Contaminated real estate: understanding the issues and liabilities.

Somewhere in Los Angeles a piece of real estate is on the market and there's an interested buyer. The buyer and seller meet, a contract is negotiated and the due diligence process begins. During due diligence, under an environmental Phase I audit, asbestos is discovered in the building. The extent of the contamination is unknown. The cost of clean up has not been determined. The buyer is nervous, can't find a lender and wants out of the deal.

This scenario is not unusual. Many real estate transactions in today's market are complicated or even terminated as result of environmental concerns. The presence of hazardous and toxic material is known and perceived as a health threat. That threat creates an environmental contingency and potential liability that complicates business for owners, lenders, appraisers and other real estate professionals. The sale and purchase of real estate which is known or thought to be contaminated clearly has added complications and may require the assistance of specialists. As an example, the remediation of asbestos in a shopping center or other commercial building may call for an abatement program which could include removal or encapsulation, may require the temporary relocation of occupants thus interrupting operations, and may provide for an ongoing monitoring program. Environmental specialists and lenders with experience in dealing with such issue can lead you through the complex web of regulations and red tape that plagues this area.

Buyers and Sellers: Beware!

Whether you are a buyer or seller of real estate, early identification and confrontation of environmental issues can save time and money. As a seller, your best course of action may be to remedy any contamination before selling. As a buyer, uncovering contamination is paramount before closing the deal. As a buyer you simply may want to avoid contaminated property all together Many common environmental problems which result in failed transactions or future litigation can be mitigated if they are recognized and dealt with early. Potential liabilities may be contained if they are addressed in the preparation of the acquisition agreements in the form of representations, warranties and indemnities.

Understanding the Issues

Understanding environmental issues can be the best defense in avoiding or managing environmental problems. Real estate owners/buyers and professionals must understand the nature of environmental problems as they relate to; site selection (type of soil, presence of surface and ground water, geologic features, adjacent land use, etc.), existing structures (presence of Radon, PCBs, Asbestos, lead, etc.), and operation (managing hazardous substances used by the owner or tenant). Environmental problems and risks require a strong team of consultants including engineers, environmental lawyers, and real estate appraisers. Environmental consultants can provide such services as;

* facility citing including permitting and regulatory negotiations,

* environmental due diligence including environmental phase 1 audits and assessments,

* drafting of contracts dealing with the allocation of risks and liabilities including protective covenants in purchase and sale documents, loan documents and leases,

* negotiating with governmental agencies under CERCLA and RCRA

* negotiating and litigating cost sharing agreements with potentially responsible parties on cleanup,

* review of assessed property values to determine whether contaminated property is over valued,

* real estate valuations dealing with the effects of environmental concerns.

The extent to which consultants are used will depend upon many factors but primarily will hinge upon the nature of operations conducted on the site and whether the site is thought or known to be contaminated.

Environmental contamination is defined and governed under several regulatory acts and varies widely depending upon the nature of business activities and real estate involved. Environmental regulations have been developed by governmental agencies in order to safeguard the environment and human health. These regulations provide the clearest definition of hazardous substances and practices and stipulate the parties responsible for clean up.

Who's Mess is it?

In the case of existing environmental contamination, the current property owner is generally responsible for clean up. However, in certain cases the current owners are protected under regulation that stipulates that property owners who took title to property after they had made an appropriate environmental investigation and uncovered no environmental problems would not be liable and the former owner would be. Again, understanding these regulations and their implication is paramount to doing a real estate deal with environmental implications.

During the last twenty five years several regulations have been promulgated and amended including the following:

* Clean Air Act

* Clean Water Act

* Resource Conservation and Recovery Act (RCRA)

* Comprehensive Environmental Response Compensation and Liability Act (CERCLA)

Real estate owners and buyers are not expected to fully understand the various environmental regulations and hazardous substances. However, owners and buyers should appreciate the severity of any environmental contingency, the costs associated with any clean up and the need to bring in an environmental specialist.

Environmental Review

As a safeguard in today's market, real estate buyers and lenders commonly require an environmental review before the consummation of a deal. This review can be completed by an experienced environmental lawyer or engineer. A review will provide a knowledgeable investigation and analysis of the nature and potential costs of such issues, if any. An environmental review, also know as a Phase 1 Audit, includes but is not limited to;

1) a review of title documents,

2) a review of existing environmental liens,

3) an inspection of the property for potential environmental hazards,

4) a review of relevant federal, state and local records and

5) the completion of a formal report. The review will specify whether further on-site analysis is required and will provide valuable information in order to continue due diligence and contract negotiations.

The environmental review will also be important to the lender. The lending industry has heightened its awareness of environmental concerns. The last thing a lender wants is to be in a position to assume the liability of its security interest. Lenders, in certain circumstances, can be held liable for environmental clean up of secured property if the owner is not able to pay the costs. This liability can arise in situations where the lender participates in the financial management of the borrower or in certain situation where the bank takes title to the property in a foreclosure. The extent of the lender's liability is provided under CERCLA as amended and through developing case law.

As with any real estate transaction, choosing the lender is critical. Lenders with experience in environmental concerns are likely to understand and appreciate the complexities of analyzing and handling environmental contamination and thus will be more willing to work with a buyer.

Conclusion

The impact of environmental contamination on real estate can be severe and complex. A property owner may have no choice but to remedy existing contamination to simply sell the property. Buyers on the other hand must work carefully with environmental specialists when involved with property known or thought to be contaminated. Additionally, both buyers and sellers must realize that contaminated property requires more stringent due diligence on the part of lenders, appraisers and other professionals.

Tom McMillan, CPA is Partner-in-charge, Real Estate Services and Robert Kurges, CPA is Manager of BDO Seidman, Accounts & Consultants, Los Angeles.