Environmental Risk Management and Best Practices for Lenders and Appraisers

1. Environmental Risk Management and Best Practices for Lenders and Appraisers 2014 Appraisal Institute Annual Meeting August 5, 2014

2. Current Trends in Lending/Financing of Commercial Real Estate • Pressure from regulators • New ASTM Standard for Phase I’s • New Transaction Screen Assessment (TSA) Standard • SBA Lending • Lenders updating environmental/appraisal policies • More levels/forms of due diligence than ever before on more loans • Seems to be a big push in the CRE market again…

3. How Environmental Issues Often Seem

4. 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)

5. 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…

7. Comments from LinkedIn by Appraisers I agree that hardly anyone outside the appraisal world reads USPAP. That includes AMC's and Lender's that often make requests to appraisers which are not compliant with USPAP. This leads to both appraiser and lender frustration. If USPAP is the governing document for appraisers, you would think at a minimum that underwriters would be required to understand the document. I dread taking the refresher every 2 years. It's definitely the most boring CE class. It usually turns into 8 hours of complaining about the profession. What is USPAP? Does any lender really care about USPAP anymore? Basically, lender guidelines appear to always over rule USPAP.Professor Warren, your last comment it sooooo true. We all need to wake up to what is really happening vs debating appraisal methods among ourselves, as if the typical big boy lenders really care about appraisal methods or quality.That being said, it seems a bit ridiculous that we create and enforce rules that many lenders could care less about.

8. Comments from LinkedIn by Environmental Consultants • You will always have a problem until lenders start rejecting sub-standard Phase I ESA's. When lenders are accepting Phase I's that have zero historical research and records reviews that cost $1200 and were done in five days, it will not matter who does the site visit.  • Unfortunately, a significant part of the industry has a product mentality rather than one of service. The result is a business solely driven by price, thus tempting the industry shortcomings.Professor Warren, your last comment it sooooo true. We all need to wake up to what is really happening vs debating appraisal methods among ourselves, as if the typical big boy lenders really care about appraisal methods or quality.That being said, it seems a bit ridiculous that we create and enforce rules that many lenders could care less about.

9. Appraisal Institute Survey - 2013

10. CRE Appraiser Concerns • Fee pressure & expanding scope of work • Formulary approach (forms, checklists, ratios, indices) gaining more prominence • Greater liability • Increasing barriers to direct communication with lenders resulting in appraisal report acceptance and/or perceived report quality issues • Over regulation of appraisal profession

11. Concerns of Appraiser Clients • Long turnaround times • Cost of appraisals • Misunderstandings concerning the scope of work in engagement letters • Compliance with standards/regulation • Sufficiently supported value conclusions • Quality work product • Shortage of qualified appraisers • Concise valuations (do not want lengthy reports)

12. Hottest Topics for Staff Appraisers • Inadequate market analyses • Appraisal compliance with bank regulations • Not recognizing or appreciating clients’ needs • Insufficient details on market conditions and trends affecting real property • Going concern valuations (different methodologies causing confusion) • Reluctance to interact with client out of fear of violating appraiser/client “firewall”

13. Appraiser Challenges

14. Take Aways • Communication Breakdowns • Tough and uncertain regulatory environment • Unsatisfied clients and frustrated service providers • Clear need (and opportunity) to bridge the gap

15. Challenges that Appraisers Face • Challenges • Pressure on bank appraisal/environmental departments • Cost to cure calculations • Not all appraisers are competent to assess environmental impacts (might have to call one in) • Bidding process – appraisers would need to know this upfront because the as-is impaired is a different kind of assignment • Potential project delay/cost increase

16. Lenders’ Reaction to Environmental Issues…

17. Issues Important to Lenders Collateral Devaluation Direct Liability - Loan origination to foreclosure Reputational Risk (Brand and Image) Operational & Enterprise Risk Credit & Trust Risk …but at the end of the day, the primary issue for lenders is Business Risk

18. Key Changes to Phase I’s - 2013

19. Who Qualifies as an Environmental Professional? Page 22

20. 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

21. Agency File/Records Reviews • 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

22. 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 • Clarifies “Indoor Air” non-scope

23. Vapor Intrusion

24. 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 • REALLY??

