environmental risk management trends and best practices for lenders and appraisers

Environmental Risk Management Trends and Best Practices for Lenders

and Appraisers

Derek EzovskiOutsourced Risk Management Solutions LLC

Eric SchwartzAmegy Bank

July 24, 2013

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Agenda1. Current Trends

2. Regulatory Changes to the Environmental Due Diligence process

3. Commercial Issues

4. How Appraisals and Environmental Converge

5. Q & A

Appraiser Poll

Question:

Are environmental issues typically not looked at because of ignorance or apathy?

Response:

We don’t know and we don’t care…

How Appraisals and Environmental are similar for Lenders

• Borrowers and lenders don’t “love” them• They are both often considered commodities by

the user• Lots of people seem to think they cost too much• There are many less than competent providers• Report can differ based on who the user is• Often the last thing necessary for loan approval

How Appraisals and Environmental are different for Lenders

• Appraisals are regulated• Environmental is often still considered

discretionary• Most regulators do not define the appropriate

level of environmental due diligence

Risk Management Challenge

• “…data is old the minute that it is put in. Information is more available than it has ever been, but the ability to know what is pertinent and what is true is more challenging today.”

– Martha Cummings – head of Risk, Banco Santander

Current Trends in Lending• Pressure from regulators

• Workouts/Foreclosures

• SBA Lending on the Rise

• Continuously trying to do more with less

• Lenders updating environmental/appraisal policies to conduct: – More due diligence…on a greater % of loans

Current Status of Banking• Bank closures have been occurring since 2007, most of which had

unusually high commercial-mortgage exposure.

• 2006 - 0• 2007 – 4• 2008 – 25• 2009 – 140• 2010 – 157• 2011 – 92• 2012 - 53

• EBA Survey - 63% of lenders that had an examination over the last couple of years were asked about their

environmental policy.

Former State of the Market

CRE Lending

• While increasing bank leniency and improved fundamentals have helped revive the CRE

market, the high level of maturing debt remains a significant barrier to recovery.

• However, lenders’ focus on permanent loan resolutions through pre-foreclosure sales will likely provide opportunities for investors to acquire overleveraged properties at attractive prices. - excerpt from Deloitte CRE Study

Banking Issues

• Credit & Trust Risk• Collateral Devaluation• Direct Liability, Loan origination to foreclosure• Reputational Risk (Brand and Image)• Operational & Enterprise Risk• Market & Interest Rate Risk• Restructurings and Foreclosures• Sustainable Development & Finance

Major Changes EPA’s All Appropriate Inquiry (AAI)

ASTM 1527-05

EPA’s All Appropriate Inquiries (AAI) Rule

• For the first time, there was a federal statutory authority saying what is needed for a Phase I environmental site assessment (not just an ASTM standard)

• Created by EPA under Brownfields Amendments to CERCLA in 2002.

• Biggest impact of AAI on lenders were the changes to FDIC guidelines – but there are other impacts of AAI including…

Key Changes to Phase I ESAs under AAI

1. Defined qualifications for environmental professionals (EPs);

2. Emphasized responsibilities of the “user” (person seeking liability protection);

3. New levels of Phase I research for consultant;

4. Shorter shelf life for Phase I reports.

Impact of AAI: Who Qualifies as an Environmental Professional?

Professional/Educational Qualifications

Relevant

Experience

Professional engineer or professional geologist license/registration

3 years

Federal or state license/certification to perform environmental inquiries

3 years

B.A./B.S. degree or higher in any science or engineering field

5 years

No B.A./B.S. degree 10 years

Changes to Phase I’s - 2013

Key Changes:

Simplified “Recognized Environmental Condition”

Definition

• More closely aligned with the EPA’s All Appropriate Inquiries (AAI)

“objective”

• de minimis extracted as a stand-alone definition

• Some instructional language added to historical and site visit sections

• A Recognized Environmental Condition includes the presence of a release

• “de minimis” added to allow the Environmental Professional to immediately dismiss a minor spill

• “de minimis” used by some to describe contamination left in place and accepted by an agency

• E1527 Task Group (and EPA) concluded that the same term should not be used to describe both situations

Key Changes:

De minimis

• Historical Recognized Environmental Condition definition originally developed pre-2002

– before the Bona Fide Prospective Purchaser landowner liability protection/continuing obligations requirements)

• Conditionally-closed sites currently handled four different ways

• Consistency needed

Key Changes:

Historical REC

New: HREC Split

• Redefined Historical Recognized Environmental Condition– Past releases addressed to unrestricted residential use– Must consider current regulatory framework (rules change)– HRECs are not RECs

• Created new Controlled Recognized Environmental Condition term– Past releases addressed to non-residential standard, subject to some type of control– CRECs are RECs and must be included in the conclusions section of the report

