Environmental Insurance for CMBS Deals – What You Need to Know

The environmental due diligence required for loans that will be securitized into commercial mortgage backed securities (CMBS) does not differ much from that required by most other types of lenders. This consists of a Phase I Environmental Site Assessment (ESA) that meets the requirements of the American Society for Testing and Materials (“ASTM”) and is conducted by a reputable environmental consultant. In most cases the report must have been conducted within 12 months of loan origination.

Where CMBS is unique is in the way that it treats issues identified in Phase I ESA reports. The loan level representations & warranties provide us with the framework that must be followed. Historically, environmental issues have been triggered by material noncompliance with environmental laws or the existence of a recognized environmental condition (REC) as indicated in the Phase I ESA. More recently, however, some additional triggers have been added to certain representations and warranties that include environmental conditions (or any successor provision to the Phase I ESA) or the need for further investigation even if there is no REC. When any of the above triggers are identified in the Phase I ESA for CMBS projects, then one of the following statements must be true:

• 125% to 150% of the funds reasonably estimated by a reputable environmental consultant to be sufficient to cover the estimated cost to cure any material noncompliance with applicable environmental laws or the environmental condition has been escrowed by the related mortgagor and is held by the related lender;
• If the only environmental condition relates to the presence of asbestos-containing materials and the Phase 1 only recommends the implementation of an O&M Plan then such a plan has been implemented by the mortgagor;
•  The environmental condition identified in the Phase 1 has been remediated or abated and a no further action or closure letter has been obtained from the applicable governmental regulatory authority (or the environmental issue affecting the related mortgaged property was otherwise listed by such governmental authority as “closed”);
•  An environmental policy or a lender’s pollution legal liability insurance policy that covers the liability for the identified circumstance or condition was obtained;
•  A party not related to the mortgagor was identified as the responsible party for such condition or circumstance and the loan seller has reasonably estimated that the responsible party has financial resources adequate to address the situation; or
•  A party related to the mortgagor having financial resources reasonably estimated to be adequate to address the situation is required to take action.

I don’t blame you if you didn’t read all of the above bullet points but they are important in that they present options to loan originators and borrowers. Historically if a REC was identified during an ESA then the most likely next step was a Phase II Environmental Site Assessment in which sampling was conducted and if no contamination was identified then the REC would be removed from the Phase I report and none of the above options would be needed.

In the last two years we have seen a significant increase in the number of deals where lenders and borrowers are forgoing a Phase II and going right to either the first bullet point (a 125% – 150% hold back of the cost to cure) or to the third bullet point (environmental insurance). The benefits of these options are that they are faster than conducting a Phase II investigation and they provide certainty of loan closure.

With these two mitigation options coming into the commercial real estate mainstream, some rating agencies have taken notice and are requiring engagement with environmental consultants to provide an Opinion of Probable Cost (OPC) (sometimes also referred to as Cost of Remediation) to confirm that the amount of the hold back or the amount of the environmental insurance policy is adequate to potentially address the identified environmental conditions.

Because the need for an OPC is a relatively new requirement, there is no standard OPC deliverable or framework for scope of assessment/reporting. Some rating agencies require formal letters with a detailed breakout of what the cost estimates are based upon, while other rating agencies require an email with the cost estimate or will accept a cost estimate provided in the executive summary of the ESA. There can be a lot of variability in how the Opinion of Probable Cost is determined and formulated, but the trend is clear that a formal OPC letter is quickly becoming the industry standard.

The OPC presents an opinion based upon the information provided and the experience of the consultant. They are based on many quantifiable and hypothetical scenarios, the uniqueness of the site, and the expertise of the consultant in a variety of environmental remediation techniques. Rating agencies do not hold the opinion of all consultants in the same regard. An OPC report from a well-respected consultant will give a more precise estimate for evaluating liability, planning, budgeting, and potential regulatory compliance. In turn, it will streamline the transaction process and ensure a successful investment.