25. Regulators Are Now Talking About Environmental http://www.occ.gov/publications/publications-by-type/comptrollers-handbook/cre.pdf

26. NCUA Environmental Guidance

27. FDIC Highlights FDIC emphasizes process and consistency. Training Policies and Procedures should be established; Environmental Risk Analysis should be conducted; Document due diligence; Track changes to policy and consistent application of policy. Monitoring Lenders must avoid “participating in management” of the business and thereby assuming liability under CERCLA. Most attorneys recommend a Phase I ESA in the event of foreclosure.

28. OCC Updates Develop policies and procedures that reflect potential environmental risks associated with lending Provide for receipt and evaluation of environmental reports prior to making final commitment. Ensure that persons responsible for evaluating environmental risk possess relevant knowledge, skill and competence. A bank’s policy should reflect the EPA’s AAI rule.

29. OCC Updates The policy should include: Analysis of current laws and due diligence requirements; A level of due diligence internally required on all real estate transactions Risk thresholds based on property type, use and loan amount for determining when and what type of due diligence is used; Varying due diligence methods depending on the type of loan, the loan amount and the risk category, including questionnaire or screening, site visit, government records review, historical records review, etc.

30. OCC Updates The policy should include: The potential for impacts from asbestos and lead based paint; Appraisal requirements for disclosing and taking into consideration any environmental risk factors; Criteria for evaluating environmental risk factors and costs in the loan approval process; Criteria for evaluating environmental risk factors and costs in the loan approval process; Environmental documentation for commitment letters, reps and warranty, etc. A means of evaluating potential environmental liabilities for foreclosures.

31. Small Business Administration Update SBA updated its Environmental Policy Effective August 1, 2008 and updated six times since (most recently in January 2014). 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.

32. SBA Environmental Due Diligence Policy 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

33. Sample SBA Policy Matrix

34. Dry Cleaners

35. The Trouble with Dry Cleaners

36. Size has Mattered (but that doesn’t have to be the case) Regional & National Lenders Resources in place to understand environmental issues on the property Screen all loans by an EP Have staff/internal resources to manage environmental risk Credit Unions/Regional & 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. Environmental Due Diligence Options Environmental questionnaire (EQ) Desktop due diligence (various levels) Transaction Screen Assessment (TSA) Phase I Environmental Site Assessments Phase II, III, Remediation, etc. Storm water Issues Sustainability/Green Issues Environmental Insurance Others

38. Policy Matrix Page 43

39. Common Commercial Issues USTs Fuel Oil Tanks Spills Storage/disposal of Hazardous Waste Vapor Intrusion Mold Gas Stations Dry Cleaners Lead, asbestos Radon Storm water Runoff Superfund

40. What the Seller Sees

41. What the Buyer/Lender Should See

43. Best Practices/Takeaways • Create and follow environmental policies and procedures; • Use commitment fees from borrowers to cover the costs of the due diligence; • At a minimum, obtain an environmental questionnaire and some form of government environmental records for each commercial transaction; • Different types of properties require different levels of due diligence; • Start the process as early as possible to allow enough time for evaluation and follow-up work that may be required. • Work with a company or expert that has experience in this area and consider outsourcing the review process similar to other functions that are not “core-competencies” of the bank .

44. 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 state. 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.

45. How Much and How Long??

46. Upcoming EBA Meetings January 2015 – Charleston, SC June 2015 – Denver, CO January 2016 – Long Beach, CA June 2016 – Fort Worth, TX

47. Convergence of Appraisal and Environmental Services within Financial Institutions Eric Schwartz, MAI, SRA Chief Appraiser Appraisal Review Department Amegy Bank of Texas August 2014 Disclaimer: The opinions expressed are solely those of the author and are not necessarily the opinions of the management or employees of Amegy Bank. August 5, 2014

48. Management of Environmental Services Vendor Pool • Qualifications – Who is “qualified”? • Professional Credentials • Geographic competency • Property competency August 5, 2014

49. Management of Environmental Services Database Management • In-house • Pros- • Easily tailored to individual requirements • Use of existing resources • Customizable • Integration into other databases August 5, 2014

50. Management of Environmental Services Database Management • In-house (continued) • Cons: • Reallocation of limited resources • Functional requirements may not be understood by staff • ASTM standards may seem “foreign” to appraisers/reviewers August 5, 2014