COVER STORY, OCTOBER 2008

FINANCING BROWNFIELDS IN TODAY'S CAPITAL MARKETS
Lack of developable land spurs brownfield interest, but financing these projects can be challenging.
Craig Carbrey

In an uncertain development climate, the emphasis on well-located infill properties is more important than ever. In many established markets with a lack of developable land, brownfield sites provide a means for savvy developers to acquire infill sites with outstanding development potential. However, despite having a significant upside, a number of key challenges abound, particularly with regard to financing these contaminated properties. With conventional lenders continuing to exercise extreme caution and tightening their lending standards, acquiring higher-risk properties, such as brownfields, requires the right mix of expertise and vision for both the developer and lender.

So, how can developers successfully complete these transactions? There are several scenarios in which to find these great deals, flex their equity and achieve return on investment.

During the real estate boom of the early 2000s, prices for contaminated sites were not adjusted for the added risk and, in some cases, cost of remediation. At the time, there was a lot of cash chasing but few development opportunities, creating an imbalance in supply and demand in the market. With the tightening of the credit markets, there have been fewer buyers, and sellers are adjusting their price expectations to reflect the risk of a brownfield development.

Additionally, current market conditions have had a measurable effect on environmental insurance and environmental engineering consultants, a key component of all brownfield developments. With demand across the market dipping, insurance carriers and consultants are now more willing to negotiate terms, providing an outstanding opportunity for developers to both contain their risk and lower their development cost.

Specialization Reduces Risk

Unlike financing a “greenfield” property, brownfields bring a number of added environmental risk factors for both the developer and lender, and require an extra level of due diligence to satisfy various environmental rules and regulations. For example, the basis of regulatory approvals for risk-based cleanups is based upon the level of exposure and risk to the public. As a result, development risk is more significant for residential projects than commercial, office and industrial uses. Successfully evaluating and hedging risk involves a highly sophisticated approach to environmental risk analysis and management, which conventional lenders are often hesitant to take on. Some of the most significant environmental challenges associated with brownfield financing include the structuring of appropriate insurance coverage, environmental liability, regulatory process and protection from cost overruns. When encountering an environmental issue, many conventional lenders would rather pass on the deal than to assess the situation to make the deal a reality. 

This need for specialization, combined with the climate of uncertainty in the capital markets, has enabled private equity and specialized lenders to become much more significant players in brownfield finance. Specialized brownfield lenders provide a unique expertise in how to identify and manage risks, a skill that the majority of traditional lenders do not possess.

Guidelines for Successful Development

As with any real estate transaction, developers must be highly strategic when seeking out the right financing partner. In addition to the fundamental characteristics associated with the financing process, lenders favor borrowers who possess the following criteria when evaluating a potential brownfield project:

• A talented team of professionals with brownfield experience. Evaluation includes ensuring that the environmental consultant, the insurance broker and the engineer will work well with the regulators to assess risk and get remedial plans approved.

• Extensive due diligence. Favored applicants must have completed significant due diligence on the environmental investigation to which they are near or have obtained regulatory approval. A phase I and/or II assessment is insufficient.

• A well defined exit strategy upon completing the remediation.

• Favored debtors with previous experience in dealing with brownfield transactions and knowledge of the environmental issues involved to manage the risk. 

This type of underwriting will help developers mitigate the numerous risks associated with brownfield development and tap into the vast potential associated with a well-located land parcel primed for long-term growth.

Location Yields Opportunity in the West

Modern development projects are placing an increasingly high importance on “smart growth,” which uses existing transportation centers, proximity to employment, infrastructure and a reasonable cost of housing to maximize the utility of the property and its benefit to the community. When properly implemented, smart growth is a win-win scenario for all parties involved; the municipality gains revenue from property and sales taxes, while the quality of life is improved for the city’s residents.

Perhaps the greatest opportunity to implement a smart growth strategy is on infill locations with environmental challenges. Two good examples of urban infill brownfield transactions can be found in Honolulu and Vallejo, California.

In Hawaii, $11 million in financing was provided for the remediation, infrastructure and site development of a 174,240-square-foot land parcel, which housed a former manufactured gas plant. The facility is contaminated with high concentrations of benzene and will undergo extensive environmental remediation to remedy the 70 years of industrial contamination. The Honolulu property is strategically located near some of Hawaii’s most successful retail outlets, so once developed, the four-acre land parcel will likely house an expansive retail center located approximately 15 minutes from Pearl Harbor and adjacent to a lively retail district.

In the urban outskirts of Vallejo, $7.25 million in senior and subordinated secured financing was provided for the acquisition of four separate, land parcels encompassing approximately 15 acres. The four parcels previously served as school sites, and two of the sites consisted of underground contamination resulting from storage tanks once containing petroleum. The loan will be used to fund a portion of the acquisition price, in addition to remediation/clean-up, land planning and entitlement costs to rezone the parcels from public use to residential and mixed-use development.

Honolulu and Vallejo are not the only municipalities seeking urban growth via brownfield development. With a growing number of cities realizing the financial benefits from putting dormant properties back into productive use, it is expected that brownfield development opportunities will continue to represent a significant portion of America’s urban revitalization efforts, even after the residential and commercial sectors recover from the credit crisis.

 The foundation of brownfield development is taking underused properties and grooming them toward economic growth to generate income for the developers, and generate property and sales tax revenues for the community. A clear path to the end goal is paramount and remains the ultimate measure for success, as the philosophy of “if you build it, they will come” is long gone from lenders’ lists of financing criteria.

Opportunity in an Uncertain Environment

The significant growth in remediation innovations and increased bargaining power for developers in today’s real estate market have given rise to a number of previously unavailable opportunities for brownfield development. Amidst this new development climate, it is the responsibility of brownfield lenders to offer programs that are both financially feasible and take into consideration the variety of inherent risks in brownfield development. It is this combination of knowledge and understanding that will help to further solidify the importance of brownfield development in the real estate industry and continue to bring communities positive development projects that improve quality of life.

Craig Carbrey is president of Sacramento, California-based EnviroFinance Group LLC, a brownfield lender.

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