Environmental due diligence is no longer just box-ticking exercise

The last few years have seen unprecedented levels of US-based private equity investment in European real estate. This activity has been most pronounced in Germany, but investors have more recently been focused on the Nordic region and Central and Eastern Europe. In addition, some investors, driven by the increased competition for property portfolios, have diversified into new developments or major refurbishments.

Yet as investors branch into new geographies and strategies, their due diligence requirements increase in tandem, particularly when it comes to environmental concerns. Environmental due diligence in Europe presents a number of significant challenges when compared to US transactions, including the relatively poor availability of information and the lack of any mandated standards.

Increased competition for real estate portfolios by private equity companies increases the importance of due diligence, not only as a tool for liability assessment, but also as a means of identifying opportunities to add value to the portfolio post-acquisition.

US due diligence methods (such as those developed by ASTM) are only partially applicable in much of Europe and the US Environmental Protection Agency’s All Appropriate Inquiry requirements (the requirements for assessing the environmental conditions of a property prior to its acquisition) are largely inappropriate. Larger property portfolios also represent a significant logistical challenge as they can contain thousands of individual assets.

Recently, property investors have also had to address additional environmental concerns, driven mainly by climate change considerations. Measures of sustainability and energy consumption are now key issues, particularly for prestige developments, and factors such as flood risk and the potential impact of severe weather events have also entered the debate. While these issues are of marginal importance at present, new European legislation suggests that they will likely become more important in the future.

Therefore, it is critical that property investors in Europe (and beyond) understand the major components of environmental due diligence. Here we provide an overview of the major legislative drivers and technical issues for due diligence in property transactions.

Legislative drivers
For the majority of real estate transactions, key potential environmental liabilities include soil and groundwater contamination and the presence of asbestos or other deleterious materials. Other factors to consider, usually of lesser significance, include hazardous materials storage, waste management, wastewater discharge and operating permits.

Under European law, the polluter of soil and/or groundwater is, in most cases, liable for the investigation and clean-up of the contamination. However, in some member states, particularly in the UK and France, if a purchaser has knowledge that the land is contaminated, the liability can pass from the seller to the purchaser at the time of transfer, which can have significant financial implications in terms of remediation. Therefore, it is important for both the seller and the purchaser to assess whether the property’s soil and/or groundwater is potentially contaminated before a sale proceeds.

Consequently, during the due diligence process, it is important to determine any potential contamination. Typically, this is achieved via a review of existing environmental assessments and/or soil and groundwater investigation reports. If no site information is available, a Phase 1 Environmental Assessment can be conducted. This includes a review of historical maps, geological information and regulatory environmental databases, as well as site visits and interviews with key personnel.

Usually, the Phase 1 Assessment provides sufficient information to determine whether the property would require further investigation or remediation by a regulatory authority in the short term. If potential contamination is likely and if time allows, a seller or buyer could conduct further analyses to determine the extent of any contamination, as well as the likelihood and costs of remediation. However, purchasers are usually restricted from performing physical investigations; in some cases, if investigations are conducted, it is mandatory to submit the results of the investigation to the authorities, potentially creating a trigger for regulatory intervention.

The time frame for environmental due diligence clearly varies with the number and types of properties in the transaction, but typically ranges from one to six weeks. URS uses the International Accounting Standard (IAS) 37 for assessing potential costs associated with any contamination investigation and/or remediation work, if required by law or for the redevelopment of a site. IAS 37 requires that a company must recognize environmental provisions (predominantly for contaminated land liabilities) when there is a present obligation resulting from past events, e.g. contamination liabilities due to spills and leakages they have occurred in the past. Using statistical financial models, URS is able to report these provisions over the short- or long-term enabling the client to budget them into a transaction.

The presence of asbestos-containing materials (ACMs) is another factor to consider during the due diligence process. However, in the majority of cases, commercial properties do not contain significant quantities of ACMs and, in Europe, it is generally only properties more than 20 years old that are found to possess such materials.

