Phase Is, Transaction Screens or Insurance?

With the continued efforts to lower the costs and time frames associated with closing a loan, many lenders have searched for or tried a variety of options for dealing with environmental concerns. The most common approaches looked at include the traditional "Phase I Environmental Site Assessment" ("ESA"), the "Transaction Screen" or "Limited Scope ESA" and most recently "Environmental Insurance."

Which product is the best or right for you? It depends on your perspective and risk tolerance. A purchaser of a property may want more information than someone refinancing a property. Lenders planning on securitizing their loans may have different needs than ones holding their loan. Provided below is a discussion of the various forms of environmental due diligence.

Phase I ESAs

The traditional ESA, as defined by the American Society of Testing and Materials ("ASTM"), includes a review of the historical uses of the subject and adjacent properties, a review of readily accessible environmental databases, and a walk-through of the property to identify the presence of above ground and underground storage tanks ("USTs"), visual signs of contamination and the presence of PCB-containing equipment. Standard & Poor's, as well as many national and local lenders, have added the identification of asbestos, lead-based paint, radon and other similar potential environmental concerns.

These studies typically cost between $1,800 and $3,000, depending on the scope of work and the size, age and nature of the property. The reports can generally be provided in three to four weeks.

While no ESA can guarantee that a property is free of environmental concerns, conducted properly, an ESA can reduce environmental concerns to manageable risk levels. Concerns identified, if any, can be priced into the deal, insured against, removed, or managed with an ongoing Operations and Maintenance ("O&M") Program. This form of due diligence is the most widely accepted and provides protection for the lender and borrower.

Transaction Screens and Limited ESAs

ASTM also developed standards for a Transaction Screen as a limited form of due diligence. The Screen consists of a questionnaire filled out by a consultant or someone familiar with the property, an environmental database review, and limited prior-use history research consisting of a review of available Sanborn Fire Insurance maps, if they exist.

Transactions Screens typically cost $750 to $1,250 and take two to three weeks to complete. When considering a screen, it is important to remember that the screen was developed solely to enable the use of the innocent landowner defense to federal CERCLA liability. It does nothing to protect against issues such as asbestos or lead-based paint liabilities, state laws on USTs and other environmental issues, or protect a financial institution against its loss of collateral due to an environmental problem.

The reduced cost of the screen has drawn the attention of many lenders seeking to lower costs, particularly on small loan programs. As a result, many lending institutions have added a more detailed historical review and expanded scope of work to create a limited ESA. Unfortunately, no standardization currently exists for limited ESAs, and many lenders may not be getting the information they need. With proper attention to scope, particularly including an emphasis on historical usage, the Limited ESA can be a cost-effective environmental due diligence tool.

Environmental Insurance

Led by a number of large insurance companies, there has been a strong push to use Environmental Insurance to replace ESAs. The policy is designed for lenders and covers their losses arising from a default by the borrower if contamination is discovered. The policy promises to eliminate the bank's risk of loss to their collateral due to environmental problems. In addition, the insurance is designed to lower costs and speed up transactions, with costs ranging from $750 to $1500 per loan.

While these policies have the potential to protect the lender, they do not cover the borrower, who actually pays for the coverage. In addition, since most knowledgeable and experienced buyers of commercial real estate choose to have an ESA performed, the requirement of insurance can actually result in an increase in due diligence costs.

More importantly, since the insurance is only triggered after both a default by the borrower and the discovery of an environmental concern, it may actually open lenders up to the very liabilities in excess of the collateral the ESA was originally designed to prevent. For example, a property is foreclosed on by a financial institution and managed until it can be sold. If it is discovered later that a dry cleaning operation or other tenant had caused a serious environmental concern, the insurance will cover the cost of the collateral, but does not cover the liability incurred by the lender acting as owner or operator. If the lender considers it vital to conduct an ESA prior to taking ownership to avoid this liability, wouldn't the time and money have been better spent before making the loan?

In conclusion, ESAs, Limited ESAs, Transaction Screens and Environmental Insurance are not mutually exclusive. All are valuable weapons in a financial institution's arsenal. In this period of record low foreclosures, it is hard to evaluate the true effectiveness of untested insurance programs. History has shown the benefits of more information and knowledge when making lending decisions. Therefore, it is unlikely that the need for ESAs will disappear.

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