3 Financial Reasons Environmentally Impaired Real Estate Deals Fail

Jul 12, 2016

Written by: Michael Malley, President, RESIGHT Advisors

Valuation of liability in environmentally impaired real estate transactions represents the single greatest obstacle to successful transactions on this asset class. This is particularly true for corporations, including publically owned companies, seeking disposition options for environmentally impaired assets through merger, acquisition, restructuring and one-off transactions. Buoyed by a common set of misperceptions, both owner (Owner) and buyer (Buyer) are viewed by the other as seeking unreasonable economic and transactional terms when in fact there are legitimate financial reasons for these terms, mostly borne out of differing approaches in valuation and allocation of liabilities in a transaction.

Despite the sophistication of both corporate Owners and Buyers, there remains a gap in awareness of how the respective parties approach valuation of liability in environmentally impaired asset transactions.  This article sheds light on Owner and Buyer perspectives when transacting on environmentally impaired assets, illuminating differences in quantifying liability and how these differences, if not adequately recognized and addressed, sets the table for unsuccessful negotiations and failed transactions.

Stating the Case

In transactions involving environmentally impaired real estate assets, Buyers will seek a discount from the “as clean” purchase price based on a valuation of the liability assumed in the transaction.  Buyers and Owners approach valuation of environmental liability differently for these assets.  There are three key areas of valuation conflict that commonly result in transaction failure.

  • Fair Market Value of Liabilities Are Higher Than Environmental Reserves

Buyers assuming environmental liability will establish the cost of liabilities based on fair market value.  Fair market value is defined as the probable price at which a willing buyer will buy from a willing seller when both are unrelated, know the relevant facts, neither is under any compulsion to buy or sell, and all rights and benefit inherent in, or attributable to the item, must have been included in the transfer.  Owners, particularly publically owned companies, account for environmental liabilities as a reserve in financial statements in accordance with U.S. Generally Accepted Accounting Principles (GAAP).  Accrual of an environmental liability occurs if it is “probable” that an asset has been impaired or a liability has been incurred and the amount of loss can be “reasonably estimated”.

Fair market value of environmental liabilities are almost always materially higher than environmental reserves established for the same liability.  This occurs because fair market value captures full life cycle costs through extinguishment of the liability and typically incorporates risk and uncertainty, whereas reserves estimate only those environmental obligations that are probable and estimable in present time and seldom incorporate risk or uncertainty.  Moreover, transactions on environmentally impaired real estate assets may create a book loss at closing when the environmental liability exceeds the current reserve.  These two conditions often have a material impact on the valuation of liabilities and economic terms of the transaction, thus putting the transaction as a whole at risk.

  • Valuations in Nominal Dollars Will Always Exceed Discounted Valuations

Buyers commonly establish environmental liabilities in nominal dollars (gross or undiscounted) as opposed to net present value (NPV) discounting.  Buyers use nominal dollars that reflect relatively short time frames for realizing return on investment and aversion to risk associated with economic factors such as inflation or real estate market cycles.  On the other hand, Owners, particularly publically owned companies, are allowed under GAAP to estimate environmental reserves on a discounted NPV basis.

In some cases, Owners may use opportunity cost as the basis for establishing a discount rate when calculating the NPV of environmental reserves or liabilities.  Companies are in competition for internal capital and typically set investment return hurdles for capital projects that reflect expected minimum rate of return on the investment.  This expected rate of return can be defined as “opportunity cost”.  Applied to a business decision, opportunity cost represents the rate of return of a certain action that must be forgone in order to pursue an alternative action (e.g., allocating company funds for a non-core business transaction).  Discount rates established on the basis of opportunity cost can be substantially higher than other commonly used discount rates such as a risk-free rate of return based on U.S. government backed bonds. Thus, NPV estimates of environmental reserves using opportunity cost as a discount rate can be materially lower than NPV calculations using a discount rate based on a risk-free rate of return.

The difference between estimating environmental liabilities in nominal dollars versus NPV can be material, particularly when discount rates used in NPV calculations are high and the period over which the liability is estimated is long.

  • Buyer Risk Premium Greatly Exceeds Owner Expectations

Buyers contractually assuming environment liability in a transaction will place a “risk premium” or a contingency cost on the liability in an effort to protect against future unexpected or unknown costs.  Whether liability contractually assumed by the Buyer includes known and unknown on and offsite cleanup liability, change in environmental regulations, bodily injury/property damage (BI/PD) or third party toxic tort liability, the risk premium can be significant. Coupled with an ever evolving environmental insurance market that has recently shied from insuring many of these types of risks, it is not uncommon to see Buyer risk premiums range from 20% to 50%, or more of the estimated liability in these types of transactions – an unexpected premium that Owners are almost never in position to consider or acknowledge prior to entering into these transactions.

Summary       

Owners and Buyers entering into negotiations to transact on environmentally impaired real estate assets must overcome unique hurdles to ensure transaction success.  Critical to success is agreement by the parties on valuation of environmental liabilities, recognizing the path to agreement on valuation and ultimately purchase price is paved with differing expectations that if not adequately recognized and addressed can quickly can turn negotiations into a failed transaction. The solution is each party’s ability to understand and internalize the other party’s constraints early in negotiations, set reasonable expectations for success and be prepared to make informed decisions regarding valuation of environmental liability that ensures the economic viability of the transaction for both Owner and Buyer.

Additional information can be found at www.staging.resight-ai.com or by contacting Mike Malley or Brent Anderson via e-mail at mmalley@staging.resight-ai.com or banderson@staging.resight-ai.com, or by phone at 303.972.6633