michael millikan, mai, ai-grs: ◦ vp/ chief appraiser of homestreet bank ◦ 17 years at bank, 10...

Environmental Risk Management Updates and Best Practices for

Lenders and Appraisers- Part 2 -

Michael Millikan, MAI, AI-GRS:◦ VP/ Chief Appraiser of HomeStreet Bank◦ 17 years at Bank, 10 years in Chief Appraiser

role◦ Manages the Bank’s Environmental Risk

Management Program, which was developed/ implemented in 2012.

Presenter Background

2

What We Will Cover:◦ Bank’s Environmental Risk Management

Program: Regularity Considerations Appraisal Regulations and Environmental

Considerations USPAP – Advisory Opinion 9 Bank Environmental Policy Case Study

Environmental Risk Management Program – Overview

3

◦ Regulatory Considerations: OCC (2013) and FDIC (2006) Environmental Risk

Management Program Guidance (foundation for bank policy) – key components include (but not limited to): Consider level of nature of the bank’s real estate lending

activities, risk profile and consideration of environmental laws.

Address environmental concerns prior to bank acquisition or foreclosure activities.

Ensure that evaluation of environmental risk is performed by persons with appropriate knowledge, skill and competence. Who performs the Bank’s environment review processes?

Environmental Risk Management Program

4

◦ Regulatory Considerations – Cont. Require a level of internal due diligence for all real

estate loan transactions. Structure due diligence requirements by loan type, loan

amount and property risk category. Appraisal requirements for disclosing and consideration

of environmental risk factors. ◦ Boil it Down

Adopt a risk-based approach to environment due diligence products and services.

Establish an environmental review process of due diligence products.

Integrate environmental risk into the valuation process (do not isolate valuation from environmental – they go hand-in-hand).


5

◦Appraisal Regulations and Environmental Considerations Interagency Appraisal and Evaluation Guidelines

(IAEG) and Title XI of FIRREA Applies to all real estate-related financial transactions

originated or purchased by a regulated financial institution

“As-Is” Market Value is Required Defined in IAEG as: “The estimate of the market value of

real property in its current physical condition, use, and zoning as of the appraisal’s effective date.”

“As-Is” Market Value can never be subject to a Hypothetical Condition – or conditions contrary to know facts about the physical, legal or economic characteristics of the subject property as the effective valuation date.


6

◦Appraisal Regulations and Environmental Considerations – Cont. How Does this Relate to Environmental?

Environmental impairment must be considered within the “as-is” market value estimate relied upon for lending purposes. Can be provided by 3rd-party appraisers or internal

licensed appraisal/ reviewer bank staff Consideration of environmental impairment should not be

managed as segregated process Example, appraisal reflects “unimpaired” market value

(often labeled as the “as is” market value) because the appraiser is unaware of a property’s adverse environmental condition. But, a cost-to-cure deduction is considered internally within a bank’s credit function.


7


8

◦Appraisal Regulations and Environmental Considerations – Cont. USPAP – Advisory Opinion 9 (AO-9) – Outlines

guidance pertaining to the appraisal of real property impacted by environmental contamination. Several key components include: Competency: an appraiser must be aware of, understand,

and correctly employ those recognized methods and techniques necessary to produce a credible appraisal. Reliance should be placed on opinions from Environmental

Professionals, such as cost-to-cure estimates. Use of an Extraordinary Assumption is applicable to

reliance upon an opinion from an Environmental Professional within an appraisal. Competency, in this context, does not mean that the appraiser possesses environmental expertise.


9

◦Appraisal Regulations and Environmental Considerations – USPAP AO-9 Cont. Several key components include – cont.:

Environmental Risk Defined as: “The additional or incremental risk of

investing in, financing, buying and/or owning property attributable to its environmental condition. This risk is derived from perceived uncertainties concerning: The nature and extent of the contamination Estimates of future remediation costs and their timing Potential for changes in regulatory requirements Liabilities for clean-up (buyer, seller, 3rd-party) Potential for off-site impacts Other environmental factors”


10

◦ Appraisal Regulations and Environmental Considerations – USPAP AO-9 Cont. Several key components include – cont.:

Environmental Stigma Defined as: “An adverse effect on property value produced by the

market’s perception of increased environmental risk due to contamination.”

