Some of the money we’re deploying on behalf of an investor right now comes out of a 1031 exchange.
For those who don’t know, a 1031 is a way to avoid paying capital gains on sale of an investment property by immediately purchasing another property with your sale proceeds. Arranging a 1031 exchange requires the help of an exchange intermediary, a firm which holds the money between the sale of your old property and the purchase of your new one.
Because the exchange intermediary theoretically takes title to the new property (though only for a very, very short period), the intermediary can be quite skittish about the risks associated with your new purchase.
In this case, our intermediary is requiring Phase 1 environmental reports for all of the properties we’re considering buying. Since I’m going through the pain of arranging these things, figured you might be interested in learning a bit about them.
So, what is a Phase 1?
It’s a written report, compiled by an environmental consultant, that details the prior uses of the parcel and, if necessary, the adjoining parcels. The idea is to flag any potential environmental risk from, say, old gasoline tanks, leaks of dry cleaning chemicals, etc. that may not be apparent from a physical inspection of the property.
Who cares about a Phase 1?
Surprisingly, many potential owners don’t care that much about Phase 1s. If you’re buying a commercial property which you’re not going to develop (say, an existing bar), who cares if there’s a gas tank buried underneath it?
The most important consumers of Phase 1 reports are actually lenders. Why? Because, in the event they have to foreclose, they want to understand exactly what kind of environmental risk they are taking on.
If the property you’re considering buying is dirty and banks won’t loan on it, then the value is impaired and you either need to walk away or else demand a price reduction.
Are Phase 1s common in LA apartment deals?
In LA, the vast majority of the multifamily land has been residential since it was subdivided. That means it’s incredibly unlikely that there is anything bad going on. And, indeed, I have never seen a phase 1 done on existing LA multifamily product in all of the years I’ve been doing deals.
That said, commercial streets are a different story. If you’re looking at buying something on a commercial street, particularly if it’s on a corner (where gas stations are almost always located), you would be well-advised to consider a Phase 1.
What happens if something bad pops up on a Phase 1?
The Phase 1 is used as a road-map for understanding potential risks.
If the historical records indicate there was, say, a gas station on the subject lot, the Phase 1 will flag it and include recommendations for (very expensive!) further testing.
This further testing is conducted as part of what’s called Phase 2.
N.B.: I’m not an environmental consultant and you should not rely on this blog for environmental consulting advice. Hire an expert!