• de minimis” CAN be used to describe an HREC

• de minimis” CAN NOT be used to describe a CREC

Agency File/Records Reviews

• Some argued additional records review already required under current standard

• Some argued additional records beyond a database report are not required under current standard

• Clients thought it was already being done

• Consistency needed

• New language:– Should be conducted for property and adjoining properties– If not conducted, explain why– Alternate sources ok

“User” Responsibilities

• The purpose of the “User Responsibilities” not previously explained– Grounded in “Factors the Courts will Consider” CERCLA amendments– Re-iterated in the 2002 amendments to CERCLA– 2002 amendments extended these responsibilities to include brownfield grantees

• Loan officers/realtors/brokers/etc., not typically seeking CERCLA liability protections or brownfields grant

• Some EPs asking the wrong people to the complete the “User” questionnaire

• Clarification needed

• E1527 has been silent on vapor

• EPA recommended the task group not ignore the vapor pathway

• 2013 revision acknowledges the vapor pathway in “migration” definition

• Proposed language acknowledges soil vapor in “Activity and Use Limitations” definition

• Added discussion in Legal Appendix regarding vapor intrusion as it relates to CERCLA

• Clarifies “Indoor Air” non-scope

Vapor

• Clarified “indoor air” exclusion– Added “unrelated to releases of hazardous substances or petroleum products

into the environment

• Revamped non-binding appendices– Revised Legal Appendix

– Revised Report Table of Contents and Format

– Developed a “Business Environmental Risk” Appendix to provide references and resource guidance

Non-Scope Considerationsand Appendices

• Task group split about 50/50

• Ultimately agreed that:– Recommendations are not required by the standard.

– User should consider whether recommendations are desired.

– Recommendations are an additional service

Recommendations

• Anticipate ASTM/EPA process and publication completed sometime in 2013

• Can re-ballot existing E1527-05 as-is if necessary

Publication Timing

Regulatory Issues

“New” FDIC Guidance

• FDIC updated its Guidelines in November 2006.• Other regulatory agencies also updated their guidelines:

– NCUA (effective May 2008)– OCC– OTS– Federal Reserve

• FDIC’s guidance set the standard; FDIC is regarded as a leader in terms of environmental requirements.

• FFIEC implemented environmental policy training/education for examiners across all agencies (October 2007, May and June 2008)

• A majority of banks have reconsidered and revised their environmental policies.

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NCUA Environmental Guidance

FDIC Focus

– FDIC emphasizes process and consistency.

– Ensures proper document management and records retention;

– Document due diligence;

– Track changes to policy and consistent application of policy.

– Banks must avoid “participating in management” of the business and thereby assuming liability under CERCLA.

– Many attorneys recommend a Phase I ESA in the event of foreclosure.

Small Business Administration Update

• SBA updated its Environmental Policy

• Effective August 1, 2008 and updated five times since (most recently in June 2012).

• Went from 1000 pages to 400 pages.

• Especially important for institutions with preferred status who do SBA underwriting.

• 7A and 504 lenders must adhere to this policy.

• Has become default policy for many lenders.

SBA Environmental Due Diligence Policy

2 levels of Environmental Due Diligence for SBA1. Phase I – for high risk properties

• If property type/use matches the list of NAICS codes for Environmentally Sensitive Conditions

2. Records Search with Risk Assessment – low risk properties• Includes a search of the government databases (compliant with AAI);

• A search of historical use records, and;

• A risk assessment by an environmental professional determining whether the site is “High”, “Elevated” or “Low” risk

• New Gas Station/Dry Cleaner Requirements

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Sample SBA Policy Matrix

Minimum Due Diligence Requirements

Real Estate Loan Type

<$150K $150K < $2M

Low Risk Loans Questionnaire RSRA/TSA

High Risk* Loans – NAICS Codes

Phase I Phase I

Gas Station Phase I + Evidence of UST Compliance

Phase I + Evidence of UST Compliance

Dry Cleaners Phase I Phase I

Dry Cleaner (older than 5 years old)

Phase I and Phase II Phase I and Phase II

Special Use Facilities (i.e. Daycare)

More specific requirements (i.e. Lead Paint Testing, Lead in

Drinking Water, etc)

More specific requirements (i.e. Lead Paint Testing, Lead in

Drinking Water, etc)

Impact of Lender Size/ResourcesRegional & National Lenders

• Resources in place to understand environmental issues on the property

• Screen for lower-risk loans

• Have staff/internal resources to manage environmental risk

Credit Unions/Community Banks• No on-staff environmental expertise (typically)

• Not as sophisticated with regard to environmental issues or due diligence options available

• Often rely only on environmental questionnaires and/or proceed without accurate knowledge of environmental condition of property

• Rely on external guidance to dictate their practices

Types of Due Diligence

• Environmental questionnaire

• Desktop due diligence

• Transaction Screens

• Phase I Environmental Site Assessments

• Phase II, III, Remediation, etc.