Remediation Cost Defined as: “The cost to cleanup (or remediate) a contaminated

property to the appropriate regulatory standards…” Valuation Structure

Market Value - “As If” Unimpaired Subject to a hypothetical condition

“As Is” Market Value – As Impaired Subject to an Extraordinary Assumption (pertaining to reliance

upon environmental reports, cost-to-cure estimates. Market Value – “as-if” unimpaired less impairment = “as-is”

market value


11

◦ Bank Environmental Policy Outline (portion) Environmental Due Diligence Requirements

Policy should follow a tiered, risk-based approach Based on loan transaction type, loan amount and

property type One metrics for new loans (higher risk = higher

requirements) Purchase transaction? Should EPA’s AAI Rule be

considered? One metrics for subsequent transactions w/ no new

monies (lower risk = lower requirements) Investor requirements supersede bank requirements

(SBA, Fannie Mae DUS, Etc.) These are minimum requirements and finding may

dictate higher-level due diligence.


12


13

◦ Bank Environmental Policy Outline (portion) Use of environmental reports ordered prior to loan

application and not an approved vendor Build flexibility into policy to support the ability to use the

report. Such as, validation of report through a bank-ordered, 3rd-party review from an Environmental Professional

Usable Age of Environmental Reports Build flexibility into policy to allow use of older reports

18-month old Phase I ESA can be used in conjunction with a Database/ Desktop Review Report in order to bridge the time gap, etc.

Engagement of Environmental Consults Use engagement letters to ensure that bank requirements are

met, including out of scope items such as including recommendations in relation to significant findings.

Develop approved environmental consultant list and approval processes and criteria.


14


15

◦ Bank Environmental Policy Outline (portion) Environmental Review Requirement

A review process of environmental due diligence reports prior to the loan transaction is critical to ensuring quality control

Considered a tiered, risk-based approach to review A lower review requirement for non-complex assignments A higher-level review requirement for non-complex

assignments If elevated risk is present, ensure that the review process is

handled a competent Environment Professional. This could consist of an outsourced 3rd-party Environment

Professional or internal bank staff. The review should be documented

A standalone document Include in the appraisal review process to ensure

appropriate integration of environmental and valuation.


16


18

Case Study - Cherry Street Property

19

Property, Loan Detail and Motivation: ◦ Retail buildings totaling 5,000 sq. ft. on an 8,000

sq. ft. site built in 1925 ◦ Loan type: acquisition financing ◦ $1,000,000 pending purchase price ◦ Buyer motivation: purchase by adjacent property

owner for assemblage and future mixed-used retail/ multi-family development. Value upside due to assemblage considerations

(atypical motivation).


20

◦ Environmental Scenario: Environmental contamination from former dry

cleaning use on adjacent property to west from 1944-1960 – recently purchased by subject borrower (part of assemblage effort with subject). Responsible party (prior owner) does not have “deep

pockets”. Borrower has spent two years in environmental due

diligence to identify and characterize source and extent of contamination on the source property (not subject).

Prior Phase I ESA shows adjacent, former dry cleaner property has known contamination of halogenated hydrocarbons in soil and ground water.


21


22


23

◦ Environmental Scenario – Cont.: Groundwater flow direction and plume map shows

tetrachloroethylene contamination in ground water has migrated to the subject property and is above clean-up standards

Additional considerations include historical heating oil tank use at subject.

Dept. of Ecology issued advisory opinion letter (Vapor Intrusion Assessment) stating that indoor air screening levels/ air quality is acceptable for commercial use – but not residential. Vapor intrusion mitigation will be necessary during

redevelopment to mixed use residential use.


24

◦ Mitigating Considerations and Risks Mitigating Considerations

Financially strong borrower and existing bank customer The responsible party has insurance coverage to fund

remediation. However, policy cannot be produced and recovery of remediation expense is speculative.

Bank proposed a new environmental insurance policy as a condition of the loan.

Acquisition loan did not allow demolition and property redevelopment. Remediation cost outlays are unlikely until redevelopment.

The subject property is not the contamination source/ responsible party.

Desirable in-city property location with strong redevelopment upside.


