The Impact of Environmental Liability on Industrial Real Estate Development

Under U.S. environmental statutes, someone buying a commercial property may acquire a substantial pollution cleanup liability. Experts familiar with environmental liability and commercial property markets widely presume that such liability will have a substantial and adverse effect on the purchase and redevelopment of property in old, urban industrial areas (brownfield sites). According to these experts, the threat of potential environmental liability makes it increasingly likely that commercial development will occur in previously undeveloped areas in suburban or exurban locations (greenfield sites) where environmental contamination may be comparatively unlikely. The result of this shift from brownfield development to greenfield development, it is argued, is urban sprawl, which brings with it a host of environmental and other problems.

Each of the sources of uncertainty that we studied can be traced to ambiguities and inconsistencies in current federal and state environmental statutes and their enforcement. The environmental evaluation, which determines whether a site is contaminated and ranks sites on the basis of the health and ecological risks they pose, is a key determinant of subsequent regulatory scrutiny and a signal of potential cleanup costs. The evaluation can employ either CERCLA's ranking system or state programs' hazard ranking systems. While the quantitative standards employed by these systems provide needed consistency in evaluation across sites, the criteria used by the federal and the state systems can differ. Moreover, many uncertainties are inherent in the data and risk analysis that form the basis of these ranking systems. From the perspective of a current or potential property owner, the outcome of the preliminary site evaluation and listing process is highly unpredictable.

The cost of the site remediation that will be mandated once a site is slated for cleanup is also difficult to predict, as no consistent, objective standard exists for the level of cleanup that will be required. In general, individual cleanups are viewed as unique problems requiring unique solutions: there is bureaucratic latitude in selecting the remediation process, and cleanup goals and definitions can vary. There is also no method, even after a site remedy has been "completed," by which current or prospective developers or property owners can determine whether the cleanup is "permanent," because no statutory or administrative definition of a completed cleanup exists.

Perhaps the greatest source of uncertainty facing developers and property owners is how liability will be allocated in the event of a site cleanup. Common law historically has included concepts such as negligence, trespass, and nuisance in adjudicating environmental issues. CERCLA and its attendant case law have altered typical common law standards of liability and made cleanup liability strict, retroactive, and joint-and-several. This means, among other things, that both past and current property owners are liable for the cleanup of pollution created years ago and that a single producer who shipped waste to a site may be held liable for the costs of cleaning up waste shipped by other producers. The intent of these liability provisions is to obtain cleanup costs from potentially responsible parties.

The practical impact of this change is that it is difficult for former, current, or prospective property owners of an abandoned factory site, for example, to know whether they will be held liable for cleanup costs, irrespective of whether they caused the release of pollution. The current liability approach sends a strong signal to polluters and those with whom they do business that they may eventually pay for the costs of environmental damage. In their current form, however, environmental liability rules can introduce a great amount of uncertainty into real estate markets.

We argued above that a developer should be indifferent to the choice between purchasing a contaminated property and purchasing a similar but uncontaminated property if contamination costs are discounted from a property's price by the market. However, uncertainties created by CERCLA-related liability, along with the aversion of buyers and sellers to taking risks, could make contaminated properties less desirable than uncontaminated properties.

As an illustration, consider a transaction involving a former gas station site worth $3 million to a potential buyer and $2 million to the current owner. It is in both parties' interest to trade the property, since the gain from trade—or the difference in the value placed on the property by the buyer and by the seller—is $1 million. Now if both parties knew that the property was contaminated and that the cost to clean it up was $1 million, that knowledge would not reduce the gains from trade. Given the contamination, the property would have a net worth of $1 million to the seller if he or she does not trade the property and a net worth of $2 million to the buyer if he or she purchases the property.

Liability can be contractually assigned to either real estate sellers or buyers through indemnity agreements. If the seller indemnifies the buyer, he or she in effect offers a warranty that absolves the buyer of liability attached to the property. Covenants-not-to-sue are a related arrangement in which a state government or the federal government will agree not to impose liability against a new owner of contaminated property.

By limiting liability or providing insurance against liability, both indemnity agreements and covenants-not-to-sue can reduce the negative impact of uncertainty and thus reduce distortions that lead to the greater relative desirability of unpolluted sites. However, such mechanisms are limited in scope relative to the many ways in which a property owner can be found liable under CERCLA and state environmental laws. They are also easily contestable by the government and other potentially responsible parties (PRPs).