• Environmental insurance

Policy Matrix Becoming Common

Minimum Due Diligence Requirements

Real Estate Loan Type

<$250K $250K < $1M >$1M

Low Risk Loan - new

Questionnaire/Desktop Desktop/Transaction Screen

Phase I

High Risk* Loans - new

Phase I/Transaction Screen

Phase I/Transaction Screen

Phase I

Renewals -Low Risk

Questionnaire/Desktop Questionnaire/Desktop Questionnaire/Desktop

Renewals -High Risk

Questionnaire/Desktop Questionnaire/Desktop Desktop/Transaction Screen

Multi-Family Questionnaire/Desktop Desktop/Transaction Screen

Desktop/Transaction Screen

Outdated Phase I Questionnaire/Desktop Questionnaire/Desktop Desktop/Phase I update

Common Residential Issues

• Lead Based Paint• Asbestos• Radon• Mold• Neighboring properties• Stormwater Runoff (for incomplete C&D)• Heating Oil Tanks• Meth Labs (emerging)

Common Commercial Issues• UST’s

• Spills

• Storage/disposal of Hazardous Waste

• Superfund

• Vapor Intrusion

• Gas Stations

• Dry Cleaners

• Mold, lead, asbestos, etc.

• Stormwater Runoff

Environmental Issues In Real Estate Valuation

–Contamination

–Green/Sustainability

Environmental & Appraisals

Types of Contamination– Building Contamination

• E.g., asbestos, lead paint, radon, formaldehyde– Encapsulate, Enclosure, Removal

– Soil & Groundwater Contamination• E.g., hydrocarbons, solvents

– Phase I (initial review) through III (remediation)


Green/Sustainability

– A development that meets the needs of the present without compromising the ability of future generations to meet own needs

– Goal – merge the priorities of economic prosperity, environmental quality and social equity.

NET ZERO HOUSE

LEED PLATINUM 801 17TH, NW, DC


Green/Sustainability - Valuation Issues– Initial Costs are typically higher– Benefits both direct & indirect

• Direct – Reduced operating expenses – Reduced maintenance costs– Increased occupancy rates– Decreased tenant turnover– Possible increased rental rates

• Indirect – Appeal to tenants’ social conscience/image

– Is it too new to measure value premium???

Examples of Environmental Concerns for Lenders

1. Foreclosures

2. “Boring” property that used to be auto shop…

3. Retail that used to be Gas Station

4. Removal of waste from a property by lender triggers possible action

What the seller sees…

What the buyer/lender should see…

Summary • Lenders have unique processes and reasons for conducting due

diligence.

• Market pressures have reinforced long-term trend to increased due diligence.

• Regulators enforcing risk management due to a perceived over-concentration of risk regarding commercial real estate.

• Risk Management (Credit, Collateral, Environmental, etc.) is as critical as ever to lenders.

• Environmental and appraisals are both pieces of the puzzle that are being revised under the current environment.

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Contact Information:

Derek Ezovski

[email protected]

How to Learn More?

Convergence of Appraisal and Environmental Services within

Financial Institutions

Eric Schwartz, MAI, SRAChief Appraiser

Appraisal Review DepartmentAmegy Bank of Texas

July 2013

Disclaimer: The opinions expressed are solely those of the author and are not necessarily the opinions of the management or employees of Amegy Bank.

July 24, 2013 53

• Vendor Pool– Qualifications – Who is “qualified”?

• Professional Credentials• Geographic competency• Property competency

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Management of Environmental Services

• Database Management– In-house

• Pros-– Easily tailored to individual requirements– Use of existing resources– Customizable– Integration into other databases

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• Database Management– In-house (continued)

• Cons:– Reallocation of limited resources– Functional requirements may not be understood by staff– ASTM standards may seem “foreign” to appraisers/reviewers

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• On-line database management tools– Real Estate Management Information Service – RIMS

• Web based project management system– Procurement and tracking– Vendor management– Performance

• Pros:– Reasonably low cost– Automated credential monitoring– Secure report upload/download/storage

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• Features to look for –– Online service request– Ease of interface for vendor and management– Automated task and project tracking– Vendor Performance reports– Contact database management system– 24/7 accessibility

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• Synergies of task types– Appraisals and environmental reports must be tied to the same

project. Requires a hierarchical management system similar to:• Project

– Task» External » Internal

– Reporting» External» Internal

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• Environmental due diligence• Least stringent to most stringent

– ASTM Transaction Screen– Phase I “Lite” ESA– AAI/ASTM Phase I ESA

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• Bank personnel and appraisers should possess some level of competency with:– ASTM E-1527-05: Standard Practice for Environmental Site

Assessments: Phase I Environmental Site Assessment Process (known as ESA)

– ASTM E-1528-06: Standard Practice for Environmental Site Assessments: Transaction Screen Process

» Reference: www.astm.org

July 24, 2013 61


• Process Management – Within the appraisal/real estate unit?

