Due Diligence - Interesting "Phrase" But What Does It Mean?
by Cal Chapman
Last month at the Texas Eagle Ford Shale Expo in Corpus Christi, I heard several discussions about big assets changing hands. Thanks especially to my environmental engineering background, I have many times worked with real estate professionals, attorneys, and developers, on big commercial deals where “due diligence” was being performed. What is “due diligence?”
To start the story, let’s talk about a “for instance” property: it’s been a little strip center for 30 years, with a dry cleaning operation and a convenience store as two of the tenants over that time. The seller wants to make a sale, at the best (highest, of course!) price the market will offer. The buyer wants to get it at a reasonable price, AND know before the closing if there are any “un-obvious” and unreasonable risks involved. In the perfect world, and the perfect transaction, the seller is supposed to accurately describe ALL of the conditions present that might pose unusual or unreasonable risk, and tell the operating history he or she knows. In my opinion, the principle of “full disclosure” ought to mean that the entire history is described no matter what. And one major point to always keep in mind: if you buy the property without learning of the risk (or properly attempting to learn), you may be “joined” into that liability forever!
Of course, the real world doesn’t often work in “full disclosure” mode. We all are guilty, at least sometimes, of slanting the story to make ourselves look a little better, or make the strip center look a little more valuable, and a little less risky. If the convenience store had underground gasoline storage tanks for many years, and I am the seller, I may describe the on-site operation as “just great, never any spills or leaks.” And for a dry cleaning operation? Did they use cleaning chemicals on site, or did the clothes get sent to an off-site cleaning facility? Did it start out in 1985 with on-site chemical use, and then a few years later that tenant decided to “job out” the actual clothing treatment? What kinds of chemicals were used, and how much volume, for how long? Where did used or spent chemicals go? Most of the sellers I meet answer, “I don’t know,” or “Oh, it was a great operation, really clean!”
For this kind of commercial real estate deal, we are often asked to perform a “Phase I Environmental Site Assessment.” This is a study of the property, intended to write up the environmental history of the particular site, and the neighboring properties! Yes, it’s possible that a neighbor has actually caused environmental damage to the property we are evaluating! So this study documents all of the historical information that can be learned about the site and the area, and there are MANY sources to comb for this data. We can search old maps and aerial photos, regulatory registration databases that show old gas stations, landfills, manufacturing plants, and the like. We may find old city directories, which were used for advertising. They list property addresses and business names, year by year, often from the 1920’s through the 1970’s. And, by the way, another element of the study is to declare “data gaps” – those time frames for which NO information shows up on the property we’re researching.
Once we have all that data pulled together and understand what it appears to describe, it’s time to walk the property and the neighborhood in detail. It’s time to interview people who are knowledgeable about this little strip center, its tenants over the years, and what’s been happening in the local community. It’s time to learn if the structure, and utilities, and other property improvements are in good shape, or if they’re really run down. Once we’ve done all that sleuthing, the report is written, and we make recommendations about any risks that might need further study. We might recommend a “Phase II Environmental Site Assessment” with actual sampling, and laboratory analysis of those samples. What might we sample for? There could be gasoline residues in soils around buried fuel tanks and product dispensers. It might be that solvents from dry cleaning got dumped out the back door into the grass or the alley for a time. There might be high concentrations of lead in an old exterior paint on the building, or the water tank, or the canopy.
The commercial strip center is a big real estate deal in some people’s eyes. To others, it’s a pretty small asset. For comparison, what if the asset is an Eagle Ford Shale production lease? It could easily include oil and gas wells, water wells, well pads, pipelines, and a processing facility or terminal.
What if the asset is a petroleum refinery? Or what if it’s a terminal, for storage and shipping of petrochemicals, fuels, fertilizers, or other hazardous but valuable materials? The same principles of due diligence should be applied, to check out all existing conditions of the facility. Environmental factors, physical and mechanical factors, the neighbors – all of these need checking, of course. But there are so many other elements to evaluate. For the Eagle Ford production, somebody needs to review the minerals lease and terms involved. The same needs to be done for any surface rights leases. All environmental factors should be reviewed.
For a complex facility, what about the operating permits required by various regulatory agencies? Are any pollution control, or water treatment, or electrical system improvements needed to stay in compliance with regulatory agencies? Are there any regulatory inspections or enforcement actions “hanging over” this business Does a change in ownership mean you have to get a new “Certificate of Occupancy” for an operating business?! If pipelines are included, what inspection information is available to say they’re being operated right, protected against corrosion, kept in compliance with regulations?
