Capital Infusion: Practical Environmental Considerations in Acquiring or Securing Financing with Real Estate

Introduction

This article focuses on environmental due diligence issues in the context of acquiring commercial/industrial real estate or using real property to secure financing. The analysis and risk factors for the acquisition of real estate and using real property as security for a loan are generally the same and, accordingly, the remainder of the article will refer to the acquisition context. Note, too, that acquiring an existing entity that owns real estate may present the same risks and liabilities as acquiring the real estate directly. Thus, the practical considerations discussed in this article also apply in the entity merger and acquisition context for the entity that will emerge from the transaction owning the real estate.^[1]

If a property under evaluation has associated environmental risks, it is critical to identify and quantify those risks before the property is acquired. Under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), in the absence of adequate pre-acquisition due diligence, identifying environmental issues post-acquisition is too late to avoid liability. The first step, then, is to conduct a Phase I Environmental Site Assessment (“Phase I”) that meets the criteria established by the United States Environmental Protection Agency (EPA) to qualify the buyer as an “innocent purchaser.” Aspects of the Phase I include considering historic uses of the property, generally identifying uses in, and the character of, the neighborhood, and conducting a careful walk-through inspection of the property and current operations. In addition to being a necessary component of a Phase I, each of these steps is a straight forward, practical way to identify potential environmental risks.

A number of other environmental and land use factors and considerations should also be evaluated before signing the closing papers. These include whether the property is in an oil and gas producing area or subject to mineral leasing. If so, further investigation is warranted, as will be discussed. These due diligence issues can include: i.) whether there are other nearby uses that may pose problems—real or perceived—resulting in devaluation; ii.) whether the property is served by adequate water supplies; iii.) accessibility; iv.) availability of necessary services at an affordable cost; and v.) related regulatory considerations. Given adequate evaluation (it need not be exhaustive, nor overly time consuming), the decision to acquire is still a matter of individual buyer risk tolerance. Following the steps discussed in this article will properly inform the prospective buyer and avoid unexpected and costly environmental risks and liability.

What Is a Phase I and Why Conduct One?

CERCLA establishes liability in owners and operators of property where hazardous substances have been disposed of, generators of those hazardous substances, and those who accept such hazardous substances for transport to disposal or treatment facilities, if the release of those hazardous substances would present an unacceptable risk to human health or the environment. The terms “owner or operator,” “hazardous substance,” and “release” are all defined in the statute. CERCLA includes several limited defenses to liability. Specifically, a potentially responsible person (also known as a “PRP”) can avoid liability by establishing, by a preponderance of the evidence, that the hazardous substance release was caused solely by: i.) an act of God; ii.) an act of war; or iii.) an act or omission of a third party “other than an employee or agent” or “one whose act or omission occurs in connection with a contractual relationship.”

A PRP can still avoid liability under the third defense—using what is known as the landowner liability protections—even when the PRP has a deed, lease, easement, or other indicia of title to real estate if, at the time the PRP acquired the real estate interest he did not know, and had no reason to know, that any hazardous substance was disposed of on the property. But to be able to make that demonstration, the PRP must have: i.) made “all appropriate inquiry” before acquiring the property; ii.) exercised due care concerning the hazardous substances upon discovery; iii.) taken precautions against foreseeable third-party acts; and iv.) continued to cooperate with EPA regarding the hazardous substances. EPA has adopted regulations defining all appropriate inquiry. The American Society of Testing and Materials (ASTM) has also adopted standards, that have evolved over the years, that EPA has endorsed as all appropriate inquiry. The current operative ASTM standard is ASTM E1527-05 Standard Practice for Phase I Environmental Site Assessments. On August 15, 2013, EPA also proposed to accept the updated ASTM standard, ASTM E1527-13, as equivalent to all appropriate inquiry, but the rule will not go into effect until November 13, 2013.

