Environmental Issues to Be Aware of When Buying Commercial Real Estate

Performing due diligence is an essential part of preparing to purchase or lease commercial real estate. Due diligence aims to uncover information that might not be immediately apparent during a cursory property evaluation so buyers or tenants can reduce their exposure to risks and liabilities.

In addition to researching the potential market, zoning, legal, structural and financial risks associated with prospective building or property purchases, clients need to determine if any environmental issues exist. Decontaminating property can be a lengthy and costly process, and owning or occupying a contaminated site can create liabilities far surpassing the original cost of the property.

What Is a Contaminated Site?

A property is considered contaminated if pollutants are above background levels and pose, or are likely to pose, an immediate or long-term hazard to the environment or human, animal and plant health.

The environmental contaminants of most concern include:

• The primary compounds found in fuels such as kerosene, gasoline, diesel, motor oil and different jet fuels (also known as Petroleum hydrocarbons (PHCs))
• Toxic organic chemicals such as PCBs and pesticides
• Metals such as zinc, cadmium, lead and mercury
• Radioactive materials such as uranium, heavy water and radon gas
• Animal manure or human waste
• Elevated levels of potassium, phosphate and nitrogen from agricultural practices
• Nuisance substances such as iron, sulphur, methane or unexploded munitions

Assessing Environmental Risks During Commercial Real Estate Due Diligence

The history of a particular property – along with that of any surrounding properties – is of key importance in environmental due diligence processes.

Due diligence specialists typically gather the history of a property from third-party sources such as provincial contamination registries, municipal governments’ brownfield inventories or from the owner or landlord of the property.

If the history or rent roll of a property reveals that any of the following high-risk activities have occurred on or near a prospective location, commercial real estate buyers, lessees and investors should be on high alert:

• Mineral and metal extraction and processing
• Oil and petroleum extraction, processing, transport or distribution
• Sale and storage of gas or oil
• Pulp and paper manufacturing
• Cement or asphalt manufacturing
• Chemical, plastic, polystyrene or rubber manufacturing or processing
• Food or animal by-product processing
• Wastewater treatment or contaminated soil processing
• Garbage or snow disposal
• Transportation-related activities, including the manufacturing, distribution and servicing of automobiles, aircraft and locomotives

It’s important to understand that even seemingly innocuous retail or office properties now found in mixed residential areas may sit atop land used for industrial or other environmentally detrimental purposes in the past.

So, whether a property’s previous activities and occupants are known or not, it’s still best practice to conduct an environmental site assessment (ESA). And because many Canadian lenders require ESAs performed according to Canadian Standards Association norms as a condition for financing commercial real estate transactions, you’ll likely need one anyway.

Environmental site assessments can also establish the baseline condition of a property at the time of a lease or sale. This could become important if you need to distinguish between environmental contamination that happened before or after a transaction.

Adding Time for ESAs and Other Legal Protections into Contracts and Leases

Environmental due diligence needs to begin before real estate purchases are closed. Real estate lawyers can play a significant role in helping their clients mitigate risks by including allowances in offers to purchase that set aside enough time to complete a Phase 1 assessment to check the historical use of the property and its neighbours, as well as Phase 2 activities such as on-site inspections for asbestos, lead paint and mould, plus soil and water testing if necessary. Offers should also include the right to terminate the transaction at any stage of the ESA or if the ESA reveals any contamination whatsoever.

This approach also allows strategic purchases to take place. For example, even if a property is contaminated, a purchaser might still be interested in it because they deem it adequate for their specific business use. Because discovering contamination reduces a property’s value, the right to terminate gives buyers leverage to renegotiate a lower price tag.

Many issues that require attention in agreements of purchase and sale for property also apply to leasehold relationships.

One of the most important concerns for prospective tenants is protection against potential liability for pre-existing property contamination. This is especially true when a tenant has limited knowledge regarding the historic use of the site. To accomplish this, tenants will require an express covenant by the landlord as to the physical quality and fitness of the space and for ‎the repair and remediation of any adverse environmental issues arising from pre-existing conditions or future conditions caused by third parties.

Allocation of environmental risk can be achieved in the form of an indemnity from the landlord and should also include coverage for any losses arising from interruption to the tenant’s business caused by environmental issues at the property.

In turn, landlords may require protection against potential environmental impacts caused by the ‎activities of their tenants. Depending on the ecological risks associated with the tenants’ business operations, standard clauses requiring a tenant to leave the rented premises in good repair at the end of a lease term may not be enough to protect a landlord against liability for environmental contamination.

Environmental Site Assessments: Timing and Cost for Commercial Real Estate

An environmental consultant should take 60-90 days to complete Phase 1 and Phase 2 tasks and analyses associated with a typical commercial real estate ESA.

A Phase 1 assessment can cost between $3,000 and $5,000, while Phase 2 assessments can range from $7,000 to $60,000, depending on the seriousness of the environmental issues identified.

Make Environmental Due Diligence a Must

Hidden environmental contamination can turn your dream investment into a nightmare of time-consuming, costly remediations, ruin your company’s reputation and expose you to unwanted liabilities. Environmental due diligence can alert you to issues before purchasing or leasing so you can make informed decisions and stave off adverse outcomes that could devastate your business.