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Lurking liability.

Due diligence in residential transactions may uncover environmental demons that can come out of the woodwork.

Environmental issues affecting residential properties are gaining increased attention as the critical nature of these concerns continues to become clear. Consumers and lenders alike are being confronted with environmental issues and the repercussions these problems carry with them in terms of human and financial costs.

Lenders and consumers share the dual concerns about the impact environmental problems can have on the health of homeowners and the value of the affected residential real estate. Essentially, these problems span the full spectrum of the business--from mortgage origination, servicing and ultimately on into the real-estate owned (REO) process.

The residential real estate market presents several environmental issues typically not confronted on the commercial side of the business, where, to date, most of the environmental research has focused. However, commercial transactions pose a convenient backdrop against which to begin an analysis of residential issues.

Research in the commercial real estate area has focused primarily on methods to mitigate clean-up liability through pre-purchase environmental assessments. These assessments anticipate environmental contamination that could be found on, in or near the property in question.

In a residential setting, such attention is of much less importance. Furthermore, the costs associated with this process are prohibitive. Residential transactions require closer attention to potential property devaluation as opposed to clean-up liability. Although clean-up liability certainly exists in limited circumstances, other liability issues should be examined. These include personal injury and proper disclosure of environmental defects upon the sale of a property.

What level of environmental due diligence should be conducted in a residential transaction? It is important to be careful with the use of the term "due diligence" in this context. In a residential setting, the term should reflect traditional business or marketplace due diligence, as opposed to legal due diligence, which is often the focus on the commercial side. The shift from the legal emphasis derives from the fact that there is relatively small likelihood that owners, lenders or servicers will be faced with a legal obligation to clean up a contaminated residential property. But on the other hand, they may well be confronted with a property that has suffered a significant loss in value due to environmental forces.

Lending institutions, secondary mortgage market participants and others involved in the residential mortgage industry will play an important role in responding to this issue, given their role as gatekeepers and policymakers in residential property transactions.

Lenders often indicate a lack of experience in identifying specific instances of loss due to environmental problems tied to residential transactions. However, several recent court cases, together with escalating environmental awareness on the part of consumers, indicate that close attention should be paid by those who want to prepare and respond properly to these problems.

This article analyzes the major concerns typically confronted in a residential real estate setting and reviews policy developments throughout the industry, including EPA's recently passed policy on residential liability (OSWER Directive #9834.6).

What is an environmental hazard?

The term "environmental hazard" encompasses a wide array of potential risks. Health risks may result from exposure to materials used in constructing the homes in which we live, to chemicals in the soil, to the water we use or to gases in the air we breathe. Property values may be hurt by the existence of contaminants on the property itself or by the stigma of contamination present on nearby sites. Owners of property may be held liable for the extremely high costs of cleaning up contaminated sites or for the costs of mitigating hazards identified within the site improvements. This could range, for instance, from having to remove contaminated soil to containing or removing an asbestos material present within a facility.

Lenders face the real possibility of default on loans made to owners who later are held liable for clean-up costs. Lenders also may find their liens pre-empted by states eager to recover funds expended to clean up property. Builders, Realtors and lenders also may find themselves defendants in lawsuits alleging failure to disclose known defects in a property.

While concern about environmental risks in residential real estate is a relatively recent phenomenon, we believe it is a concern that is here to stay. Consumers have become increasingly aware of environmental problems and now realize that the risks are real. No one can safely assume they are immune.

Mortgage lenders must address the issue, but their actions must be in keeping with the risks posed by the hazard and the nature of residential property as an asset. In other words, the actions and costs required to discover environmental hazards must be reasonable for the size and simplicity of residential transactions. The response made by the lending community should also provide some benefit to the other parties involved in the transactions (i.e., the investor and the homeowner) to gain acceptance of the cost-effectiveness of the clean-up action.

