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For the last two decades, the real estate market has been through plenty of fluctuation. In 2008, the bubble that much of the industry was enjoying burst, sending prices tumbling and bringing down the financial markets with it. All signs were pointing to a long-tail recovery for much of the real estate industry, particularly the commercial market. By 2009, banks, which were reeling from the real estate crash, had cut their commercial and industrial lending business by $100 billion. If investors could buy, they would have to do it on their own dime.

The impact on the normally favorable real estate investment trust (REIT) sector was significant, as they were hit harder than expected. REITs were dropping or suspending their dividends, and a market once known for its low volatility declined by 70 percent, more than the 57-percent drop in the S&P 500 at the time.

Yet commercial and industrial properties were still in demand, and the REIT market withstood the recession and the interest rate increases that followed. Distressed assets and foreclosures were acquired and the market recovered.

Today, the stresses of a global pandemic and a faltering economy have turned up the pressure on the real estate market yet again. As property owners sell to recoup financial losses from uncollected rent or unpaid mortgages, the opportunities are once again there for REIT transactions to increase.

However, as property portfolios are divested and REITs rush to complete transactions quickly, some of the properties could be hiding environmental exposures that could pose significant risks. Especially when purchasing large property portfolios, REIT investors could inadvertently overlook some not-so-obvious environmental concerns that could turn into costly claims or litigation in the future.

Exposure: Historical Use and Conditions
One environmental concern that could be missed: uncovering historical problems. Conducting a Phase 1 Environmental Site Assessment (ESA) can give buyers a concise picture of how the property was used in the past, and what operations the previous tenants conducted on the premises. For example, was the property, which is now an apartment complex, once part of an industrial operation that used and stored hazardous chemicals? Looking beyond the current use to the property’s historical use can uncover potentially high-risk activities that may become liabilities in the future.

A Phase 1 ESA can also uncover a recognized environmental condition, or REC. A REC is the presence or likely presence of hazardous substances associated with the property that could release into the environment. A leaking underground storage tank would be considered a REC.

An ESA may also uncover regulatory determinations. A No Further Action (NFA) letter issued by a regulatory agency is evidence that the property has an existing contaminant that poses no risk to current site uses and occupants. However, such a ruling does not apply to future use, especially in a case where the contaminant could be released by further development of the premises.

Before purchasing any commercial, industrial, hospitality, technology, retail, commercial office, multi-family, or senior housing properties, make sure to conduct a Phase 1 ESA complete with an on-site inspection. Also, just because a property is currently unused and vacant, doesn’t mean it has always had a low risk history. With just a little more due diligence, you can get a full picture of any environmental risks that may be lurking out of sight.

Exposure: Zoning Changes
Those same risks could be hidden by changes in how a property is zoned and used. As more millennials seek out a lifestyle that allows them to live and work in the same community, there has been a noticeable movement toward converting older structures into multi-unit apartments. The trend of redeveloping commercial and light industrial properties into mixed-use commercial and residential has REITs looking for such conversion opportunities.

These changes in zoning or end use are yet another area where hidden risks could lie.

These changes in zoning or end use are yet another area where hidden risks could lie. For example, Silicon Valley, which underwent rapid growth during the technology boom of the late 1990’s, has seen a noticeable shift in property needs as technology firms downsize. Prior to housing light industrial and research facilities, the area was agricultural. Initially, soil analysis may not have been conducted due to the intended use of the property. However, a change in zoning from industrial to residential often triggers a more stringent level of environmental testing and sometimes potential cleanup.

In fact, many proposed redevelopments that shift use to residential will typically come with additional requirements to sample soil and groundwater. Even if prior industrial or commercial uses did not impact the site, it is possible that historic agricultural use may have resulted in the presence of pesticides/herbicides or heavy metals. Sampling results will be evaluated using the stricter requirements for residential properties.

