Foreclosure Policies as a Risk Management Tool

Finally, some positive news regarding the state of commercial real estate: According to EDR Insight’s 4Q12 Quarterly Benchmarking Survey of Financial Institutions, foreclosures on commercial properties are decreasing. The average percentage of an institution’s overall environmental due diligence that was for foreclosures fell from 17% in 4Q11 to 9% in 4Q12. Additionally, 38% of respondents expect to see lower foreclosure volume in 2013, and another 45% expect levels to remain this year as last year.

The Need to Remain Vigilant

Even as commercial real estate foreclosures stabilize or decrease, lenders need to remain vigilant about their environmental risk exposure when foreclosing on commercial properties. Without a clear pre-foreclosure policy, a bank becomes especially vulnerable.

If the property securing a loan transaction has environmental issues, there are a number of downsides, which is why most lenders require some type of environmental screening as part of their underwriting, particularly in today’s risk-averse climate. In general, environmental issues on properties used as collateral can:

  • expose the bank to direct liability for cleanup costs as well as probable litigation;
  • cause buyers to default if they are forced to divert cash flow to pay for cleanup; and
  • damage a bank’s reputation, brand and image.

Environmental due diligence takes on even greater significance for lenders in cases of foreclosure. Most lenders require some type of environmental screening as part of their underwriting for new loan originations; most commonly following or requiring their borrowers to follow AAI/ASTM E 1527-05 protocol at origination. It is less common for financial institutions, especially small community banks, to have policies that dictate environmental requirements specifically for pre-foreclosure situations. The purpose of this Technical Brief for lenders is to explore how lenders’ policies for foreclosures are different than for other types of bank activities (i.e., new loans, refinancings, etc.).

When Lenders Become Owners

What makes foreclosures unique—and potentially problematic—is that they essentially turn lenders into owners, subjecting them to the same environmental liability that property owners face under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), even if they did not cause the contamination, and even if they sell the property quickly. As a result, regardless of whether or not they conducted (or required the borrower to conduct) environmental due diligence at origination, lenders should address it before foreclosing on a commercial property. Usually this is by having a Phase I environmental site assessment performed in accordance with the U.S. Environmental Protection Agency’s All Appropriate Inquiry (AAI) Rule or its equivalent, ASTM’s E 1527-05 standard.

A look at EDR Insight’s recent survey on commercial property foreclosures reveals that:

  • 87% of lenders have some form of environmental due diligence requirements pre-foreclosure.
  • 56% have a different scope of work for foreclosures vs. new originations/refis.
  • 28% have vapor intrusion screening requirements pre-foreclosure.

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Pre-foreclosure Due Diligence

When it comes to pre-foreclosures, banks typically have more stringent environmental due diligence (EDD) policies than for originations or refis. In the case of originations, in general, the loan amount determines the level of EDD, says Bank of America’s Randy Muller. In the case of pre-foreclosures, a Phase I ESA is required regardless of property value. “Any and all commercial real estate asset for which we are considering taking title (friendly or otherwise), we require a Phase I ESA as the initial EDD,” says Muller. “What is truly different is the manner of interpretation. A ‘pre-lending analysis’, while thorough in its own regard, is largely intended to support the financial underwriting by facilitating ‘an informed business decision’. A ‘pre-foreclosure evaluation’ by contrast must consider potential liabilities that may occur if the tenets of Secured Creditor exemptions are inadvertently violated.”

In addition, Phase II ESAs are generally more common pre-foreclosure. “Banks face greater environmental risks in foreclosures. As a result, most banks will be quicker to progress to a Phase II than they would in pre-lending situations,” according to a regional bank. Additionally, the likelihood of a bank conducting a Phase II “is greater for bank assets that have been acquired through a merger/acquisition,” because the level of environmental due diligence at origination is unknown, notes one risk manager from a Fortune 500 Bank.

Whatever the reason, reliance on Phase II ESAs have been on the rise. The likelihood of “needing further intrusive investigation had historically been 17% to 23%,” Muller says. “Through the end of 2012, the ‘hit rate’ had been closer to 30% to 35%, reflecting a need to be truly cognizant of any and all environmental concerns for purposes of valuation, as well as liability protection. The numbers in 2013 have largely shown a return to the historic lower levels of situations requiring Phase II ESAs.”

The High Cost of Contamination

If a bank forecloses on a contaminated property, cleanup costs can be considerable. Contaminated property can also be difficult—if not impossible—for a financial institution to sell. In one case, a bank originated a loan on a strip mall that once housed a dry cleaning facility, but conducted no testing on the property at the time of loan origination. When the bank later foreclosed on the property and conducted due diligence, the investigation detected significant soil vapor contamination and possible groundwater impacts. In the end, the total cost of the cleanup amounted to a significant one-third of the appraised value of the property.

In developing a pre-foreclosure policy, banks should consider all types of environmental risks. Vapor migration/intrusion is one issue that is getting a significant amount of attention. Some environmental consultants automatically include consideration of vapor intrusion (VI) as part of their Phase I ESAs, while others do so only at a client’s request. According to one regional bank, “We don’t have a formal policy yet on vapor intrusion. We would expect that issue to be brought up in a Phase I if the consultant has reason to believe that it could impact collateral value or due-care requirements. We haven’t had a situation where VI was brought up in the absence of other on-site contamination issues.”

Likewise, nearly one-third of financial institutions have policies that require some type of screening for vapor migration on pre-foreclosures, while others do so only on a case-by-case basis. “Our Phase I ESA scope of work does not specifically address VI, however it is a standard aspect of review analysis—subject site or neighboring properties for evidence of a VOC or SVOC release,” Muller says, “in addition to CERCLA substances—mold, radon, lead based paint (for residential and other sensitive usages), and asbestos-containing materials.”

Foreclosures present extremely different liability concerns for lenders than just extending credit, primarily because the lender is essentially becoming the unwilling owner of the property with all of the potential liability that carries. This is very different than being able to assert a secured creditor defense in a case where the borrower holds title to the site. As such, banks should define clear plans for pre-foreclosure environmental due diligence to effectively manage their risk exposure and avoid unwelcome environmental surprises in trying to resell the property.

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In writing policies to manage their liability exposure when foreclosure appears imminent, lenders should consider:

  • Writing a pre-foreclosure policy that is more stringent than those used for new loan originations, given the added risk exposure to the financial institution.
  • Starting with an AAI/ ASTM E1527-05-compliant Phase I ESA to ensure the institution can qualify for CERCLA liability protection.
  • Having a site visit conducted before tensions with tenants escalate and site access becomes an issue.
  • Consulting with a trusted, qualified environmental professional to set triggers in bank policy for which loans would merit adding inspections for other environmental issues, like mold, asbestos, lead-based paint or vapor intrusion.

NOTE TO READERS: EDR Insight would like to sincerely thank Randy Muller and other lenders who contributed to this Technical Brief.