Environmental Due Diligence Critical In Any Real Estate Transaction

By Arlen Gunner

Due to the fact that any person or entity that takes title to real property has essentially perpetual liability for environmental matters (with a few very narrow affirmative defenses that are difficult to prove) under both federal and state of California laws, it has become increasingly important that some level of environmental due diligence should be performed as a condition to closing a transaction involving real property.

Several different situations concerning the environmental condition of real property that was the subject of a long-term ground lease, where one of our clients was the lessor and another was contemplating becoming the lessee, have crossed my desk in recent months. I have also addressed situations on behalf of certain nonprofit clients who were scheduled to receive real property as charitable donations. In reviewing the environmental condition of the properties involved in the aforementioned situations, the environmental condition of each of the separate properties was a determinative factor as to whether or not the transaction would proceed.

One of our clients held title to real property for a long period of time upon which the client was operating a profitable business. Due to overtures made by a very financially stable potential lessee, a long-term ground lease was contemplated and a great deal of time was spent negotiating the proposed lease. The lessee had a contingency in the lease running in its favor which stated that the environmental condition of the property had to be acceptable to the lessee in its sole and absolute discretion.

When an environmental inspection was conducted it was discovered that there was underground hazardous material migration affecting our client's property, which emanated from a nearby gas station. Our client also was informed that the Regional Water Control Board was already monitoring the situation and eventually included our client's land in its investigation thus causing our client a great deal of out-of-pocket expense and a loss of the transaction since the lessee had a cancellation right if the environmental condition of the property was not satisfactory to it.

In another ground lease transaction where one of our clients was contemplating acquiring the tenant's interest under the lease, as well as fee title to other assets owned by the proposed transferor, our client was initially hesitant about incurring the expense necessary to conduct a Phase 1 review of the property in question. With a certain level of persistence (some might call it nagging) the client eventually ordered the Phase 1 report to be prepared by an environmental consulting firm. Within a short period of time, our client's environmental consultant uncovered a serious contamination issue which potentially could have had immense financial liability consequences for our client should it have closed the transaction and enterrd into the chain of title.

I am currently working on a probate situation where the trustee of an estate has instructions to convey the real property to one of our nonprofit clients as a gift. We have advised our client that it should perform the ordinary and customary real estate due diligence that would normally be performed if it was going to buy the property in an arm’s length transaction. While this may cause our client some upfront expense, the cost and expense would be de minimis if the property has any environmental liability attached to it.

One must also keep in mind that any lender, before it will be obligated to fund a loan, will in virtually every instance, involving real property, require an environmental Phase 1 report to be prepared at the borrower's expense, and they would probably also require an indemnity for environmental matters from not only the borrower but also its constituent stakeholders.

In the real estate market that currently exists, the longer a period of time that a property has been in service, the greater chance of environmental contamination coming into play due to the unknown prior uses of the property. Therefore, regardless of what position a client has in its transaction, an environmental review is more than ever a necessary due diligence contingency item.

(Mr. Gunner was named a “Super Lawyer” in 2008 in three practice areas: real estate, corporate and business, and mergers and acquisitions. Arlen was named a “Super Lawyer” in 2009 and 2010 in the area of real estate and also in 2010 as corporate counsel.)