The concept of contribution is central to indemnity. Under case law related to CERCLA, a PRP who pays to resolve his or her liability may in turn seek to have other PRPs "contribute" to that payment. An indemnity agreement thus prohibits one PRP—the party providing the indemnity—from seeking contribution from another PRP—the indemnified party.

Any single indemnification agreement, however, provides little insurance against liability given the many pathways by which liability can be imposed. Under joint-and-several liability, a property owner can be sued directly—by the state or federal government or by neighboring property owners—or indirectly via contribution by PRPs that have not indemnified the owner. Similarly, a state covenant-not-to-sue does not bar federal enforcement actions, and vice versa. Moreover, covenants-not-to-sue do not bar liability claims brought by other PRPs, public interest organizations, or injured neighbors.

While indemnity contracts and covenants-not-to-sue can reduce, in principle, the uncertainty associated with the cost of liability, overlapping jurisdictions and the joint-and-several standard of liability reduce their effectiveness. Such covenants provide meaningful assurance only when both state governments and the federal government agree not to sue a new property owner.

Property purchases are typically financed by a lender. As exposure to liability increases the lender's expected costs, the availability of finance for brownfield properties could be restricted, making greenfield development increasingly attractive. CERCLA exempts some lenders from liability under certain conditions; but if lenders are in a position to influence the borrowers' environmental decisions, then lenders would be potentially liable. This potential liability on the part of the lender affects the cost of a loan, since the lender will require compensation for the risks incurred by financing a brownfield investment.

Lender liability serves a beneficial purpose, as well, in that it encourages lenders to assess the environmental risk posed by a site. In addition, it encourages them to take other steps to protect the value of their loans. For instance, lenders may choose to make state-of-the-art waste management by borrowers a condition for a loan.

Even in the absence of CERCLA, lenders would have an incentive to take such steps, because environmental liability can lead to the bankruptcy of the borrower and the foreclosure of his or her property. When this occurs, the collateral on which the loan is based is devalued and may even become worthless. Moreover, with the borrower in default, no further interest payments can be collected by the lender, independent of whether the lender is liable.

In other words, lending to a property owner whose site is contaminated is not likely to be profitable. All else being equal, finance costs arising from lenders' liability exposure will decrease the relative attractiveness of brownfield development.

Detection of contamination and the supply of brownfield sites

Given tight budgets for enforcing environmental laws and the difficulty of detecting environmental contamination, the government's ability to identify contaminated properties is limited. An effective way to avoid the discovery of contamination—and the costs of cleaning it up—is to keep property off the real estate market. Entering into property transactions greatly increases the likelihood of detection, because it is in the interests of both buyers and lenders to investigate environmental conditions.

It is easy to illustrate why a site would be withheld from the market if the current owner fears that contamination will be discovered. Suppose that the value of a property—absent liability—is $4 million to the current owner and $5 million to a buyer. In this case, the property would be purchased and redeveloped by the buyer.

Our case studies of urban commercial property sales suggest that all the above-noted uncertainties associated with environmental liability can distort undesirably the market for brownfield and greenfield property. The studies reveal that these uncertainties are to some extent discouraging brownfield redevelopment. In particular, they indicate significant practical limitations regarding the use of indemnity agreements and covenants-not-to-sue and instances in which it can be argued that property is being withheld from the market in order to avoid detection of contamination.

The case studies also suggest actions that would minimize distortions of the market for brownfield and greenfield properties. Policy changes aimed at reducing uncertainty for investors—such as consistent and quantifiable cleanup standards and enforceable indemnity agreements and covenants-not-to-sue—would reduce the impact of liability on choices of properties for redevelopment. For the same reason, clarifications of and limitations on lender liability would be desirable, particularly given that lenders already have incentives to conduct due diligence assessments. Finally, more timely and conclusive efforts to detect contamination would allow property sales to proceed, because current liability would be more definitively established than at present.

As long as the sale of property triggers regulatory scrutiny, the supply of available brownfield sites will be restricted while owners "wait out" their liabilities. With improved detection efforts, real estate markets would function better, as owners of brownfield properties with redevelopment potential are more likely to offer those properties to the market when their environmental liabilities are more precisely known and discounted.