-owner loans we cannot ignore and must plan ahead for these potential issues in all deals. Buyers, Sellers, and Brokers have options but getting to the closing table is increasingly difficult, but not impossible when they are discovered. As Benjamin Franklin once said, “energy and persistence conquer all things”.
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