From the lender's perspective, potential benefits from requiring action to address the problem include protection from liability for future damages or clean-up costs, preservation of collateral value and prevention of loan default. From the consumer's perspective, the benefits include better disclosure of property condition, identification of potential health hazards and useful information for informed decision making. For the investor, benefits include protection from adverse selection, more confidence in the collateral and greater assurance of an investment-quality loan.

The EPA's response

A policy recently proposed by the United States Environmental Protection Agency (EPA) has somewhat reduced lenders' fears about being held liable for environmental clean-up costs under existing federal laws. In July 1991, EPA released its Policy Towards Owners of Residential Property at Superfund Sites, which precisely outlined its policy stance for residential properties.

In residential settings, environmental contaminants often migrate and impact the groundwater, soil or surface of nearby properties. This policy enunciates an approach that the agency claims already had been its practice and is now incorporated into the official policy of the agency. Pertinent elements of the policy read as follows:

Under this policy, the Agency

will continue to exercise its

enforcement discretion and will not

pursue an owner of residential

property to undertake response

actions or pay response costs.

However, if the owner's activities

lead to a release or threat of

release of a hazardous substance

resulting in the taking of a

response action, this policy does

not apply, and the Agency will

contemplate taking an

enforcement action against the owner.

This policy is meant primarily to deal with homeowners whose property had been contaminated as a result of their proximity to a hazardous waste site. The title of the policy itself makes reference to "owners of residential property at Superfund sites."

Several caveats should be noted. First the policy only applies to Superfund sites or a location more commonly referred to as a National Priorities List (NPL) site. Such a site is technically defined as a site where EPA clean-up activities are pending or in progress. There are approximately 1,300 such sites currently identified by EPA. There are more than 30,000 such sites which comprise the CERCLIS data-base of sites that are reviewed and prioritized for inclusion on the NPL. Additionally, there are several hundred thousand additional hazardous sites classified by state agencies that may also affect residential properties.

Second, the policy defines residential properties as follows: single-family residences of one- to four-dwelling units, including accessory land, buildings or improvements incidental to such dwellings that are exclusively for residential use. EPA indicates in a footnote that this definition is consistent with the designation for single-family residence under the National Housing Act, 12 U.S.C. Section 1701. This definition would not include multifamily properties, whether developed or undeveloped.

Third, the policy is applicable to EPA actions (such as enforcement actions and legal actions) and does not apply to actions brought by other federal, state or local governmental agencies. More importantly, private-party legal actions are not affected, because this is an agency administrative policy rather than a statutory requirement. Private lawsuits are where most residential disputes are actually settled or litigated. (See analysis of Morgan v. Conoco later in this article.)

Property value impact

Residential cases rarely demand the attention given to a commercial real estate environmental problem. This is the case because the impact of residential environmental problems are local in nature and are typically distributed over several individuals. However, each of these individuals may, nevertheless, face a substantial financial burden. Viewed individually, residential properties have a significantly lower market value than commercial properties. According to the National Association of Realtors, the median selling price of an existing single-family home in the United States in the fall of 1990 was approximately $97,000.

When environmental contamination is discovered on, in or near a residential property, the value of the home is typically diminished in greater proportion than would be the case for a commercial property facing similar circumstances. This is primarily due to the lack of alternative land uses for such properties and the potential for health impairment of any present or future occupants. For example, it would be difficult to shift the property from a residence to even the least intense land use, possibly a parking lot, in the middle of a residential neighborhood. Incompatibility with neighborhood uses and restrictions imposed by zoning ordinances would prevent this.

In a commercial location, however, such low-intensity uses may be justified given their similarity to the surrounding land uses. Accordingly, there may be some salvage value to a commercial property affected by environmental problems. Zoning requirements in the commercial setting also would not be as stringent. The new use would usually be seen as less intense but one typically found in a commercial setting.

The personal health risk, while not the primary focus of this article, is also more significant in a residential setting given the longer duration of exposure to environmental contaminants. Individually who would be prone to longer daily exposure in a home setting would include children and the elderly, who may, from the outset, be ultra-sensitive to environmental problems, further compounding potential risks.