The key component of compliance with all appropriate inquiry is conducting a Phase I—before the acquisition of or securing financing with the real estate. The objective of a Phase I is to identify “recognized environmental conditions,” where that term means the presence or likely presence of any hazardous substances or petroleum products on a property under conditions that indicate an existing release, a past release, or a material threat of a release of any hazardous substances or petroleum products. A de minimis condition that would not pose a threat to human health or the environment and would not be the subject of an enforcement action is not considered a recognized environmental condition. The conduct of a Phase I, if done properly, will qualify as all appropriate inquiry. If the Phase I does not identify any recognized environmental condition then it will protect against CERCLA liability if a hazardous substance release is later discovered on the property, if the owner exercises due care, takes precautions against foreseeable third-party acts, and cooperates with EPA regarding the hazardous substances upon discovery. Conversely, if the Phase I identifies a recognized environmental condition, the risks associated with the condition can be appropriately assessed before liability accrues through acquisition.

CERCLA Requirements for a Phase I

All appropriate inquiry requires inquiry by an environmental professional, interviews with past and present owners and occupants of the property, review of historical sources, review of government records, a visual inspection of the target and adjacent properties, and consideration of other commonly known or reasonably ascertainable information. In addition, the inquiry should take into account information provided to the environmental professional such as whether the purchase price is consistent with fair market value assuming the property is not contaminated, and the existence of environmental liens by regulatory agencies. In short, the inquiry should include evaluation of those sources of information that would be most likely to indicate the presence of hazardous substances at the property from historic or current site operations or activities.

Identify Historic Property Uses

The objective of evaluating historic property uses is to determine past activities that may have involved use or disposal of hazardous substances. Historic property use should be evaluated as far back as the records show the presence of structures or as far back as the first known use for an active purpose (e.g., residential, commercial, industrial or agricultural). Historic use can be evaluated using aerial photographs, fire insurance maps such as Sanford maps, building department records, telephone or street directories, or chain of title documents. Often, one set of records is not conclusive so several of these methods and sources are used together to evaluate historic property uses. In addition, as part of the on-site review, the environmental professional may identify one or more longstanding neighbors and develop additional information through personal interviews.

What does this type of historic evaluation accomplish?  For example, had a qualified person examined a combination of  aerial photographs and fire insurance maps or street directories in the Love Canal area, it would have been apparent that a valley was filled in proximity to a chemical plant. This information should then have led to more detailed inquiry before houses and schools were built. As another example, aerial photographs of a target property, in sequence from the 1950s to the 1980s, reflecting that the property was continuously wooded and without road or construction disturbance until the first structure was constructed at the target property in 1980 would indicate that the property was likely undeveloped until construction of that first structure. Since the structure was built after lead-based paint was banned by EPA in 1976, one could also conclude that the structure likely does not contain lead paint. Of course, as the requirement for “all appropriate inquiry” suggests, historic record review is only one line of evidence to consider in evaluating whether hazardous substances are likely to be present at the target property.

Know Your Neighbors

Current and historic activities on neighboring properties may present an environmental risk to the target property. For example, the operation of a gasoline service station for many years on adjacent property may present a risk of gasoline contamination in the groundwater beneath both the adjacent and the target property. Local or state regulatory records documenting the presence of leaking underground storage tanks at the adjacent property would further support this concern. In developing an understanding of the environmental condition of the target property for the Phase I, the environmental professional is also required to consider topography, presence of nearby streams or water bodies, and likely direction of surface and groundwater flow. The topographic and likely groundwater flow direction information would be considered to determine whether the gasoline station is up-gradient or down-gradient from the target property. The distance between the two sites is also considered. This information is factored together to assess whether a leaking underground storage tank at an adjacent property may contaminate target property groundwater and, thereby, constitute a recognized environmental condition.

