July 23, 2002

Commercial Mortgages & Real Estate Loan News:
Environmental Insurance

For the last twenty years, Phase I Environmental inspections have been as much a part of commercial real estate transactions as appraisals and property condition assessments. However, as the mortgage industry evolves, all participants are looking for ways to streamline the due diligence process without compromising the level of acceptable risk - this includes investors and lenders alike. Environmental insurance is quickly coming to the forefront of real estate transactions as an acceptable means of mitigating both past and future claims of environmental contamination, and replacing the Phase I requirement. This seems like a positive move, but with the emergence of environmental insurance, commercial real estate investors should be aware of the various components of this new product.

Environmental insurance allows the burden of liability to shift away from both the investor and the mortgage lender. As stated in the July 2002 issue of Mortgage Banking magazine: "For the first time, lenders can transfer future risk. A Phase I does not have eyes; it cannot look forward and anticipate a new environmental event during the term of the commercial real estate loan. Unlike environmental insurance, Phase I's do not protect the lender in case of loan default and environmental damage." An increasing number of lenders are now accepting environmental insurance for the obvious reason that they are actually reducing their overall exposure to potential environmental risks in the future. This coverage also applies equally to the property owner. Additionally, it should be noted that Phase I inspections typically take 2-3 weeks to complete at an average cost of $2,000 to $3,000. As most investors know, there are certain out-of-pocket expenses, including the cost of a Phase I, incurred with each acquisition or refinance regardless of whether the transaction closes or not. However, environmental insurance not only eliminates the inspection process altogether, but environmental insurance premiums are only paid if the transaction closes and can be ordered in a matter of days not weeks. Adding to the validity of this option is the fact that, through ratings agencies that generally agree that environmental insurance mitigates yet another area of potential concern that covers the lender on a forward-looking basis, the CMBS market likes it as well.

While the article in Mortgage Banking was all very positive, Goodwin Procter's June 2002 "Environmental Law Advisory" suggests potential shortfalls that should be considered. The topic of the insurance industry's role in commercial investments as it relates to terrorism, mold, and business interruption is widely discussed and has certainly been highlighted most notably over the last eighteen months. One of the concerns is that insurance providers are testing the marketplace and may or may not be committed to offering coverage on a long-term basis. "This fluidity in the marketplace tends to signal that success and profitability is not guaranteed. It is also an indication that caution is warranted in selecting an insurance provider, as not every insurer may be in the market for the long run." The other major consideration revolves around the absolute necessity of reading the fine print included in policy coverage documentation to ensure there aren't any loopholes that would preclude insurance providers from paying on claims. Such loopholes are typically found within the language that addresses permissible claims as defined in the policy itself, as well as policy conditions that require timely reporting as soon as reasonably practical. These areas leave room for ambiguity that could cause problems for the policyholder, and so should be carefully considered.

The insurance industry is in a major state of flux given recent events relating to terrorist threats and mold claims, and we believe it's critical to watch and report what we're seeing. Insurance costs have an immediate and direct impact on a commercial real estate investment's NOI, and so we'll continue to share our findings in order to better assist you in achieving your investments objectives.

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