Optimizing Environmental Due Diligence in CRE Transactions

By Sanyu Kyeyune

Dan Spinogatti

To accurately determine the extent of environmental impact on a property, it’s important to understand both current and historical tenant operations, cautioned Dan Spinogatti, senior vice president of real estate services with EBI Consulting—an environmental and engineering due diligence firm. Addressing attendees of the Mortgage Bankers Association CREF/Multifamily Finance Conference in San Diego, he presented some of the biggest environmental risks for each property type. 

Environmental risk factors, by asset type

Multifamily: Often, the environmental hazards that affect apartment communities are caused by contamination from neighboring areas, such as air-quality issues created by nearby manufacturing facilities. These risks tend to be more pronounced in legacy buildings, including Class B and C communities and public housing.

“When we work with agency financing groups—Freddie Mac, Fannie Mae, HUD—they provide very prescriptive scopes of work, which require extensive in-unit testing for things like radon, asbestos and lead-based paint,” Spinogatti explained. And because these types of investments often include a capital improvements component, they are likely to involve renovation work, which increases the risk of unearthing hazardous substances.

Office: Especially in older office buildings, emergency power generators may be kept in underground storage tanks to conserve space and prevent fires. But when these tanks leak, the risk of contamination magnifies, necessitating thorough environmental due diligence.

Retail: The growing trend among retail investors of repurposing former big-box stores for recreational uses—like indoor racing tracks—calls for heightened attention to environmental due diligence. And dry cleaning shops continue to create long-term problems, thanks to the chlorinated solvents used in operations. Slow to degrade, these substances can easily migrate through concrete and soil, contaminating groundwater.

Similarly, an environmental site assessment of a space previously occupied by an auto repair business—such as Sears, which faces considerable bankruptcy risk this year and operates Sears Auto Centers nationwide—can uncover such issues as the presence of underground storage tanks containing petroleum products.

In both of these cases, further investigation is required, increasing time and cost for investors.

Industrial: Facilities that process metals or chemicals, including those that manufacture semiconductors or other electrical components, face amplified environmental risks. Tenants of these properties often store the substances that factor into their operations in underground storage tanks, which can degrade or pill and disperse toxic chemicals.

Property condition assessment

From the lender’s perspective, properly pricing the loan requires determining whether the borrower has adequately sized their potential investment’s replacement reserve. The property condition assessment needs to take into consideration the extent to which immediate repairs will be required, the expected useful life of systems and cost estimates for property improvements.

“The property condition assessment could lead the lender to hold back funds from the loan until the borrower makes certain repairs,” Spinogatti noted. “That’s why it’s so important to make sure the report has the correct scope of work applied for that use.”