To obtain a complete picture, the Phase I must include evaluation of current and historic uses at the target and all directly contiguous properties, a search of federal, state, and local regulatory, and emergency response records, and a visual inspection of the target and all adjoining properties. The regulatory records of interest include environmental permits, emergency response, public health records, any evidence of environmental remediation or environmental liens, public utility records (which may show historic use/release of polychlorinated biphenols or PCBs), and water and sanitary sewer service records (which could show use of a septic system rather than a municipal sanitary sewer service). The mandatory radius within which regulatory information must be obtained varies depending upon the type of site. For example, the Phase I must identify and evaluate the impacts from any listed Superfund site within a one-mile radius of the target property, any hazardous waste disposal site within one mile, any leaking underground storage tank within one-half mile, etc. These environmental data are a critical component of the Phase I and cannot be efficiently or cost effectively compiled on a Phase I-by-Phase I basis. Happily, relevant regulatory data has been compiled by a number of companies, including for example GeoSearch, Inc. and Environmental Data Resources, Inc. These environmental data providers provide maps and release reporting information.

Evaluate Current Operations

Another critical component of the Phase I is a visual inspection of the target and adjacent properties. Typically, the site visit is conducted with a property manager, operations manager or senior environmental staff. The inspection thereby provides the opportunity to interview a person with knowledge about past and current operations, as well as review on-site environmental compliance and safety records. Through the visual inspection, one can determine generally what chemicals are used, how they are stored, whether there are persistent spills during operation, whether spills are contained or whether floor drains and sumps provide a pathway for spill release to the environment. Additionally, outdoor storage areas can be viewed to determine proximity to storm drains and water bodies. Not only is this information required for a Phase I, it is vital for the buyer to understand whether the acquisition will include legacy environmental concerns or the potential for future enforcement action due to current non-compliant or sloppy operations.

Other Property-Specific Issues

The Phase I analysis, when presented in a report with the opinion of the environmental professional regarding the existence or absence of recognized environmental conditions, is sufficient to meet all appropriate inquiry requirements and minimize CERCLA liability. However, it may not be enough to identify and understand all of the environmental risks and property valuation concerns of interest to a buyer or secured lender. Specifically, certain uses on the target or adjacent properties may not present a regulatory risk, but may impact the value or suitability of the property. For example, a nearby microwave tower may provide excellent mobile phone service but create real or perceived risks that are incompatible with the buyer’s intended use or eventual resale. Similarly, high voltage electric wires have been the subject of numerous, albeit generally unsuccessful, personal injury litigation. A large scale fertilizer manufacturer, such as the former plant in West, Texas, could present unacceptable risks of explosion to the prospective buyer of a neighboring property. The presence of these kinds of non-regulatory, but real risks near the target property may be beyond the risk tolerance of the buyer. Several other common concerns are identified in the following section.

Oil and Gas/Mineral Property

Target property in an oil and gas producing or mineralized area may be impacted by current or eventual resource development. It is not uncommon in areas with valuable natural resources to have “split estate” property. A split estate is where the surface rights and ownership have been legally severed from the mineral and subsurface rights and ownership. If the estate is split, the mineral interest owner has the dominant estate and has access rights and the right to make reasonable use of the surface. For example, the owner of an oil and gas lease may have the right to establish a drill pad and, at least temporarily, a surface impoundment to hold flow back or produced water, and the right to stage drilling mud, drill cuttings and related material or waste streams from oil and gas production. A mineral split estate may include the right to “consume” a portion of the surface if the mineralization is near surface.

The presence of split estates and the relative rights of the surface and mineral, oil, and/or gas owners may be impacted by both federal and state laws. Many states in areas with abundant natural resources have developed laws to address split estate concerns. For example, Colorado requires that a developer notify all mineral interest owners of record at least 30 days prior to a public hearing on a preliminary plat for development approval. Careful title work evaluation is important to determine whether the acquisition target property includes both surface and mineral interests. If the estates are split, then understanding the use constraints and environmental risks attendant with third-party development of the non-owned interest is critical to making a sound acquisition decision.

In some cases, water rights may also be separated from the property. If the target property is in an urban area and served by a municipal or water district water provider, access to water should not be a determining factor for acquisition. However, in drought-prone areas, there may be water use restrictions that are incompatible with the intended use of the target property. If significant water volume is required, the cost of water should be determined prior to land acquisition. If the target property only has access to well water, water availability, quantity and quality must be determined before acquisition. Property located in a historically agricultural area or zoned for agricultural use may not be readily convertible to commercial or industrial use. The water rights available to the property may be limited to agricultural use, only. Even if convertible, the conversion process may take too long or be prohibitively expensive. Finally, available water may be highly saline or otherwise not of suitable quality for the intended use without treatment. Accordingly, consideration of water needs, whether those can be met at the target property location, and the cost of water in sufficient quantity and of suitable quality are all important pre-acquisition considerations.