A cursory analysis indicates that property value loss in a residential setting fundamentally appears to be a reflection of underlying perceptions of threats to personal health held by those who occupy, purchase or finance such properties. In some cases, the lost property value can be a manifestation of real or even perceived health risks held by persons who occupy these dwellings. These risks will be evidenced through an "environmental risk offset" in the market value of the home.

An excellent illustration of this offset is the case of Morgan v. Conoco, (1990) that involved the settlement of a class-action lawsuit brought by nearly 2,000 homeowners in the vicinity of a Ponca City, Oklahoma oil refinery owned by Conoco. All of the homes in this area were serviced by municipal water sources not dependent on groundwater supplies. Over several decades, the nearby Conoco Refinery had emitted pollutants through groundwater aquifers, surface runoff and air contamination. The non-groundwater migration is significant to the extent that it illustrates that even properties that do not depend on groundwater for fresh drinking water supplies are susceptible to devaluation. This case calls into question the often-cited argument that environmental contamination is only a problem in rural settings that rely on underground aquifers for drinking water.

A $23 million settlement was announced on April 2, 1990, which involved in intricate proximity analysis based on a series of maps identifying six different categories of compensation based on proximity to the Conoco site. Property owners in closer proximity were generally more highly compensated than those further out. The Morgan case has laid the groundwork for a well-developed settlement structure that can be used in similar settings.

The stigma effect

Predicting the potential migration of environmental contaminants is a complicated science that must incorporate the unique composition of resources in proximity to the source of contamination. An inability to precisely quantify present impact or accurately predict future migration results in having to identify an additional "zone of concern" that extends beyond the proven or likely zone of concern that can be established using available scientific methods. This larger zone of concern creates risk factors that affect property in this second zone, even though there is no known, provable and existing environmental impact on the subject property. This results in the stigmatization of such properties in the outer zone that is manifested in property value loss.

One frequently used mechanism to measure property devaluation due to environmental conditions is property value assessments typically determined by local taxing authorities. A group of homeowners in Macomb County, Michigan, who claimed property devaluation due to leachate migrating from a nearby landfill, was granted a rollback in their assessed values to only $1.00. Such assessments are a conservative mechanism because they typically do not entirely reflect true market conditions and often lag behind actual market indicators by a significant period of time. Another example can be found in East Setauket, New York, where a residential subdivision in this Long Island neighborhood faced serious groundwater contamination caused by a leak at a nearby oil storage facility. To date, cleanup costs have surpassed $10 million. Property devaluations were reflected by a 30 percent reduction in assessed values on 200 houses in the nearby Story Book subdivision.

Decreasing consumer resistance

Today, consumers demand environmentally safe products even though they carry an increased cost. They have demanded that governments act to protect or clean up the environment, even at the price of higher taxes. This willingness to pay for environmental security should also extend to home-buying. We can expect the consumer to be ready to pay a reasonable amount for an environmental review of a prospective home in return for greater peace of mind. From the homebuyer's perspective, the time to check for environmental problems is prior to purchase. The big questions yet to be answered are how much is peace of mind worth and what information is of most value to the consumer.

Consumers have generally been willing to pay for information they perceive to have value--the cost of a title search, for example. Consumers are also generally willing to pay for protection for things they value--hazard insurance, for example. In the area of environmental hazards, we can, therefore, expect consumers to be willing to pay for products that provides information about risks that may seriously affect their health or jeopardize their investment in the property.

Where the interests of the lender and the consumer coincide, there is normally little friction about requirements made as part of the lending process. In the area of environmental hazards, the key to developing a successful risk management tool for lenders/investors will lie in finding a process that both the lender and the consumer perceive as providing value. For the past several years, the mortgage lending industry has been seeking such a process for residential property.

Evolving mortgage market policies

Some lenders recognize the risks posed by environmental hazards, but have felt incapable of addressing the issue in isolation. In part, their inability to act is due to competitive forces, because a lender that imposes additional costs or requirements will at at a disadvantage in the marketplace. But the inability for individual lenders to tackle these problems is also due to the magnitude and complexity of environmental issues themselves. The secondary mortgage market may be able to help lenders with both these concerns.