25

◦ Mitigating Considerations and Risks Risks

Highly problematic contamination source – almost impossible to fully remediate. Removal/ treatment of soil and groundwater in addition to vapor intrusion measures are most probable.

Contamination is not adequately characterized on subject property.

Cost-to-cure was not possible to estimate based on known data.

Responsible party has limited financial ability to cover remediation.

Subject borrower, who purchased the adjacent contaminated property, is now in chain of title.


26

◦ Bank Environmental Due Diligence Process (following Policy requirements) Current Phase I ESA from a Bank-approved vendor

was ordered, which considered and consolidated all prior reports/ environmental due diligence to date.

Updated Phase I ESA was reviewed by a 3rd-Party Environmental Professional (ORMS) in order to validate the findings and recommendations and other considerations, including: ORMS recommends that the investigation and remedial

actions associated with the former dry cleaning facility continue to be monitored as the subject property has been impacted.


27

◦ Bank Environmental Due Diligence Process (following Policy requirements) – Environmental Prof. Review, Cont. If the subject property is redeveloped with a new building,

adjustment to the construction design should be considered to prevent vapor migration. ORMS recommends that a vapor barrier and sub-slab vapor collection system be installed during construction of the new building to minimize potential for vapors inside the building. This could be accomplished at a nominal expense as part of construction. In addition, precautions should be taken during the excavation activities for footings and utilities to monitor for potential encounter of impacted soil and groundwater.

Based upon the age of the subject property building, ORMS recommends that an Operations and Maintenance (O&M) Plan be implemented to ensure appropriate management of the potential ACM and LBP should the current building not be demolished in the near future and the subject property redeveloped.

The above-referenced report was not prepared for the Bank. Therefore, ORMS recommends that the Bank obtain a reliance letter from the vendor to assign the report to the Bank.


28

◦ A review of the Bank’s environmental insurance policy was ordered (ORMS), which identified key weaknesses and policy issues to be resolved, including: Cleanup costs exclude all known issues (most

significantly the dry cleaner source contaminants that migrated on the property).

The insurance policy has many limitations/exclusions that may very well restrict coverage.

Bodily injury is covered, even if from known issues. Policy excludes any costs related to vapor intrusion

prevention/mitigation. If the subject property gets held responsible for

contamination down-gradient, there appears to be coverage.

If regulations were to change to force a lower standard to be met, this policy would apply.


29

◦ Appraisal Outcome The “as-is” market value determination must

consider the environmental impairment Although a cost-to-cure estimate applicable to a

potential buyer of the subject property could not be reliably developed by an Environmental Professional for the appraiser to rely upon, the following considerations applied: The due diligence to date, and validation during the

environmental review process, presented a reliable characterization of the risk, liability and potential cost outlays to a buyer. These conclusions were relied upon via an Extraordinary Assumption.

Remediation cost outlays “as improved” were unlikely, rather only upon redevelopment.


30

◦ Appraisal Outcome – Cont. The highest and best use determination indicated a

higher value “as improved” compared to “as vacant”, suggesting that a typical buyer would leave the improvements in-place.

Evidence existed that some, if not all future remediation costs, were recoverable (but not guaranteed).

Since the subject is not the contamination source, the liability of other proximate property owners impacted by the contamination source would not fall to the subject.

An environmental impairment discount was developed based on price discounts from commercial properties selling with restrictive title covenants prohibiting redevelopment due to adverse environmental conditions (CRECs).

A 30% value discount was applied, which considered environmental risk and stigma.


31

◦ Final Outcome: The loan was funded at 75% LTV and a 50% loan-to-

purchase price. The Bank’s business decision considered the

strength of the existing borrower relationship and the first right of refusal to fund the (sizable) construction loan of the future assemblage and redevelopment.

The remediation costs relative to a large, mixed-used redevelopment property were manageable.

The borrower closed at full price with additional cash. The value upside due to the proposed assemblage was the primary motivation.


32

33

Questions??

michael millikan, mai, ai-grs: ◦ vp/ chief appraiser of homestreet bank ◦ 17 years at bank, 10...

Documents

environmental impairment

property type environmental

environmental review

address environmental

risk profile

property risk category

riskbased approach policy

diligence requirements