That could mean an increased exposure for REITs. By conducting a Phase 1 ESA, buyers can see a more comprehensive portrait of the environmental risks associated with the property and determine if additional investigation is warranted. Soil, soil gas, and groundwater sampling and a risk assessment may need to be performed before the site can be redeveloped for different uses.

Exposure: Off-site Pollution Sources
The ESA can also identify contamination sources on adjacent or nearby properties that could be impacting the property’s environmental exposures. With the focus during acquisition often primarily on the property to be purchased, neighboring properties are easy to overlook. Are any of the nearby properties currently operating with hazardous substances or heavy metals present? Has the adjacent site seen that kind of activity in the past? Has any legal or regulatory action been taken against adjoining properties in response to environmental hazards? What is the potential for the contamination to reach your property?

While an adjoining property owner is responsible for investigation and cleanup of any known, contamination, the contamination itself could reduce property values and cause legal issues for any neighboring property. Evaluating the impact that an off-site source of environmental risk has on the property you intend to purchase can help determine the actual source of contamination, particularly if both properties are using similar chemicals onsite.

This particular type of determination could help you avoid future liabilities, especially if neighboring facilities are required to conduct soil sample and groundwater tests on your property. Having a comprehensive picture of the contaminants present on your premises, and documenting the contaminants related to off-site locations could serve as a benchmark for preventing future liabilities.

Other Exposures
Even in the case of a sale-leaseback arrangement, REITs need to exercise caution. While a sale-leaseback – selling a site and then leasing it back from the buyer – offers a safer investment option, alternative financing could mean that the appropriate level of environmental impact analysis is missing.

In such an arrangement, buyers should pay particular attention to historic use and what residual contamination may be present. Buyers should also require agreements that detail known historical issues between the landlord (buyer) and tenant (seller). This helps determine any future source of contamination and liability.

It can also determine contamination that may not have been analyzed when the property was first purchased. In some cases, properties were acquired prior to any environmental analysis being required. This can become problematic when the new owner attempts to refinance or use property equity for upgrade or improvements. Such financial arrangements typically require a Phase 1 ESA, which, absent any historical due diligence, could uncover serious environmental liabilities.

Clearing the Way
Today’s real estate market is once again in flux. As a result, REITs are moving fast to purchase properties and take advantage of this slower business period and lower prices. However, moving too quickly could mean that costly unknown environmental dangers are lurking in and around the property.

Overlooking the necessary due diligence could mean these hidden exposures could come front and center as buyers begin to develop the property. Conducting a thorough Phase 1 ESA can help REITs identify problems before the sale and make a sound investment decision.

Work with regulatory agencies to ensure that the property meets current environmental standards. Also, make sure to look at historical use of the property, paying attention to how zoning may have changed.

Working with your insurance carrier too can ensure that you protect your investment from environmental exposures. Prior to providing coverage, underwriters can often help identify pre-acquisition environmental exposures that you should be considering. Unexpected environmental liabilities do happen. Knowing what lies beneath the surface can help you reduce your risks, and insurance can help you manage the risks that remain.

For more on REIT transactions and environmental risks, read the AXA XL Risk Bulletin titled: What’s Below the Surface? Don’t Hazard a Guess: Managing Environmental Exposures in REIT Transactions.

 
  • About The Author
  • Risk Control Associate, Environmental, AXA XL
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Global Asset Protection Services, LLC, and its affiliates (“AXA XL Risk Consulting”) provides risk assessment reports and other loss prevention services, as requested. This document shall not be construed as indicating the existence or availability under any policy of coverage for any particular type of loss or damage. AXA XL Risk. We specifically disclaim any warranty or representation that compliance with any advice or recommendation in any publication will make a facility or operation safe or healthful, or put it in compliance with any standard, code, law, rule or regulation. Save where expressly agreed in writing, AXA XL Risk Consulting and its related and affiliated companies disclaim all liability for loss or damage suffered by any party arising out of or in connection with this publication, including indirect or consequential loss or damage, howsoever arising. Any party who chooses to rely in any way on the contents of this document does so at their own risk.

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