A uniform set of standards for addressing environmental hazards would provide all lenders with a level playing field while ensuring that each lender addresses the same risks. The secondary market may also be able to bring greater resources to bear on complex environmental issues, because its standards should foster the growth of support industries and new technology to detect environmental hazards.

Since 1986, the secondary market has undertaken initiatives to develop a response to environmental hazards in residential real estate. Early policy development efforts of the secondary market were focused on protecting lenders and investors from liability for cleanup of serious environmental problems under existing federal laws. In 1991, the EPA issued a proposed rule on lender liability that would clarify the secured creditor's exemption from clean-up liability contained within existing federal law. This proposed rule would provide additional support to the EPA policy specifically directed to residential properties that was released in July of last year.

This action by EPA was significant because past court decisions in environmental cases had clouded the lender exemption under Superfund law. The EPA rule in late April became final and, its message, and that of similar pending federal legislation, have made lenders and the secondary market breathe easier about potential liability. Even though there has been some progress on this front, we can expect the secondary market corporations to continue their efforts to develop environmental policies for residential loans because of the continuing risks of value decline and borrower default.

Fannie Mae has recently announced a requirement for environmental hazard assessments on all new type B or C condominium projects. The new policy sets forth standards for conducting Phase I and Phase II assessments (if necessary) and criteria for judging the acceptability of projects based on a review of the environmental assessments. Fannie Mae has had a similar requirement for multifamily mortgages since 1987. (see sidebar.)

Freddie Mac has internal work groups underway to develop environmental policies for both multifamily and single-family loans. The single-family work group is focused on the issues of value decline, borrower default, and disclosure that may arise as a result of environmental hazards in residential property. As part of its efforts, Freddie Mac is exploring sources of information and products that may provide the tools lenders need for evaluating and disclosing environmental matters affecting residential property. The result of this effort is expected to be a policy that provides Freddie Mac and its lenders with some protection against the adverse effects of environmental hazards and provides the borrower with valuable information for informed decision making.

The Office of Thrift Supervision (OTS) published its guidelines for thrifts to use in developing policies to address environmental hazards in residential lending in 1989. These guidelines remain in effect and are taken into account during a thrift institution's examination.

The U.S. League of Savings Institutions has also published a set of suggested policies and procedures for thrifts to use in responding to environmental risks. These were announced at the U.S. League's 1991 Real Estate Lending conference.

The Resolution Trust Corporation has developed an environmental procedure that entails having its contractors complete checklists when inspecting property. If an environmental problem is indicated, a Phase I assessment is ordered from an environmental contractor. Further actions are determined by the results of that assessment. The date, RTC's focus has been primarily on commercial and multifamily property.

Hopefully, some or all of these efforts will result in greater recognition of the risks posed by environmental hazards to residential real estate and lead to a process that benefits both lenders and consumers.

Liability for nondisclosure

In residential transactions, the focus on liability for cleanup of contaminated properties typically is overshadowed by the potential impact on property values. Liability in a residential setting may originate from situations where homeowners doe not properly disclose their knowledge of known environmental contamination that could have a negative effect on the value of the property.

As the general public becomes more sensitive to such issues, it would not be unreasonable to mandate disclosure where the homeowner had actual knowledge of such a defect or should reasonably have known of the defect, given his or her status as a homeowner in an environmentally contaminated community. The status of a leaking roof or a termite-infested foundation, typically conditions requiring disclosure, would seem to be dwarfed in comparison to groundwater contamination in the neighborhood that could have long-lasting health impacts on the residence.

The second liability problem is faced by lenders who will increasingly be under a duty to disclose knowledge of known environmental defects present in the communities where they lend. There are established cases in the area of damage caused by floods where lenders did not adequately advise homebuyers of a requirements to purchase flood insurance on a property, which was later damaged by flood. In such cases the lenders were found to be under a duty to disclose this "defect" given the nature of their relationship to the purchaser (See Small v. South Norwalk Savings Bank [1988]). When factoring in the potential costs tied to personal injury compensation and liability for non-disclosure of environmental defects upon sale of a property, the need to address environmental issues in a residential setting become even more compelling.

