Legal Briefs

Contamination Examination

Tainted properties may be worth the risk for savvy investors.

Real estate recessions create terrific investment opportunities — the trick is figuring out which ones are right for you. With banks and loan servicers increasingly swamped by foreclosure properties, environmentally contaminated properties can offer particularly good deals. A fair amount of fear and uncertainty continues to shadow contaminated properties, especially for companies not experienced in dealing with environmental issues. And lenders and servicers have enough problems today. The complexity that comes with environmental contamination may cause them to unload such properties as quickly as possible and far below market value.

Investment in this arena is not for the unsophisticated or the faint of heart. But for investors with experience and good legal and technical advisers, there will be some remarkably good opportunities. But first investors must understand the two broad categories of risks associated with tainted properties: the potential liabilities connected to the contamination and limitations on the use of the properties after the cleanup.

Cleanup Costs

The Comprehensive Environmental Response, Compensation, and Liability Act, also known as CERCLA or Superfund, is a federal statute intended to make sure that environmental contamination gets cleaned up with as little cost to U.S. taxpayers as possible. The statute applies a strict liability rule, making current owners and users of the site liable for cleanup costs even though they had nothing to do with contamination that may have occurred decades ago. The owners and users who actually caused the problem also are liable, and the government will go after them first if possible. But often they are insolvent or long gone.

CERCLA is only one of many state and federal laws imposing obligations on owners of contaminated properties. Other federal laws may impose environmental liability, and many states also have complex laws governing transfers of contaminated properties and imposing environmental cleanup liability, not to mention the potential for common law liability claims, such as for nuisance and trespass, often employed by nearby affected property owners or water users.

Exemptions

Typically, CERCLA’s brute force is blunted by some exemptions. The innocent purchaser defense is available to contaminated property buyers who do not know at purchase that their properties are contaminated. However, potential buyers must do “all appropriate inquiry” into previous uses and current environmental status — in essence, the ASTM E1527-05 Phase I Environmental Assessment that has become standard practice in real estate acquisition and financing.

This defense is not available to buyers who discover that their properties are contaminated. Other defenses, such as so-called third-party defense, are available where the buyer had no involvement in the contamination and no contractual relationship with anyone who did. This unsatisfying defense has rarely protected anyone from liability.

Similarly, CERCLA provides an exemption for secured creditors, as long as they do not exercise any control over actions taken with respect to the contamination. The exemption is supposed to cover lenders even after they take title through foreclosure, as long as the lender offloads the property as soon as reasonably possible. As a practical matter, though, this may not help. The lender can’t effectively sell the property until it has dealt with the environmental issue. This will cause it to step up and manage a cleanup, the cost of which often can defeat the purpose of foreclosure.

For these reasons lenders almost always require an environmental indemnity from the borrower or from a deep-pocketed owner of the borrower. These indemnities typically permit assignment of the indemnity to a buyer of the loan or the property in or after foreclosure. The problem, of course, is that if the property is distressed, it is very likely that the borrower and indemnitor also are distressed and may not be able to pay on the indemnity.

So it’s easy to understand why lenders are not anxious to become owners of such properties and why sophisticated buyers may be able to pick up good deals. There have been more than a few cases in which lenders faced with these properties have simply walked away from their loans, refusing to foreclose. In many of these situations, the lender is sufficiently leery of stepping into title that it will prefer to sell the note and mortgage before foreclosure.

Any contaminated-property buyer normally will ask for a discount for the estimated cost to clean up the contamination, plus a percentage to account for the possibility that the estimate is low since these costs are somewhat difficult to determine in advance. In addition, a buyer of the mortgage note will apply another discount to account for the risk that the borrower may file for bankruptcy protection, delaying or possibly thwarting acquisition of the property. Therefore, well-advised investors who can calculate appropriate discounts for both cleanup and foreclosure risks may well find very significant bargains from well-motivated lenders and servicers.

Use Restrictions

The science, practice, and regulation of environmental remediation have progressed greatly over the past 25 years, so the characterization of most contamination and methods for dealing with it have become largely routine and relatively predictable. Thus investors should be able to quantify their risks with contaminated properties and may even be able to insure against some of those risks.

However, it’s not just a question of the appropriate discount from the purchase price. Government-mandated cleanup plans may require that underground remediation equipment remain in place for years, taking vapors or liquids out of the soils and groundwater, which can delay development or render site sections undevelopable for a time. Cautious regulators may require that the property be permanently deed-restricted to prohibit certain uses, such as residential.

Finally, environmental contamination often complicates the land-use entitlement process. Neighbors may fear that development will stir up and expose them to harmful substances and may oppose property re-use plans. Planning commissions and city councils may require health risk assessments and identify expensive mitigation measures as a condition to development.

Despite these potentially formidable obstacles, with the help of experienced legal and technical advisers to properly assess and manage the risks associated with environmentally tainted properties and plan accordingly, investors may be able to find some of the best property investment opportunities this market has to offer.

Tom Muller

Tom Muller is a real estate partner at Manatt, Phelps & Phillips LLP in Los Angeles. Contact him at tmuller@manatt.com.

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