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Environmental risks in real estate property conversion

Learn insurance and risk management strategies to mitigate environmental risks in property conversions.

09/17/2024 · 6 minute read

Insurance and risk management strategies to mitigate environmental risks in property conversions

The commercial real estate industry is experiencing a period of change as some post-pandemic trends persist. The shift to remote or hybrid work has led to a record office vacancy rate that exceeds 20%. And changing shopping preferences are contributing to more than 10% of retail space remaining unused.

As property owners look for new ways to capitalize on their investments, there is increased interest in converting existing and unused properties to align with today’s needs, a process referred to as “adaptive reuse.” Vacant office buildings in urban settings are often being transformed into residential dwellings or multiuse buildings. At the same time, increased demand for fast deliveries is pushing e-commerce giants to strengthen their last mile delivery networks through distribution centers closer to their end consumers, which sometimes requires converting shuttered retail spaces or industrial properties into major distribution centers.

However, changing the use of existing properties requires a thorough understanding of the environmental risks and remediation standards that could prolong conversion timelines, lead to extensive costs, impact financing agreements, and potentially derail a project.

Top environmental challenges in property conversions

While socioeconomic trends may entice owners and developers to repurpose buildings to align to today’s needs, there are a number of potential environmental challenges that should be top of mind as they embark on these projects. The most pressing include:

1. Legacy risks

Existing property contamination can result in substantial environmental liabilities that could require costly remediation, as well as lengthy monitoring, at the owner’s expense. These may include contamination from previous operations, such as chemical spills or improper waste disposal. Additionally, issues relating to internal structures, such as mold and vapor intrusion, can pose significant health and environmental risks unless they are appropriately addressed. 

Some contamination may be uncovered during a pre-acquisition due diligence process, underscoring the importance of a thorough exercise that includes Phase I environmental site assessments and potentially soil and groundwater sampling. However, other contamination may only be discovered at a later date, possibly once conversion work is already underway. Latent contamination can stall project progress and require a budgetary rethink to finance any remediation work, such as additional excavation, vapor extraction, groundwater treatment, or the installation of environmental engineering controls.

2. Construction and renovation risks

Whether repurposing a property involves a teardown/rebuild, gut renovation, or ground-up construction, these activities can uncover or create unforeseen environmental risks that impact the budget and timeline of the project.

Subsurface excavations and grading increase the risk of uncovering or exacerbating existing contamination, whether due to historic fill, past site operations, or emanating from neighboring properties. 

Conversion works may uncover or disturb the presence of hazardous materials — such as asbestos, mold, or lead-based paint — that require specialized handling to prevent exposure and further release of these indoor hazards. Owners and developers should also consider whether a change in property use would be subject to more stringent environmental remediation standards and plan accordingly.

Further, construction and renovation works can create new environmental risks. Internal works, for example, can release dust and other airborne pollutants that can impact air quality and, if not adequately addressed, potentially lead to respiratory issues and other health problems.

3. Operational risks 

Once a conversion is complete, new environmental exposures may arise from the daily operations of the building. Mold is one of the most pressing challenges for residential properties, especially ones that do not have comprehensive water intrusion and mold management plans. 

Distribution centers and other industrial buildings may also encounter water-related risks. Further, they may also face environmental challenges that could be triggered by spills, release of ammonia from cold storage systems, leaking storage tanks, and increased traffic.

4 actions to minimize property conversion environmental risks

Environmental risks can lead to significant remediation and third-party liability costs. They may also impact a project timeline as well as the operations of an already converted building. These potential disruptions underscore the importance that owners and developers take the necessary risk management and risk transfer actions to protect their investments. Considerations should include:

1. Conduct a thorough environmental due diligence process

Whether you’re purchasing a building or converting an already owned property, owners and developers should carry out a comprehensive review of all potential environmental risks. Consult with environmental professionals to determine the appropriate due diligence processes to meet the requirements for all appropriate inquiry — the evaluation of a property’s environmental conditions and assessment of potential liability for any contamination — set out by the US Environmental Protection Agency. A Phase I or Phase II environmental site assessment will likely be required to qualify for regulatory protections and will also help you identify both known and potential hazards. Consider how evolving regulations — including those related to perfluoroalkyl and polyfluoroalkyl substances, a group of substances also known as PFAS — may lead to future cleanup requirements and the associated costs.

2. Incorporate clear indemnification language in agreements

Existing contamination — both apparent or unidentified — and other environmental issues not accounted for during the due diligence process may significantly impact your return on investment, emphasizing the importance of identifying contractual ways to transfer these risks. Work with legal counsel to review purchase agreements and advise whether the indemnification language is clearly defined and sufficient. Similar scrutiny should be applied to agreements with contractors and other parties involved in the conversion process to provide additional protection in case of unexpected environmental risks that arise during the conversion process. Contractual provisions that clearly allocate responsibilities might help owners and developers secure funding for their projects, especially at a time when lenders are carefully weighing their risks.

3. Identify the most effective risk transfer solutions

A comprehensive understanding of potential liabilities and their financial impacts lays the foundation for identifying the most effective specialty insurance and risk transfer solutions, such as pollution legal liability, contractors pollution liability, excess of indemnity insurance, remediation cost cap, and environmental liability transfers. Work with your broker or insurance advisor to develop an insurance program with tailored policies that addresses your specific risks. It is also important to consider the types and amount of insurance coverages required by lenders and ensure your program meets those requirements.

4. Develop clear risk mitigation strategies

Once a property is operational, it is important to take the necessary actions to minimize the potential of pollution releases. Develop and implement proper waste management plans and the needed protocols to dispose of any hazardous material. Ensure that you or your property managers follow a comprehensive water intrusion and mold management plan and have the needed training to identify issues and are able to take immediate action to address them. Carry out regular inspections to identify potential issues and address them immediately.

Property conversions can help owners and developers make the most of vacant sites by converting them into needed residential and commercial properties. In order to capitalize on their investments, owners and developers should take a proactive approach to risk management and take action to effectively minimize and transfer existing and future environmental risks.

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