Phase 1 Reports Still A Critical Issue
In today's super-competitive lending environment for commercial real estate assets, lenders are beginning to offer terms that include no required Phase 1 inspection or, at least, the financing institution assumes the cost of obtaining such inspection reports. This may be a smart way to win deals, but the practice is beginning to draw words of caution from environmental professionals.
For many in the environmental inspections and certification business, this practice has not yet reached an alarming level. However, they do indicate that the critical first-step process is still quite necessary. They insist that the lending institution and its borrowing client may be giving up some important risk mitigation leverage with that move.
For openers, Phase 1 inspections attempt to eliminate some of the most basic issues that can cause a deal to go sour in a hurry. At least, that is the perspective of Philip Brewer, president of Portland, Ore.-based Alpha Environmental Assessments, an environmental risk management consulting company with clients that include lenders, investors and property developers. Brewer gets alarmed when he hears of decisions to forego Phase 1 inspection reports, particularly when industrial sites and certain conversion properties are involved. He is sometimes called in to do such an inspection after the deal has been done, which makes him very uneasy.
Property history
"Most lending institutions ask for a Phase 1 property inspection report once the transaction price reaches or exceeds $500,000. This is a reasonable request, but I still think that a property's history - not its transaction price -should dictate the requirement of a Phase 1 report," Brewer tells CMI. He continues to be surprised when he learns of a transaction price being the primary reason behind a property report request, cautioning lenders about that practice.
"To the credit of some of my lenders, I have now seen a few instances where a loan as little as $200,000 required a Phase 1 report, due to the fact that the property was a previous industrial site." As one would imagine, Brewer can recall numerous occasions when a slam-dunk deal ran into problems as a result of ignoring the critical upfront environmental inspection. He indicates that there is an enormous amount of projects out there in which the need for residential units has overtaken the need for farmland and other agricultural activities.
"I cannot for the life of me understand why any developer,
investor or lender would dismiss the need for a basic Phase 1
inspection report when converting rural land into something like
multifamily, hotel or even office properties. The potential issues
from fertilizers and other agricultural chemicals are just
enormous," he says.
War stories
One of Brewer's more recent recollections of an imprudent move
involves an assessment his company performed for a developer.
"We did a part of the assessment for a city block that had plans
to demolish everything and build state-of-the-art condos," he says.
"It turns out that the other part of the assessment was conducted by
another company that failed to pick up on an important piece of
historical information.
"Apparently, there was a gas and service station on the corner of this block prior to the project's acquisition. The buyer had very limited funds for such a site-correction project and ordered quite a limited cleanup. The mistake here was that the buyer could not tell precisely how much potential cleanup was involved and went forward with purchase and development without a more detailed Phase 1 - and even more importantly, without the benefit of a critical Phase 2.
"Well, the upshot of it all is that after the purchase of property and development got well underway, it was discovered that cleanup was needed well beyond what was already spent. As you can imagine, this condo project came to a screeching halt because it just could not proceed without a large cleanup investment. What's the lesson here? Don't think you can get by the critical Phase 1 property inspection report," Brewer says.
Phase 1 and other early environmental detection issues continue to be the hot topics for organizations like ASTM - originally known as the American Society for Testing and Materials - and its International Standards Committee. The push is on to develop national and international standards for environmental and related inspection. Industrial properties, manufacturing sites, former pastureland rezoned for development, landfill, brownfield sites, and properties on the outskirts of rivers and waterways are prime candidates to have environmental issues when Phase 1 inspections are ignored.
Finally, Brewer thinks that an at-risk piece of property should
be inspected, even if the cost of acquisition is virtually zero.
"The reason is that once you are obligated to clean up a site, the
final cost could be astronomical," he says. He also indicates that
certain types of projects make Phase 1 even more critical. According
to the 16-year veteran of the business, due diligence for
environmental inspections should be a must when properties will
become affordable housing, schools, rehab projects and other
high-human-occupancy locales.
"If developers, investors and property owners don't sit up and pay attention, there is one financial giant that will sour their deals in a hurry - the liability insurance providers," he says. Since these insurers are beginning to eliminate certain types of environmental issues from their coverage, the financial burden will move back to the property owner. According to a recent survey cited by Brewer, the average cost of a Phase 1 environmental report was $1,850. He thinks the national range is in the neighborhood of $2,500.