One of the hardest parts of performing due diligence is to check out that asset that is mostly underground, can’t be accessed, or otherwise is very hard to properly For big, above-ground bulk storage tanks, nobody wants to take them out of service, empty the product, and then do a thorough cleaning, so I can climb inside with a flashlight and look around! Instead, we must rely on review of the operating records, look over this asset from the outside, check the plans for how it was supposed to be built (if plans are still available), and then maybe specify some additional testing. We want to interview operators and engineers on staff, and see if those people can give us a good feeling about the equipment, and the processes being used. In many cases, it’s the quality of the documentation, and the way in which the on-site people speak, that gives me a good feeling, or a not-so-good feeling, about the plant, or the equipment, or the pipeline, or the terminal.
This due diligence work should be done to check environmental conditions, in every case. Our approach always asks questions about air, about water/wastewater, and about waste management. These are major regulatory areas of concern, in broad categories. But just as important is to check out the physical condition of buildings, of equipment, of all the process areas. Somebody with good knowledge has to dig into written records, into all the data that is supposed to be filed under this permit, or that production report.
It is really important that a qualified, third-party consultant be brought in to do this kind of work. The seller is almost never in charge of this process. Most often the buyer asks for a feasibility or option period of time, maybe a month after an earnest money agreement is signed (for smaller deals), and these studies are done inside that first month. When the buyer gets information that supports the deal, then everyone proceeds toward transaction closing. If the study points out some questions, or even finds some hazardous condition that was not known before, the buyer may say, “no more” and terminate the contract. Or the two sides might re-negotiate the price and amend the deal.
So I said a qualified, third-party consultant is needed to do the review. Who is qualified to perform the kinds of assessment being described above? In a smaller deal, with a smaller property or set of assets, it may be one person with a lot of education and experience in the right field(s), who provides the expertise. But in many cases, it is a team of people, each of whom brings a different type of background. For me, I want to see very experienced, deliberate, and open-minded people on the team, who know the type of operation involved, are familiar with how it is regulated and permitted, and who can capably interview folks with direct site and vicinity knowledge.
Do you know the biggest problem I see in due diligence? The prospective buyer usually isn’t willing to pay enough for the due diligence work, to get the protection these studies should provide. Going back to the commercial strip center example, if a bank is providing financing for that transaction, it will almost certainly require a Phase I assessment, as part of the deal. Now, the good companies with very experienced “assessors” will charge several thousand dollars to do the study, the assessment. But there are plenty of other companies who will offer to do it for $2,000, or $1,500. In the Phase I world, “you get what you pay for!” I urge both the prospective buyer AND the banker to find a strong consultant for this type of study. Saving money on a “risk assessment” usually brings more risk!
There are some great industry-standard documents we use, built by huge efforts from many talented and experienced performers. The main standard for Phase I assessments is from the American Society for Testing & Materials (ASTM). It is referred to as E1527, and was just updated in 2013. I recommend a review of its table of contents or outline, which can be found by web search pretty easily. Interestingly, there are quite a few things a Phase I is not designed to study, including mold, asbestos, lead-based paint and some other things. These are project elements which your assessment professional should be able to address, maybe by teaming with other qualified professionals as needed.
The performance of “due diligence” work is very interesting and intensive. I often describe it as “detective work” for the non-law-enforcement person! It takes imagination and prudence, at the same time. Since I am also a student of history, it is fun and valuable to build the historical use “story” of a property with attention to building architecture, to the types of utilities observed (old electrical wiring, for instance), even the sizes of pipes, and the materials they’re made of. And it is amazing how much old information is sometimes found in fire insurance maps, city directories, almanac entries, and other historical documents!
Due diligence is a form of detailed inspection. As my old friend said, “don’t EXPECT what you don’t INSPECT!” And especially when you’re going to invest your hard-earned money in a new asset, please take the time and attention to learn its history, find out what is good AND not so good about it, BEFORE YOU CLOSE THE DEAL!
Cal Chapman is co-founder of Chapman Engineering, which began business in fall 1988. He is a licensed “Cathodic Protection Specialist” through the National Association of Corrosion Engineers (NACE, now called NACE International), and is a licensed professional engineer in Texas and New Mexico. Chapman Engineering provides cathodic protection, AC mitigation, coatings and corrosion protection specifications, and other engineering services. The company performs environmental compliance, assessment and remedy services in oilfield, petroleum wholesale, and industrial settings. In-house staff includes engineers, geologists, corrosion technicians and environmental scientists. Please contact Chapman Engineering at 800-375-7747.