Clean Sweep.

Many companies believe they can improve returns if they remediate environmentally challenged real estate instead of buying existing properties or developing pristine land. New liability standards, specialized funds and insurance products are helping them convert these "brown-fields" to assets.

Many mid-size and large corporations own contaminated land for which, under new accounting conventions, liabilities should be booked. However, recent developments make it possible to convert many of these properties to cash.

Total equity in all investment-grade commercial real estate holdings in the United States is about $2.09 trillion. Of this, two-thirds -- $1.4 trillion -- is held by corporations. An unquantified but no doubt large fraction of this land bears the legacy of past unsound practices in the handling and disposal of chemical wastes. The fear of liability for cleaning it up causes many companies to refuse to sell it even when they no longer need it. Thus, property of enormous potential value sits idle, contributing nothing but tax bills.

New accounting rules require the booking of environmental liabilities. And three developments allow such lands to become assets:

* Relaxations in federal and state liability standards, and the creation of safe harbors;

* The emergence of about a dozen highly-capitalized funds specializing in the acquisition and redevelopment of contaminated properties; and

* New insurance products to cover residual risks.

"Today, owners of contaminated property can return those assets to the productive side of the business ledger. Modern cleanup technology, revised 'brownfield' laws, environmental risk insurance and a significant amount of directed institutional capital, all utilized by skilled professionals, can effectively provide comprehensive value-added assurances about risk transfer for sellers of brownfield sites," notes Jeffrey D. DeBoer, president of the Real Estate Roundtable in Washington, D.C.

FAS 5 mandates a charge to income for a loss contingency if it's probable that a loss has been incurred and the amount of the loss can be reasonably estimated. The force of this rule in the environmental context was expanded in 1996 when the AICPA issued Position 96-1, Environmental Remediation Liabilities. SOP 96-1 creates a presumption of an unfavorable outcome if litigation, a claim or an assessment has been asserted, or is probable of assertion, and if the entity is associated with the site. The entity would then need to accrue at least the amount that can reasonably be estimated as the cleanup liability.

Toxic Shock

Moreover, SEC Regulation S-K requires the disclosure in SEC filings of any material effects that costs of environmental compliance may have on earnings, capital expenditures and competitive position. It also requires disclosure of administrative or judicial proceedings under the environmental laws if certain materiality thresholds are met. In 1998, the SEC imposed sanctions against Lee Pharmaceuticals and its CEO and CEO for material misrepresentations and omissions of certain environmental liabilities in the company's 10-K filings. Whether this case was the opening salvo in more rigorous enforcement of SEC rules on environmental reporting remains to be seen.

As the rules on reporting environmental liabilities are tightening, new ways for companies to unload the properties that are the source of these liabilities are emerging.

Previously, much of the difficulty in financing the acquisition of contaminated property derived from a 1990 federal decision, the Fleet Factors case, in which the court suggested a bank could be liable for a borrower's mishandling of hazardous waste if the bank had the capacity to control the borrower's operations. In 1996 Congress essentially overturned that decision and amended the federal Superfund law to give financial institutions a safe harbor from environmental liability under a broad range of circumstances. In a similar spirit, the U.S. Environmental Protection Agency has adopted several guidelines that protect parties that acquire contaminated property, and that encourage the redevelopment of these brownfields.

Many states also adopted laws encouraging brownfield redevelopment. Some allow relaxed cleanup standards; some give liability protection; and some provide financial assistance.

Redevelopment Funds

Strategic institutional investment in real estate reaches new highs year after year. Annual investment in new development and acquisitions by pension funds, REITs, foreign investors and private developers now exceeds $40 billion. Institutional investment in brownfields is on the rise, too. For example, over the last several years, TIAA-CREF has seen five to 10 loan applications a year with an environmental impairment. The transaction size ranges from $15 million, while the total dollar amount of its transactions may approach $100 million. The pension fund has several such transactions worth about $150 million in its pipeline.

Over the last four or five years, an emerging market has grown for redevelopers who concentrate primarily on brownfields. Many local developers take on contaminated sites, and there may be 20 companies with a national focus on redevelopment and risk transfer, It's a large and vigorous market.

LandBank, Brookhill Redevelopment and Cherokee Investment Security all have a national focus and have collectively redeveloped over 50 sites in the last two years with combined values above $100 million - and a value range of individual properties of from $4 million to over $30 million. Brookhill has completed more than 40 acquisitions in the last five years.

AMB Realty Corp., a $3-billion REIT, has a $100-million joint venture with AIG to buy contaminated assets in its core real estate markets. About one-quarter of its 1998 acquisitions involved properties with defining environmental characteristics.

While industrial/commercial redevelopment is the favorite focus of most activity, LandBank also has been involved in residential projects. For example, LandBank acquired a portfolio of properties from TransWorld Oil USA, Inc., including former bulk storage terminals for fuel oil, diesel fuel, gasoline and kerosene, and gas stations in New York and Massachusetts. And AMB purchased Taylor Rail Yards in Los Angeles from Union Pacific Railroad. The yards are being developed into a 700,000-square-foot industrial complex.

Current acquisition activity also includes four deals under contract and 30 being screened by LandBank valued at $200 million to $300 million, and 15 deals valued at $60 million being reviewed by Brookhill. The annual deal value capacity of each company exceeds $200 million.

New Lease on Life

Environmental risk transfer is essential to brownfield redevelopment transactions. Most deals provide for an insurance company with a high credit rating and strong balance sheet to assume unknown regulatory and third-party risks. All known risks need to be accounted for in the economics of a particular transaction and are reserved against.

