Environmental Risk Management Trends and Best Practices for Lenders and Appraisers

2. Environmental Risk Management Trends and Best Practices for Lenders and Appraisers Derek Ezovski Outsourced Risk Management Solutions LLC Eric Schwartz Amegy Bank July 24, 2013

3. Agenda • Current Trends • Regulatory Changes to the Environmental Due Diligence process • Commercial Issues • How Appraisals and Environmental Converge • Q & A

4. Appraiser Poll Question: Are environmental issues typically not looked at because of ignorance or apathy? Response: We don’t know and we don’t care…

5. How Appraisals and Environmental are similar for Lenders • Borrowers and lenders don’t “love” them • They are both often considered commodities by the user • Lots of people seem to think they cost too much • There are many less than competent providers • Report can differ based on who the user is • Often the last thing necessary for loan approval

6. How Appraisals and Environmental are different for Lenders • Appraisals are regulated • Environmental is often still considered discretionary • Most regulators do not define the appropriate level of environmental due diligence

7. Risk Management Challenge • “…data is old the minute that it is put in. Information is more available than it has ever been, but the ability to know what is pertinent and what is true is more challenging today.” • Martha Cummings – head of Risk, Banco Santander

8. Current Trends in Lending • Pressure from regulators • Workouts/Foreclosures • SBA Lending on the Rise • Continuously trying to do more with less • Lenders updating environmental/appraisal policies to conduct: • More due diligence…on a greater % of loans

9. Current Status of Banking Bank closures have been occurring since 2007, most of which had unusually high commercial-mortgage exposure. 2006 - 0 2007 – 4 2008 – 25 2009 – 140 2010 – 157 2011 – 92 2012 - 53 EBA Survey - 63% of lenders that had an examination over the last couple of years were asked about their environmental policy.

10. Former State of the Market Page 10

11. CRE Lending • While increasing bank leniency and improved fundamentals have helped revive the CRE market, the high level of maturing debt remains a significant barrier to recovery. • However, lenders’ focus on permanent loan resolutions through pre-foreclosure sales will likely provide opportunities for investors to acquire overleveraged properties at attractive prices. • - excerpt from Deloitte CRE Study

13. Banking Issues • Credit & Trust Risk • Collateral Devaluation • Direct Liability, Loan origination to foreclosure • Reputational Risk (Brand and Image) • Operational & Enterprise Risk • Market & Interest Rate Risk • Restructurings and Foreclosures • Sustainable Development & Finance

14. Major Changes EPA’s All Appropriate Inquiry (AAI)ASTM 1527-05

15. EPA’s All Appropriate Inquiries (AAI) Rule For the first time, there was a federal statutory authority saying what is needed for a Phase I environmental site assessment (not just an ASTM standard) Created by EPA under Brownfields Amendments to CERCLA in 2002. Biggest impact of AAI on lenders were the changes to FDIC guidelines – but there are other impacts of AAI including… Page 15

16. Key Changes to Phase I ESAs under AAI • Defined qualifications for environmental professionals (EPs); • Emphasized responsibilities of the “user” (person seeking liability protection); • New levels of Phase I research for consultant; • Shorter shelf life for Phase I reports.

17. Impact of AAI: Who Qualifies as an Environmental Professional? Page 17

18. Changes to Phase I’s - 2013

19. Key Changes:Simplified “Recognized Environmental Condition” Definition More closely aligned with the EPA’s All Appropriate Inquiries (AAI) “objective” de minimis extracted as a stand-alone definition Some instructional language added to historical and site visit sections

20. Key Changes: De minimis • A Recognized Environmental Condition includes the presence of a release  • “de minimis” added to allow the Environmental Professional to immediately dismiss a minor spill • “de minimis” used by some to describe contamination left in place and accepted by an agency • E1527 Task Group (and EPA) concluded that the same term should not be used to describe both situations

21. Key Changes:Historical REC • Historical Recognized Environmental Condition definition originally developed pre-2002 • before the Bona Fide Prospective Purchaser landowner liability protection/continuing obligations requirements) • Conditionally-closed sites currently handled four different ways • Consistency needed

22. New: HREC Split • Redefined Historical Recognized Environmental Condition • Past releases addressed to unrestricted residential use • Must consider current regulatory framework (rules change) • HRECs are not RECs • Created new Controlled Recognized Environmental Condition term • Past releases addressed to non-residential standard, subject to some type of control • CRECs are RECs and must be included in the conclusions section of the report • de minimis” CAN be used to describe an HREC • de minimis” CAN NOT be used to describe a CREC

23. Agency File/Records Reviews • Some argued additional records review already required under current standard • Some argued additional records beyond a database report are not required under current standard • Clients thought it was already being done • Consistency needed • New language: • Should be conducted for property and adjoining properties • If not conducted, explain why • Alternate sources ok

24. “User” Responsibilities • The purpose of the “User Responsibilities” not previously explained • Grounded in “Factors the Courts will Consider” CERCLA amendments • Re-iterated in the 2002 amendments to CERCLA • 2002 amendments extended these responsibilities to include brownfield grantees • Loan officers/realtors/brokers/etc., not typically seeking CERCLA liability protections or brownfields grant • Some EPs asking the wrong people to the complete the “User” questionnaire • Clarification needed

