As turmoil continues to sweep across the capital markets, both transactional volume and real estate development have come to a grinding halt. With virtually no liquidity available in the market, developers across all product types have entered a tenuous wait-and-see period.
While financing will continue to pose a significant roadblock to the majority of development in the immediate future, there remain a number of alternative opportunities for those willing to take the necessary risks to succeed.
The development of contaminated brownfield sites is a prime example of one of these risk-reward developments. But what is the motivation for developing these types of properties? And how are riskier projects like brownfield developments being financed – particularly in our current market climate? The answer is in the fundamentals.
Brownfield development affords the opportunity to find well-located infill properties at a discounted price. Although the potential upside and return on investment associated with brownfield development make it an extremely enticing opportunity, the road to success is littered with a number of potential obstacles that can only be navigated with solid expertise and beneficial partnerships.
Getting around those obstacles requires the borrower and its representatives to come to the negotiation table with a comprehensive understanding of some of the key points of differentiation between brownfield and traditional greenfield loans and a solid strategy to circumvent the risks.
Perhaps the most straightforward way to evaluate the fundamental differences between brownfield lending and greenfield lending is to begin with the inherent risks. First, the higher level of risk associated with brownfield development typically means that the deals will have lower loan-to-cost ratios than conventional loans.
Additionally, timelines for development are driven by the regulatory process, requiring a higher level of flexibility in the development strategy. This demand means that brownfield developments require both additional cash and more time – two things that many borrowers in today's financial environment simply cannot afford.
Another key point of difference occurs in the contract language. For example, a fixed-price contract may only apply to unit costs, not quantity of material. Unlike with a normal construction loan, where the quantities of construction materials are predetermined, the quantity of contamination to be removed from a brownfield site can only be estimated.
Brownfield development also involves an added layer of due diligence in weighing the environmental challenges of a contaminated site, such as regulatory issues, insurance, liability transfer, environmental engineering and remediation strategies. This step requires the expertise of a consultant with targeted brownfield experience who can ask the following questions:
- How far along is the property in the cleanup process?
- Has all of the necessary investigation been performed on the site? If not, what areas must be investigated?
- Have the necessary regulatory bodies been engaged in the cleanup process?
- Has a remedial action plan been put into action?
- Has the proper environmental insurance been procured as a means to mitigate any risks associated with the project?
In addition to fully evaluating the contamination issues at the onset of the project, the borrower is also required to search for any challenges that may surface during the remediation process and drive up costs. These so-called shadow contaminants can easily derail a project, requiring additional funding for their remediation.
Ultimately, the feasibility of a brownfield loan is predicated upon the borrower's ability to ensure that the remediation will be completed in a timely manner and within or near the specified budget.
Due to the extensive challenges and required due diligence connected to brownfield development, many traditional lenders would rather forego what may be a highly lucrative transaction than spend all the resources needed to evaluate an at-risk situation to close a deal.
When facing financing obstacles, borrowers can also consider smaller niche lenders that specialize in brownfield loans. But just as conventional lenders continue to exercise extreme caution by tightening their lending standards, brownfield lenders are taking the same precautions and, in some cases, even more precautions, given the added inherent risk involved with brownfields.
Along with the typical loan standards associated with financing, brownfield lenders have certain highlighted additional criteria they will use when granting loans and will consider the following key factors prior to financing a project:
- The borrower should have the ability to assemble a team of professionals, which should include an environmental consultant, insurance broker and engineer with prior brownfield experience in place before applying for financing. Team members should be evaluated to ensure that they will work well with the regulators to assess risk and get remedial plans approved.
- Significant due diligence beyond a Phase I and/or Phase II assessment should be completed. Applicants should be near regulatory approval, if they have not obtained it already.
- The borrower must be able to fund carrying costs in the event of an extended cleanup or exit.
- The status of communications and agreements with state regulators will certainly play a role.
- Finally, financiers should look for a well-defined and detailed exit strategy upon completing the remediation and prior to development. This component is, arguably, the most important factor.
While a vast majority of brownfield loans are limited to covering the project from acquisition through cleanup, the success of a loan is often dependent upon the developer's ability to obtain conventional financing for the ground-up portion of the development.
As a result, brownfield lenders are heavily focused on such issues as the proposed product type and exit strategy, local market dynamics and the ability to turn the remediated property into a profitable and sustainable development.
The current economic environment has been anything but friendly to municipalities. Federal contributions are declining, employment and sales tax revenues are on a downturn and local governments are feeling the strain on their balance sheets.
While often overlooked, brownfield development projects can provide opportunities to fulfill the social and economic needs of these distressed regions. Turning sites that are a liability to the community and the environment into residential, retail or commercial properties provides a number of benefits for both the community and the municipalities.
Communities gain real estate that enhances the quality of life and the viability of the neighborhood and the municipal tax revenue through both property taxes, wage taxes or sales tax on any new jobs that might be created by the property.
Developers are now placing an increasingly strong emphasis on ‘smart growth’ development, which is based upon existing transportation centers, reasonable cost of housing, proximity to employment, community infrastructures and tax benefits.
When properly implemented, smart growth is a winning stategy for all parties involved. The community benefits from new development, while the quality of life is improved for the city's residents.
Smart growth is taking flight, but perhaps the greatest areas where it has recently caught on are infill locations with environmental challenges. In comparison to other regions, the Northeast is the strongest market for brownfield development, with states such as New York, Massachusetts and New Jersey attracting the interest of developers to build on contaminated sites.
Jersey City, N.J., for example, is home to a recent urban infill brownfield transaction that allowed for the acquisition and environmental cleanup of Liberty Harbor North, a 2.7-acre waterfront land parcel in just across the Hudson River from lower Manhattan.
The Northeast is not the only region seeking urban growth via brownfield development, as locations both on the West Coast and in the Southeast also offer vast potential. Moreover, in all major markets throughout the U.S., the continued fallout surrounding the residential market has forced developers to focus on more centrally located properties near city centers and transportation hubs, which favor brownfield developments.
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 in years to come – despite a bear real estate market.
Coupled with the green movement, brownfield development has begun to go beyond simply recycling contaminated land. In many brownfield projects, the process of green remediation is implemented to reduce the footprint in contamination cleanup and mitigate collateral environmental damage.
Remediation companies have started to present their perspective on sustainable remediation, which is the equivalent to the Environmental Protection Agency's Best Management Practice in Green Remediation. This trend is slow, but brown is gaining speed and may just be the new green.
Craig Carbrey is president of EnviroFinance Group LLC, a brownfield lender specializing in financing the acquisition, remediation and redevelopment of contaminated land throughout the U.S. He can be contacted at (916) 326-5225, ext. 103.