LandBank uses a proprietary line of insurance policies intended to provide sellers and buyers with full indemnification from all environmental liability. It also offers occurrence-based policies with pollution protection in perpetuity, principally for residential repositioning. AMB seeks to align the risk management concerns and interests of both the buyer and the seller. It provides the seller with indemnifications and other contractual devices supported by a comprehensive environmental insurance program backed by AIG. Brookhill will also make certain that it has a maximum guaranteed price from a cleanup contractor on a fully characterized site, with established maximum time limits and dollar amounts.

The insurance market for brownfield redevelopment is vibrant. Many lawyers were occupied throughout the 1980s and '90s litigating whether old insurance policies excluded environmental claims. In contrast, policies written today explicitly cover environmental claims. Thus, insurance is an important element of most cleanup deals.

AIG, which has written thousands of pollution liability policies, looks at hundreds of new transactions each month and writes insurance on 30 percent to 50 percent of them. The company, which has almost unlimited ability to write environmental liability policies, has a comprehensive approach in insurance against environmental liability, and offers insurance designed to facilitate mergers and acquisitions as well as real estate sales.

AIG Environmental provides environmental insurance for large complex risks such as ports and rail yards, and smaller exposures such as local dry cleaners and shopping centers. It protects the buyer, seller or both parties from the risk associated with unknown environmental liability. AIG offers a secured creditor impaired property policy designed to protect the interests of financial institutions in connection with real estate transactions. The policy offers protection against defaults on commercial loans with environmental conditions. Coverage options can be for losses due to on- or off-site pollution conditions, transportation and owned or non-owned disposal sites. Cleanup cost cap policies manage the economic risk when environmental remediation projects exceed the projected costs.

AIG's size -- it's in the Fortune 50 -- means when a large corporation sells contaminated land with an AIG policy in place, the seller isn't the only deep pocket in the picture -- so it won't be the only viable target if the cleanup goes wrong and the buyer doesn't have the capacity to pay the unanticipated costs.

According to Ken Cornell, senior vice president of AIG Environmental, "In some cases, CFOs of large (Fortune 50 to Fortune 100) companies take a no-sell stance or have like-kind issues in mergers and acquisitions" with respect to contaminated property. The theory is that regardless of the sales contract or indemnification language that requires the new owner to assume liability, ultimately liability will never be completely transferred. This theory is mostly based on selling the property to parties without the financial position of the seller -- meaning because the seller is the "deep pocket," if a problem should arise, liability will revert to the original owner/corporation. So why sell if selling doesn't achieve the goal of transferring the liability? Regardless of the size of the buyer, CFOs can now consider environmental insurance options as a solution to enable them to sell property.

"In M&A, in addition to liabilities associated with real property, known environmental liabilities may also include outstanding fines, penalties, bodily injury or property damage claims where the original company becomes liable due to its operations," Cornell adds. "As one of the many tools utilized in a merger or acquisition, environmental insurance can enhance or add value to the successful completion by adding certainty to these variable or unknown environmental liabilities."

AIG may be the leader in this market but it's not alone. ECS Inc., an XL Capital company, has provided environmental insurance for 12 military base closures. XL Capital has $10.8 billion in assets and $4.9 billion in shareholder equity. It insured the reuse of Lowery Air Force Base in Denver, with its significant ground-water contamination, asbestos, contaminated landfill and hazardous waste storage issues. The insurance covers pollution legal liability coverage for third-party bodily injury or property damage, or pollution conditions at the site; remediation legal liability coverage to insure against the risk of the discovery of previously unknown on-site contamination; defense legal liability coverage and remediation stop loss coverage to insure against costs associated with the discovery of additional contamination, greater horizontal or vertical spread of the groundwater contamination, higher disposal costs or changes in the use-based cleanup standards. ECS also has written insurance regarding the remediation and redevelopment of Kelly Air Force Base in Texas and the Birmingham Steel Co.'s Norfolk Steel Mill in Chesapeake, Va.

Environmental Insurance Underwriters Agency, an affiliate of Citigroup and program manager for Gulf Insurance Group, a subsidiary of Travelers Property Casualty Corp., recently created the TerraGuard product. It protects parties to real estate transactions against cleanup costs, bodily injury, property damage, business interruption and legal defense expense arising from third-party liability suits and regulatory requirements. It's also used to protect against regulatory reopeners and new contamination.

Its promoters say TerraGuard has successfully satisfied the extended liability concerns of sellers in connection with the redevelopment of commercial, retail and certain industrial properties. EIU evaluates environmental risk associated with real estate transactions by looking at current and future impacts along with an environmental risk mitigation and transfer analysis. This addresses such issues as contractual risk transfer, identification and evaluation of potentially responsible parties, covenants not to sue and no further action letters issued by state governments, use of risk-based cleanup standards, legal/regulatory factors and other such items that serve to reduce, limit or more accurately quantify current or future environmental impacts and their resulting consequences.

So where is the brownfield market headed? Market forces, government policy and institutional investment create more, not less, market activity. If the redevelopment market is to succeed, it will come partly from corporate America understanding that it can add value to its real estate portfolios - and wipe out liabilities - by taking advantage of current market trends and encouraging reuse.

Rick Mandell is CEO of Aspen Portfolio Strategies in Basalt, Colo. Reach him at [e-mail]. Michael B. Gerrard is a partner in the New York office of Arnold & Porter, and an adjunct professor of environmental law at Columbia and Yale. He's also general editor of Brownfields Law and Practice: The Cleanup and Redevelopment of Contaminated Land. Reach him at [e-mail].