FEATURE ARTICLE, AUGUST 2006

DO DILIGENCE
Using Due Diligence to find the right investment property.
Daniel E. Taylor

Since the passage of the Comprehensive Environmental Response, Compensation and Liability Act (commonly referred to as “CERCLA” or Superfund) more than 25 years ago, real estate professionals are generally aware of the importance of conducting environment due diligence in commercial real estate transactions. However, with the boom in the real estate market in the last few years, developers, investors, and speculators have sought to ride the wave of the boom by getting in and out of real estate transactions as fast as possible. In so doing, some purchasers of commercial real estate properties have neglected to pay attention to the importance of environmental due diligence in their exuberance to get the deal done and move to the next or to take advantage of rapidly rising property values by flipping the property. This can prove costly when environmental contamination is later discovered on the property and the purchaser had failed to conduct the appropriate due diligence.

To prevent a good real estate transaction from becoming a bad one, the conduct of appropriate environmental due diligence is a critical first step. It will determine whether there are environmental conditions on the property that will prevent the planned development project or will require an unplanned costly remediation of the property. On the other hand, it may provide sufficient information even in cases where contamination is identified to adjust the purchase price, address the contamination and make the transaction work to both the buyer’s and seller’s satisfaction. The United States Congress passed the CERCLA legislation as a response to the environmental disaster at Love Canal, a New York area in which homes were built on top of a former municipal and industrial chemical dumpsite; and provided the regulatory basis for the United States Environmental Protection Agency (EPA) to compel those involved with a contaminated property to clean it up. Since then, federal, state and local laws regulating the environment and addressing liability for its cleanup follow and have built on the CERCLA model. CERCLA was dramatic in its scope to address environmental contamination in that it spread liability to current owners and operators; past owners and operators; those owners and operators responsible for generating the hazardous waste on the property; and if applicable, those who arranged for the disposal and treatment of hazardous substances and those who transported it. Liability is strict, several and may be retroactive to the passing of the CERCLA legislation. What this all means for an unwitting purchaser of a commercial property is that he or she could be liable for the entire remediation of a contaminated property caused by some previous owner or business on the site that took place years ago, even before the CERCLA legislation was passed. Depending on the type and degree of contamination, environmental remediation can be a very costly undertaking ranging from tens of thousands of dollars to millions of dollars.

Fortunately, Congress realized after the passage of CERCLA the unfairness of holding innocent purchasers liable for the cleanup of a property and created the “innocent purchaser/landowner” defense to liability. However, to avail oneself of this defense in the future, a property owner must be able to show that when the property was purchased, the buyer did not know or have reason to know that the property was contaminated and that if a hazardous waste is subsequently identified, the property owner exercise due care with respect to it. This does not mean that the developer or investor looking to purchase a commercial property can ignore inquiring about the environmental condition of the property and take the position of “what I don’t know won’t hurt me.” Instead, the prospective purchaser must conduct “appropriate inquiry” with the help of a qualified environmental professional in order to be able to take advantage of the innocent purchaser/landowner defense in the future. It is important that the environmental professional conducting the due diligence follow accepted industry standards. Those standards have been recognized in federal legislation and are found in ASTM Standard E1527; Standard Practice for Environmental Site Assessments: Phase I Environmental Site Assessment Process (“Phase I ESA”). This process provides for a records review, site reconnaissance, interviews with owners and those familiar with the property and an evaluation and report. The Phase I ESA will identify if there are “recognized environmental conditions” associated with a property which warrant further investigation commonly referred to as a Phase II ESA.

What are a prospective developer’s or investor’s options if a Phase I ESA identifies recognized environmental conditions or some likelihood that contamination may be associated with the site? The first option, of course, is for the prospective purchaser to walk away from the deal as long as the purchase and sale agreement provides for such. The second option may be to conduct a Phase II ESA which is a more invasive process, often requiring soil and groundwater sampling and analysis. This not only informs the purchaser whether there is contamination but also may give insight into magnitude of the contamination issue. Armed with this, the prospective purchaser is better able to determine whether the transaction still makes sense, whether the terms of the transaction should be changed or whether there is too much risk involved. All these decisions are predicated to some extent on the risk tolerance of the purchaser.

In determining whether a prospective commercial property that is contaminated or carries the stigma of being contaminated should be considered for redevelopment and investment, it is important to understand that both federal and state governments have developed programs to address such properties, thereby encouraging redevelopment. Such properties, mainly in urban areas are called Brownfields. Brownfield sites include previously developed properties where expansion, redevelopment, or reuse is complicated by actual or perceived environmental contamination. For the developer or investor considering a project in such areas, it may provide government regulatory and economic incentives to make the purchase economically viable despite the environmental contamination associated with the property. Even in areas that are not already designated as brownfields, a prospective purchaser may bring a redevelopment plan to a local community in order to obtain such a designation and incentives. In Florida, for example, obtaining a brownfields designation for property that requires environmental remediation, also requires entering into a brownfields site rehabilitation agreement (“BSRA”) with the Florida Department of Environmental Protection. However, with a brownfield designation on a property comes financial incentives which may include a 35 percent Voluntary Cleanup Tax Credit applicable to Florida’s corporate income tax or intangible personal property tax; a $2,500 Brownfields Bonus Referral for each new job created by an “eligible business”; low cost interest loans; and sales tax credit on building materials, loans and cleanup grants. There are also regulatory benefits such as a clear regulatory process called Risk Based Corrective Action, expedited regulatory review, and certain cleanup liability protections. The brownfields program is not the only governmental incentive program available. Florida also has incentives under its dry cleaning facility restoration statute when a property owner enters into a voluntary cleanup agreement with the state. This may be useful not only when dry cleaning contamination is identified during the course of a purchase and sale of a shopping center, for example, but also where the property owner is obtaining refinancing for the property.

The foregoing is only a brief overview of the environmental pitfalls and considerations that are associated with the purchase of commercial real estate. However, it highlights the importance of having the advice of environmental legal counsel throughout the developer’s or investor’s decision process in purchasing commercial real estate. It is important that such counsel drafts appropriate due diligence language as part of the purchase and sale agreement; that he or she reviews the contractual arrangement with the environmental consultant to insure that the work results in “appropriate inquiry”; and that counsel be available to advise on regulatory requirements and incentives for properties deemed contaminated or eligible brownfields. Opportunities abound in the commercial real estate market as long as environmental due diligence is used as a tool in such transactions.

Daniel E. Taylor, a director with the Fort Lauderdale law firm Tripp Scott, focuses his practice on environmental, governmental and land use law.

©2006 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.