A new tool could make real estate lending easier

Environmental insurance

set to replace

Phase I site assessments

A fundamental shift is underway in the field of commercial real estate lending, a swift movement by financial institutions toward environmental insurance policies and away from Phase I site assessment reports. In fact, major lenders have moved so quickly to change their standard operating procedures that industry experts see environmental insurance soon becoming as common as lenders' title insurance for commercial real estate transactions.

Environmental insurance, which protects lending institutions from financial loss and liability when a loan defaults and real estate collateral is contaminated, has three upsides for lenders: risk transfer, processing speed and possible favorable treatment on the commercial mortgage-- backed securities (CMBS) market.

This insurance achieves the four goals of environmental risk management: protect assets, maximize asset values, shield from liability claims, and create redevelopment opportunities. Historically, real estate developers, owners, lenders and trustees have relied on engineers to do property site assessment reports as the primary method of managing environmental risk. For buyers, the "site assessment" was thought to assist in assuring a clean property but it carried no guarantees. If needed, the Phase I report also was believed to provide grounds for an "innocent landowner" defense. Court interpretations over the years, however, have pierced this veil, giving credence to insurance products that transfer the risk from owner and lender.

This kind of insurance has drawn praise from lenders' customers who, after all, are the ones who have to purchase it. Many borrowers are seeking out lenders who accept environmental insurance in place of Phase I due diligence because, unlike Phase I's, borrowers do not have to pay for environmental insurance unless their loan is approved.

For twenty years, Phase I site assessment reports have accompanied commercial real estate loan applications not because they are better, but because they have become a 20-year tradition. Phase I's inability to address future risk over the term of the loan has compelled lenders to find a way that makes more sense. That way is environmental insurance.

In 1998-1999, about 5,000 commercial real estate transactions included environmental insurance policies. In 2001 that number had grown to more than 100,000, with projections for 2002 in excess of 250,000. Lenders that now use environmental insurance in tandem with, or in place of, Phase I due diligence include commercial banks, thrifts, real estate investment trusts, life insurance companies and pension funds. While environmental damage and its associated liability are not new to commercial real estate owners and lenders, especially with respect to brownfield properties, many state and federal laws have added to the complexity and pitfalls of virtually every commercial real estate transaction. Consider two more facts: the evolution of local governmental regulations, which have accelerated discovery of problems, and the increased movement of potential liabilities into real liabilities. Clearly, the awareness of environmental damage and potential liability has rapidly accelerated, as has the resultant need for a cost effective environmental risk management tool.

Lenders are concerned that the real estate developers' cash flow to service a redevelopment loan may be significantly impaired due to unforeseen environmental clean-up expense. This concern has broadened during the last 10 years. Lenders are now recognizing the need to maintain the liquidity and resale or redevelopment value of real estate collateral. When a loan secured by real property is in default and subsequently found to be contaminated, a lending institution must face the decision to-forego foreclosure -- rather than take title and become responsible for future remediation of the property and possibly neighboring properties.

Starting in the mid-1990s, lenders have had a new tool, one that allows them to transfer risk of known contaminants as well as undiscovered pollution, essentially receiving a warranty that the site assessment is correct and a documented environmental history of the property. If not correct, the insurance pays for the cleanup, the owner has a clean property, and the lender has marketable collateral. There is no need to litigate to establish liability, or to search out the nearest available "deep pocket" to have the site remedied.

In recent years, lenders have unwittingly taken possession of contaminated properties, only to be faced with extraordinary cleanup expenses. These lenders, and often investors, found that their financial risk management process had made no provisions for such occurrences. Now, with the use of insurance, they are able to transfer the risk of pollution, essentially receiving a financial guarantee that the site is without liability. Liability under environmental legislation is "joint, strict, severe and retroactive." Currently, there are more than 50 pieces of federal legislation from multiple jurisdictions covering environmental issues, along with a bewildering array of state and local laws and regulatory enforcement styles.

Risk Transfer

For the first time, lenders can transfer future risk. A Phase I does not have eyes; it cannot look forward and anticipate a new environmental event during the term of the loan. Unlike environmental insurance, Phase I's do not protect the lender in case of loan default and environmental damage. Essentially, Phase I's provide no comfort or protection to the lender. Lenders who now accept environmental insurance include JP Morgan Chase, Credit Suisse First Boston, Wachovia/ First Union, Wells Fargo, AmSouth, Commerce Bank, People's Bank and Legacy Banks. It normally takes two to three weeks for a Phase I site assessment to be performed by an engineer, usually costing the borrower $2,000 to $3,000. Typically, environmental insurance can be provided for a loan application within one to three days for a cost to the borrower of $300 to $1,800, depending on loan size and property type. As the commercial real estate market turns around from its 2001-slide, lenders and borrowers are looking for any fuel to get the engine started again. Environmental insurance's quick turnaround time helps-borrowers and lenders step on the gas when it comes to approving the majority of commercial real estate loans.

CMBS advantage

While all the major ratings agencies state a preference for environmental insurance along with site assessments as a requirement for underwriting CMBS collateral, they have also stated their acceptance of an insurance policy in lieu of due diligence for smaller loans. For Standard & Poor's, that means loans of $20 million or less; Fitch has called environmental insurance "a good idea" on loans up to $3 million; and Moody's stated in a recent report that "environmental insurance is an acceptable substitute for due diligence and in some cases can be credit positive." Lenders' push to accept environmental insurance on commercial real estate loan transactions prompted the agencies to develop criteria for it.

Why have the ratings agencies made the adjustment? Because due diligence on securitizations is not required to be ongoing, whereas environmental insurance is protection for the lender over the life of the loan. Investment banks that now use environmental insurance in the CMBS market include Goldman Sachs, Morgan Stanley, Lehman Brothers, Bear Stearns and JP Morgan.

Is there any reason why a lender shouldn't use environmental insurance? One banker put it this way, "If we all used environmental insurance as a standard in the business today, would we give it up for Phase I's? I don't think so." Once the logic of environmental insurance hits lenders and borrowers, they find it impossible to go back to the old way. The vision has always been to create the environmental equivalent of title insurance, and now it appears we have done exactly that.

Charles Perry is president of Environmental Warranty in West Hartford Conn.

Copyright NFR Communications Inc Jul 1-Jul 14, 2002
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