Other Adjacent Uses

It may seem obvious, but a broader consideration of the character of the neighborhood can be important in property acquisition. For example, property within the flight path of a busy metropolitan airport may not be suitable for a hospital. Residential development is not compatible with large-scale commercial farming or, worse yet, a feedlot. In that context, pre-acquisition due diligence should include a full assessment of the risks associated with incompatible neighboring uses and long-term inability to change neighborhood uses to be more compatible.

A conventional Phase I will identify adjacent property uses, but will likely not identify either of these examples (flight path or neighborhood agricultural zoning) as a recognized environmental condition. Nonetheless, environmental due diligence work should identify the potential noise pollution related to both airport operations and farm equipment. Additionally, nuisance odors and particulate air pollution are likely from a large-scale farm. In today’s push for renewable energy development, as well as the expansion of the “bridge fuel,” natural gas, it is equally plausible that a windfarm, solar farm, or oil and gas drill rig may “pop up” as a next-door neighbor. Taking the time to understand zoning, zoning trends, regional land use patterns, and possible natural resource values in the area of the target property is part of effective environmental due diligence that will prevent acquisition of property for a use that is, or quickly becomes, incompatible with neighboring uses.    

Services Available to the Property

Utility services to the target property are part of the Phase I analysis. In that context, however, we are looking for possible current or historic hazardous substance releases in connection with utility services. For example, if PCB-containing transformers are identified on or near the target property, the Phase I should identify whether they are owned by the utility such that any remediation from PCB releases is the responsibility of the utility. Similarly, if there is no sanitary sewer service, the Phase I must evaluate the potential for hazardous substances disposal through a septic system and resultant release to the environment.

In a review of the services available to the target property, consideration should also be given to utility costs, the percentage of renewable energy required by a state renewable portfolio standard (RPS), and any local energy policies. Thirty of the states and the District of Columbia have adopted some form of renewable energy requirement. See The RPS Edge™ found at http://mjbeck.emtoolbox.com/?page=Renewable_Portfolio_Standards (developed by MJ Beck Consulting LLC), an interactive map of the United States showing applicable RPS standards in each state. The City of Boulder, Colorado has recently been in the national news with the decision by a majority of its voting residents to pursue “municipalization” (municipal take over) of its electric utility, at what is likely to be a significantly increased cost to all customers. Conversely, some “anti-fracking” or “Fracktivist” communities in New York, Pennsylvania, and Colorado are considering various initiatives that could increase the cost of natural gas in those regions. For a proposed new land use that has high energy demand, these types of trends could be fatal to long-term enterprise success, making this an important aspect of due diligence.

Access

In most urban settings access to the target property is not a concern. However, for resource development (oil, gas, or minerals) and rural, or mountain acquisitions, access should be included in due diligence. The first consideration is whether access roads traverse federal lands and require right-of-way approval from the federal land manager. If so, compliance with the National Environmental Policy Act (NEPA) will be required and consideration should be given to the application process, information requirements, and likely approval delays. Even if a road exists, federal agency approval to use it may be required. If there is not an existing road, the approval process for construction of a new road will likely include public comment and be time and cost prohibitive. Other access factors to address in due diligence include: i.) whether existing roads are wide enough for the buyer’s proposed traffic (including temporary construction deliveries); ii.) whether federal approval for the existing road encompasses the buyer’s proposed use; iii.) whether access for power lines, water lines, telecommunications, and other services is available; and iv.) the cost of obtaining necessary access approvals. 

Conclusions

Conducting environmental due diligence prior to property acquisition is prudent and practical. It is also necessary before property is acquired or used to secure financing to avoid CERCLA liability. Patton Boggs can guide you through the due diligence process to avoid liability, mitigate and manage remaining risks, and position your company for a successful acquisition or financing.