Currently some European member states, including Germany, only require treatment or removal of friable asbestos materials which are damaged or could have a human health impact, and there is no current legal requirement for asbestos surveys to be undertaken. However, in the UK and France, asbestos surveys and management plans are legally required on all commercial properties. During the due diligence process, it is important for an experienced auditor to review and assess the adequacy of existing asbestos surveys and/or management reports to determine if further work is required.

Other environmental legislative drivers for real estate transactions include:

• • Assessing whether fuel and/or hazardous materials present on site in bulk quantities are adequately stored according to local fuel storage regulations;
• • Checking if sites are disposing of their waste using licensed contractors and retaining copies of relevant waste transfer documentation;
• • Where applicable (if sites handle more than 50 tons of packaging per year), ensuring that properties conform to the 1994 EU Directive on Packaging and Packaging Waste and are subject to recycling and recovery targets;
• • Where applicable, checking if sites require wastewater discharge consents for the disposal of any wastewater off-site;
• • Where applicable, assessing if sites require any permits to operate processes, for example air emission permits or operating permits for specific equipment or plants.

Key structural/technical issues
In carrying out environmental due diligence, a number of technical problems can be revealed. In the case of existing property assets, the due diligence generally consists of visits by experienced professionals who analyze the age and condition of the assets, potentially deleterious materials, maintenance and other records, site location and regulatory issues. The primary focus is to advise on issues that could either impact capital value or generate costs above and beyond what might normally be considered general maintenance.

In recent due diligence investigations, URS has uncovered some potentially significant issues, including:

• • Flat roofs in poor condition
• • An air conditioning plant using chlorofluorocarbons (compounds associated with ozone depletion, historically used in industrial applications and now being phased out)
• • Concrete defects or deterioration
• • Asbestos problems, including lack of legally required surveys
• • Slope stability problems

As a result, although deals have not broken down, sellers have had to allow for increased costs in their projections and also had to make allowances for them in their negotiations.

Many investors are now looking at new properties or purchasing existing developments on completion. This changes the focus of technical due diligence to concentrate on the standard of design and construction and checking that the appropriate permits have been issued and complied with. The technical team in this case would concentrate on documents, particularly drawings, design criteria and material specifications, to advise the prospective investor of any areas where the development may not comply with best practices. As work progresses, the quality of construction can be audited and assistance provided with building acceptance, handover and any retention of the escrow payment while defects or incomplete work are rectified.

Issues that have arisen in this process include: a building permit that the appropriate local authority denied issuing; remediation of ground contamination that was not accepted by the appropriate authority and required further verification; incomplete and poor quality work; and incorrect design calculations resulting in the need to strengthen a roof to carry the snow loading specified in the purchase agreement.

URS recently advised an investor on the acquisition of a moderate size shopping mall in northern Germany which was being purchased following a complete refurbishment. Upon our initial inspection, URS found that the work was incomplete and the retention sums were low. We also discovered that the building was located on top of a landfill site producing methane which needed to be removed and vented from under the building. As the negotiations progressed, the costs of the incomplete renovations were agreed upon and incorporated into the sale contract. Progress of these items are being monitored by regular site visits.

Conclusion
In conclusion therefore, increased competition for real estate portfolios by private equity companies increases the importance of due diligence, not only as a tool for liability assessment, but also as a means of identifying opportunities to add value to the portfolio post-acquisition. The days of due diligence being just a tick-box exercise have largely gone. The use of environmental and engineering expertise which can assess and implement measures to realize asset potential and increase yields will be necessary in many cases to maintain the returns appropriate to private equity investors.

David George is the Director of Transaction Services in Europe for URS, an environmental and engineering consulting firm. Keith McClurey is a Technical Director with the company, Tim Bescoby is a Principal Consultant and Laura Dougal is a Senior Environmental Consultant.