A clear understanding of the problems posed by environmental hazards in a residential setting is still in the early stages of development. Although some recent cases have begun to lay the groundwork for how these problems will be resolved, there is still much education and scientific understanding that needs to be achieved by all involved in the residential mortgage industry.

Has Fannie Mae Created a New Standard for Environmental Audits?

Ever since mortgage lenders realized that they could be adversely affected by the existence of hazardous environmental conditions, they have imposed requirements on their borrowers directed toward minimizing these adverse affects. To date, almost every lender has developed its own standards and requirements for determining whether a property is sufficiently "clean" from an environmental perspective for it to provide acceptable collateral for a loan. However, a recent Fannie Mae notice may provide the impetus for the use of a single set of environmental standards and requirements for the mortgage lending industry.

Although this brief article will provide an introduction to the new Fannie Mae requirements for lenders, property owners ad their environmental advisors, the actual Fannie Mae notice (Announcement No. 91-20, effective for certain mortgage loan approvals after January 1, 1992) must be studied prior to any lender or property owner actually commissioning an environmental assessment.

Fannie Mae's announcement

By now the many articles on the subject and well-publicized litigation should have sensitized every institutional lender to the serious consequences of lending on the security of property that turns out to be "contaminated collateral" (i.e., requiring an environmental cleanup). There is currently no consensus among institutional lenders and their environmental advisors regarding the minimum prudent scope of these inspections or regarding the magnitude of adverse environmental conditions that require corrective action prior to making a loan. However, Fannie Mae's Announcement No. 91-20 may mark the beginning of the development of such a consensus, at least with respect to mortgage loans on multifamily residential properties (which together with single-family loans, make up the bulk of Fannie Mae's mortgage loan portfolio).

Announcement No. 91-20, dated September 6, 1991, includes a new requirement that a "Phase I" environmental assessment be included in each application to Fannie Mae for its commitment to purchase mortgage loans secured by units in newly constructed residential condominium projects.

This announcement describes a Phase I assessment as:

"principally a screening

process that focuses on reviewing

the available documentation;

interviewing people who are

knowledgeable about the site

operations; and inspecting the

site, the building and adjoining

properties... [so as to determine]

whether information currently

exists to clearly evaluate a

property's environmental status."

Attached to the announcement is a suggested form to record the results of this Phase I assessment. Consequently, mortgage lenders may now require that this Fannie Mae form be used for Phase I environmental assessments, at least with respect to condominium projects, although the form is equally usable for all types of residential properties.

The announcement also identifies 13 conditions which, if disclosed as a result of the Phase I environmental assessment, will cause the property to become unacceptable to Fannie Mae for mortgage lending purposes unless the adverse conditions have been corrected. According to the announcement, Fannie Mae will agree to purchase mortgages secured by contaminated collateral only if (1) environmental experts determine that the "risk is minimal or can be managed" or that "remedial action [is] being taken to reduce or contain the risk," and (2) Fannie Mae is satisfied that the result of such action will make the property acceptable to a lender's underwriter. In other words, borrowers now can use these 13 items as a checklist of adverse environmental conditions that could cause their property to be denied approval for a mortgage (at least by Fannie Mae). One qualification however--the announcement indicates that this list is not intended to be exhaustive.