25. Vapor • E1527 has been silent on vapor • EPA recommended the task group not ignore the vapor pathway • 2013 revision acknowledges the vapor pathway in “migration” definition • Proposed language acknowledges soil vapor in “Activity and Use Limitations” definition • Added discussion in Legal Appendix regarding vapor intrusion as it relates to CERCLA • Clarifies “Indoor Air” non-scope

26. Non-Scope Considerationsand Appendices • Clarified “indoor air” exclusion • Added “unrelated to releases of hazardous substances or petroleum products into the environment • Revamped non-binding appendices • Revised Legal Appendix • Revised Report Table of Contents and Format • Developed a “Business Environmental Risk” Appendix to provide references and resource guidance

27. Recommendations • Task group split about 50/50 • Ultimately agreed that: • Recommendations are not required by the standard. • Usershould consider whether recommendations are desired.  • Recommendations are an additional service

28. Publication Timing • Anticipate ASTM/EPA process and publication completed sometime in 2013 • Can re-ballot existing E1527-05 as-is if necessary

29. Regulatory Issues

30. “New” FDIC Guidance • FDIC updated its Guidelines in November 2006. • Other regulatory agencies also updated their guidelines: • NCUA (effective May 2008) • OCC • OTS • Federal Reserve • FDIC’s guidance set the standard; FDIC is regarded as a leader in terms of environmental requirements. • FFIEC implemented environmental policy training/education for examiners across all agencies (October 2007, May and June 2008) • A majority of banks have reconsidered and revised their environmental policies.

31. NCUA Environmental Guidance

32. FDIC Focus FDIC emphasizes process and consistency. Ensures proper document management and records retention; Document due diligence; Track changes to policy and consistent application of policy. Banks must avoid “participating in management” of the business and thereby assuming liability under CERCLA. Many attorneys recommend a Phase I ESA in the event of foreclosure.

33. Small Business Administration Update SBA updated its Environmental Policy Effective August 1, 2008 and updated five times since (most recently in June 2012). Went from 1000 pages to 400 pages. Especially important for institutions with preferred status who do SBA underwriting. 7A and 504 lenders must adhere to this policy. Has become default policy for many lenders.

34. SBA Environmental Due Diligence Policy 34 2 levels of Environmental Due Diligence for SBA • Phase I – for high risk properties • If property type/use matches the list of NAICS codes for Environmentally Sensitive Conditions • Records Search with Risk Assessment – low risk properties • Includes a search of the government databases (compliant with AAI); • A search of historical use records, and; • A risk assessment by an environmental professional determining whether the site is “High”, “Elevated” or “Low” risk • New Gas Station/Dry Cleaner Requirements

35. Sample SBA Policy Matrix Page 35

36. Impact of Lender Size/Resources Regional & National Lenders • Resources in place to understand environmental issues on the property • Screen for lower-risk loans • Have staff/internal resources to manage environmental risk Credit Unions/Community Banks • No on-staff environmental expertise (typically) • Not as sophisticated with regard to environmental issues or due diligence options available • Often rely only on environmental questionnaires and/or proceed without accurate knowledge of environmental condition of property • Rely on external guidance to dictate their practices

37. Types of Due Diligence • Environmental questionnaire • Desktop due diligence • Transaction Screens • Phase I Environmental Site Assessments • Phase II, III, Remediation, etc. • Environmental insurance

38. Policy Matrix Becoming Common Page 38

39. Common Residential Issues • Lead Based Paint • Asbestos • Radon • Mold • Neighboring properties • Stormwater Runoff (for incomplete C&D) • Heating Oil Tanks • Meth Labs (emerging)

40. Common Commercial Issues • UST’s • Spills • Storage/disposal of Hazardous Waste • Superfund • Vapor Intrusion • Gas Stations • Dry Cleaners • Mold, lead, asbestos, etc. • Stormwater Runoff

41. Environmental Issues In Real Estate Valuation • Contamination • Green/Sustainability

42. Environmental & Appraisals Types of Contamination • Building Contamination • E.g., asbestos, lead paint, radon, formaldehyde • Encapsulate, Enclosure, Removal • Soil & Groundwater Contamination • E.g., hydrocarbons, solvents • Phase I (initial review) through III (remediation)

43. Environmental & Appraisals Green/Sustainability • A development that meets the needs of the present without compromising the ability of future generations to meet own needs • Goal – merge the priorities of economic prosperity, environmental quality and social equity.

44. NET ZERO HOUSE

45. LEED PLATINUM 801 17TH, NW, DC

46. Environmental & Appraisals Green/Sustainability - Valuation Issues • Initial Costs are typically higher • Benefits both direct & indirect • Direct • Reduced operating expenses • Reduced maintenance costs • Increased occupancy rates • Decreased tenant turnover • Possible increased rental rates • Indirect • Appeal to tenants’ social conscience/image • Is it too new to measure value premium???

47. Examples of Environmental Concerns for Lenders Foreclosures “Boring” property that used to be auto shop… Retail that used to be Gas Station Removal of waste from a property by lender triggers possible action

48. What the seller sees…

49. What the buyer/lender should see…

50. Summary • Lenders have unique processes and reasons for conducting due diligence. • Market pressures have reinforced long-term trend to increased due diligence. • Regulators enforcing risk management due to a perceived over-concentration of risk regarding commercial real estate. • Risk Management (Credit, Collateral, Environmental, etc.) is as critical as ever to lenders. • Environmental and appraisals are both pieces of the puzzle that are being revised under the current environment.