Wave of Distress and Maturities Brings Environmental Issues to Surface

This year, a record $363 billion in maturing commercial real estate debt joins the wave of $170 billion in cumulative troubled loans that remain unresolved, including past maturities that have yet to be placed. There are an estimated 22,395 properties now in distress1 across the United States, and $90 billion in troubled property loans. Banks, which hold the lion’s share of existing debt, will be challenged in wading through the volume of loans moving into play. Distress and loan maturities are driving demand for environmental due diligence as commercial real estate lenders seek to uncover issues that could complicate refinancing, disposition or foreclosure.

Part of the challenge is that the level of capital available for refinancing properties with loans maturing this year is expected to fall far short of what is required—as many as 60% of 2007-vintage loans may fail to refinance, according to Real Capital Analytics. A number of factors complicate the ability of newly matured loans to find capital this year. For one, these loans were originated during the boom year of 2007 when environmental underwriting was much more lax than it is today. Also, fewer lenders exist to help refinance this debt due to recent bank failures and consolidation. These loans will also be challenged by high loan-to-value ratios, hit hard by declining property values for the collateral that secures the debt.

There has also been limited borrower equity buildup at many properties. Some loans maturing this year are for ‘zombie’ properties that suffer from neglect and a lack of investment during the downturn. From an environmental standpoint, this can create a host of problems, especially if the properties have fallen into disrepair or hazardous substances on site have not been properly managed. Others are development projects that never got off the ground or sit half-finished. “The challenge with properties that are abandoned and neglected is that they attract dumping of wastes. Some of the problems we have seen on these types of properties involve dumping of hazardous waste like barrels of used auto fluids, old batteries, tires, improperly disposed of chemical containers and contents and biohazards,” Eric Miller, President, Odic Environmental & Energy. “In addition, at properties that have not been maintained or were abandoned, there may be no records of what was being done at the property without conducting appropriate investigation. New environmental issues may have surfaced, and outdated environmental due diligence reports will generally not reflect the current site condition or knowledge of the surrounding area.”

So a depressed pricing environment for commercial properties coupled with tighter underwriting than when loans were first originated adds up to a great deal of scrutiny as lenders are challenged to isolate the less-risky maturing loans. Many banks already have policies in place to define the level of due diligence appropriate for each situation, a strategy for effectively managing their risk exposure and avoiding any environmental surprises. “Lenders should work with counsel and qualified environmental consultants to develop and consistently implement an environmental due diligence approach for all distressed property transactions,” according to Ken Banaszek, an environmental professional in Chicago. “The approach needs to identify sufficient information regarding conditions that may exist at or near the subject property to allow the lender and other stakeholders to minimize or avoid costly environmental liabilities.” Depending on a property’s age and current or past use, there may be environmental issues to be considered not only from a risk position, but also from one of marketability. Having certain environmental issues thoroughly assessed upfront may enhance the sale of the asset. Older multifamily properties, for instance, with lead-based paint and asbestos containing materials, may warrant environmental compliance assessments, particularly prior to foreclosure. Environmental due diligence can reveal issues that may have escaped notice at origination when standards were less conservative or new environmental conditions that arose subsequent to loan origination.

With so many property loans at or approaching maturity—and a limited supply of capital to go around—expect to see a wave of defaults, workouts, refinancing, liquidations, property sales and foreclosures this year. Risk assessments, including environmental risk assessments, along with appraisals, will continue to play an important role in assessing a property’s condition, its value and its inherent risk.