• Maintain database of appropriate service providers• Understand qualifications of service providers• Internal reviews of Transaction Screens, Phase I “Lite”

and Phase I– Recommendations may need to be outsourced to qualified

environmental experts/attorneys

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• The appraiser’s role– Eyes, ears and nose of the lender

• Recognize your limitations• You are likely not an environmental professional, but…• Tell us what you see/smell and hear (the contact say)• Why?.....................

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• Some banks ask you to note if you observed any of the following:– Storage tanks– Collection Sites– Drums/containers and/or pesticides/chemicals– Asbestos– Miscellaneous

• Soil contamination• Water leaks• Water damage• Mold

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• Exposure Draft of Proposed Revisions to Guide Note 6: Consideration of Hazardous Substances in the Appraisal Process (5/28/2013)

• Guide notes are not part of the standards of professional practice but instead provide guidance on how the standards may apply to specific issues.

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• Highlights of the proposed revisions to Guide Note 6– Explains the differences between the existence of

hazardous substance(s) and environmental contamination;

– Consideration of the Competency Rule and Scope of Work Rule

– Extraordinary assumptions and hypothetical conditions

– Definitions– Basis of proper valuation

July 24, 2013 68


– Guide Note 6-Consideration of hazardous substances in the appraisal process is fundamental to the appraisal of real property.

– Need for special consideration to the impact of hazardous substance on the valuation of real property.

– Hazardous substances are considered environmental contamination when their concentrations exceed appropriate regulatory standards. (see definitions in GN6)

July 24, 2013 69


• Guide Note 6- Competency• Competency rule in USPAP, Code of

Professional Practice and the International Valuation Standards (IVS)

• Most appraisers do not have the knowledge, training and expertise required to detect the presence of hazardous substances or to measure the quantities of such material.

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• Guide Note 6- Competency (continued)• If the assignment calls for the appraiser to

take into account most appraisers rely on other professionals for assistance.

• If the appraiser lacks the knowledge and expertise they have to disclose that lack of knowledge and experience prior to the acceptance of the assignment.

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• Guide Note 6 – Scope of Work• How and to what extent the appraisal problem

will address known or suspected hazardous materials that may impact the property.

• Assignment conditions cannot limit the scope of work such that the assignment results are not credible for the intended use.

• Cannot allow the client’s objectives or the intended use to cause assignment results to be biased.

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• Guide Note 6 – Extraordinary Assumptions and Hypothetical Conditions

• Extraordinary assumptions would be employed when you are relying on the work of others.

• Hypothetical conditions are used when the appraiser estimates the value of the property known to be contaminated in an unimpaired or uncontaminated condition.

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• Guide Note 6 – Basis for Property Valuation• Impaired value – The “as is” value of the

property• Unimpaired value – The market value

developed of the contaminated property employing a hypothetical condition the property is not contaminated

• Diminution of value – Effects of costs to remediate plus use costs plus risk (stigma too).

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• What’s the appraiser to do?– If you see it….report it.

• Call the client• Take photos and send them to the client• Write it up in your report• Calculate diminution in value if appropriate• Employ a hypothetical condition or extraordinary

assumption if appropriate• Ensure your results are credible

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• What steps would you take if you saw this during the property inspection?

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• If FNMA, SBA, HUD and the bank are concerned about environmental conditions….shouldn’t you be?

• What is your client’s policy?– Do they require Transaction Screens based on

loan amounts?

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• Resources– Guide Note 6 – Exposure Draft is out (5/28/13)– Analyzing the Effects of Environmental

Contamination on Real Property (AI Seminar)– USPAP – Competency Rule; Advisory Opinion 9– SBA SOP 50 10 5(C) Subpart B, Chapter 4 for 7A

loans and Subpart C, Chapter 3 for 504 loans– NAICS Codes of Environmentally sensitive

industries

July 24, 2013 79


EBA 2010 www.envirobank.org

How it all started ...

• Lender liability issues in the early 1990s • Environmental regulations• Bankers wanted a place to share best

practices and to learn additional skills


Environmental Risk ManagementIssues

• Bank Risk Tolerance• Business Environmental Risk• Distressed Assets&

Restructurings• Loan modifications/renewals• Workouts, Foreclosure,

Bankruptcy• Climate Change Risk • Bank Failures


Training

• Environmental credit risk management • Sustainable Financing (green buildings) • Brownfield Redevelopment • Sustainable development/carbon risk

underwriting• Management issues• 2 Conferences per Year


environmental risk management trends and best practices for lenders and appraisers

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