Fannie Mae's "dirty baker's dozen"

Conditions that could cause Fannie Mae to refuse to purchase mortgage loans include the following: * The property is (or has been) used

as a landfill or other solid,

hazardous, or municipal waste disposal

site. * The property is (or has been) used

for activity related to the storage of

oil, hazardous waste, or other toxic

substances--except that the

property may have been used for the

storage of small quantities of hazardous

substances for residential uses and

maintenance of the property. * The property is the subject of

outstanding environmental or public

health litigation or administrative

action from private parties or public

officials. * There are high-risk neighboring

properties that have evidence of

hazardous waste spills or soil or

groundwater contamination on or

around their sites. * The property has documented soil

or groundwater contamination

and/or a documented tank leak that

is leaking at more than 0.05 gallons

per hour (which is the National Fire

Protection Association's standard). * The soil sampling for the property

has values for metals in excess of

certain concentration limits. * The property is contaminated from

polycholorinated biphenyls (PCBs). * The soil sampling for the property

has values for other organic

materials in excess of certain

concentration limits. * The groundwater sampling for the

property has values for other

organic materials in excess of certain

concentration limits. * The groundwater sampling for the

property has values for metals in

excess of certain concentration limits. * The property has high radon levels

(above 4 picocuries per liter) that

can be corrected only through large

capital improvements and/or

extensive ongoing maintenance programs

that are beyond the financial or

technical abilities of the owners'

association for the project. * The property has conditions

representing material violations of

applicable local, state or federal

environmental or public health statutes and

laws. * The property is contaminated by

friable asbestos-containing materials.

If the Phase I assessment is unacceptable to Fannie Mae because it discloses the presence of one or more of the specified adverse environmental conditions on the property to be mortgaged, then in order for Fannie Mae to be willing to purchase the mortgage loan on that property, an acceptable "Phase II" assessment must be conducted by "a qualified environmental consultant," who does not have any conflict of interest with the borrower or loan originator and whose "personnel have adequate and appropriate education and training to carry out the required duties." This Phase II assessment is described as being "a more detailed review of the site [than is provided by the Phase I assessment], including specific physical sampling for each hazard that was not acceptable under the Phase I assessment, and a review of historical records."

The purpose of the Phase II assessment is to confirm or deny the presence of the unacceptable environmental conditions identified in the Phase I assessment and to locate and quantify the extent of those conditions that are hazardous (such as friable asbestos) or potentially hazardous (such as non-friable asbestos). Finally, the Phase II assessment report should contain the abatement, monitoring and maintenance programs that are needed.

Consequently, Fannie Mae's announcement now establishes at least a minimal outline for what should be included in a Phase II environmental assessment, even though it does not prescribe how such an assessment should be conducted. On the contrary, the announcement makes it clear that, for this purpose, Fannie Mae will rely upon the judgment of the environmental consultant who conducts the Phase II assessment.

Implications for lenders and borrowers

It is highly likely that if this approach to environmental risk assessment proves to be useful with respect to condominium projects, Fannie Mae will extend it to most (if not all) of the other project loans that it purchases. Given the dominant position that Fannie Mae currently occupies in the single-family and multifamily residential mortgage markets, this action could result in Fannie Mae's minimum standards becoming the minimum standards of the entire mortgage lending industry (at least for multifamily residential properties and possibly for other non-industrial properties as well). Because such a standardization will benefit the entire real estate industry, Fannie Mae is to be commended for its willingness to take a leadership role in this regard.

In the meantime, it would be prudent for mortgage loan originators to study carefully the environmental requirements of Announcement No. 91-20, so as to enable them to decide whether to continue with their own environmental compliance policies or to adopt Fannie Mae's. At the same time, owners of real estate (particularly multifamily residential properties) should familiarize themselves with this announcement so that they will better understand the environmental standards that they are likely to be required to meet when selling, financing or refinancing their properties. James A. Rosenstein is a partner in the real estate and environmental departments of the Philadelphia law firm Wolf, Block, Schorr and Solis-Cohen. Mark J. Bennett is president of EDR/TOXICHECK, an environmental risk management firm specializing in the provision of government environmental record reports on companies and properties. John Hemschoot is Freddie Mac's director of home mortgage standards.
COPYRIGHT 1992 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Regulatory; includes related article on Federal National Mortgage Association's standard for environmental audits on residential property; environmental issues in the residential real estate business
Author:Bennett, Mark J.; Hemschoot, John E.
Publication:Mortgage Banking
Date:May 1, 1992
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