Copyright Appraisal Institute Apr 2000| [Headnote] |
| A simple statistical model utilizing the concept of expected, discounted value may be used to estimate financial or economic damages to impaired real property due to loss of marketability, rentability, and stigma. Analysis of a hypothetical but not unrepresentative example of a major contaminated property indicates that most of the economic damage would be likely due to the loss of marketability and rentability during the cleanup period, with only minor loss due to subsequent stigma. An early delay in taking action to remediate the property damage may significantly increase economic loss. The statistical model can easily be adapted to any economic damage situation and may be utilized in a number of ways. |
Environmental issues began to receive significant public attention in the United States in the late 1970s, culminating in the first major federal environmental legislation, the Comprehensive Environmental Response Compensation and Liability Act (CERCLA) of 1980. This legislation culminated in more than one hundred seriously contaminated toxic-waste sites being designated as "Superfund sites." More and more comprehensive federal and state legislation followed with increased public awareness of environmental issues in general and contamination in particular. Concomitant with this awareness, considerable research was undertaken in both private and public venues, and the results further fueled public awareness.1
Also, as a result of the increasing occurrence of compensatory environmental damage litigation, there developed a body of literature concerning the valuation of environmentally contaminated or damaged properties. This literature was extensively developed by appraisers, as exemplified by a number of articles in The Appraisal Journal.
Compensable damages to real property due to contamination, construction defects, undiscovered title defects, and any number of similar causes may be analyzed based on two categories which are related but different in nature. The first, direct damages, is relatively easily measured by the cost to cure, remedy or remediate the physical damage or situation. The second damage category is that of indirect damages, which has sometimes been referred to as stigma damages. Indirect damages relate to the increased risk of further economic loss associated with the contamination or other impairment or defect, and the effects of this risk on marketability, rentability, mortgageability, insurability, income, and value of the property after cleanup and approval issued by the appropriate authority.2
The purpose of this article is to examine the estimation of indirect damages in the context of the discovery of serious contamination to a hypothetical property as an illustrative example. Based on this examination, an operational method of estimating indirect damages utilizing the concept of expectation to deal with lack of marketability and rentability will be derived and illustrated.
Damages
The most readily understood aspect of damage to real property is the direct cost of remediating the damages and restoring the property to a satisfactory approximation of its condition prior to the damaging incident, thus returning the property to full market value. Experience shows that this cost is easily estimated and usually receives the bulk of professional and legal attention. These direct damages (costs) are relatively objective, and any early uncertainty is removed over time. The schedule of estimated remediation costs, as well the determination of who bears the cost, makes a considerable difference to the property owner and others involved. None-the-less, the process is relatively straightforward and almost never complex. This study will take these direct costs for granted and focus on indirect damages and their inherent uncertainty.
Indirect financial loss to property due to loss of marketability and rentability during the cleanup period, or due to other residual effects of the causal incident, present an inherently more difficult issue.3 Economic loss due to diminution or loss of rent seems obvious, yet economic losses due to diminution in value or inability to sell the property, irrespective of the receipt of rent, appears more difFcult to model. When any property suffers diminished marketability or rentability, it loses value.4
Lingering, residual effects may include:
Continuing restrictions on the use of the property, legal, physical, or otherwise
Uncertainty concerning future changes in remediation standards, technology, or statutes; increased cost of obtaining insurance, financing, or the like; or potential liability to third parties if the contamination migrates
Uncertainty concerning the effectiveness of the cleanup, repair, or restoration process (no cleanup is perfect, and recently perfection has not been required in many groundwater-contamination cases)
The possibility that further contamination may be found or imputed
Uncertainty due to the lack of generally available, accurate market information concerning the property's current status
Beyond the fact of the contamination and cleanup, and the resultant reduced marketability and rentability, any of these factors may residually affect the property economically through higher costs of operation, lower rents, higher vacancy rates, and perhaps higher capitalization or discount rates and unfavorable mortgage financing. These factors are so confounded as to be impossible to analyze fully and are the basis of the real risk related to the ownership of the property.
Economic Damages In the Literature
The American Heritage Dictionary of the English Language (American Heritage Publishing Company, New York, 1969) defines stigma as "a mark burned into the skin of a criminal or slave; a brand" and further as a "mark or token of infamy, disgrace, or reproach. " The Concise Oxford Dictionary of Current English (Clarendon Press, Oxford,1995) similarly defines stigma as "a mark or sign of disgrace or discredit" or a "distinguishing mark or characteristic." It further defines stigmatize as to "describe as unworthy or disgraceful." This language is rather dramatic but not completely inaccurate as a description of contaminated real estate.
In a series of articles appearing in The Appraisal Journal Peter Patchin discussed how stigma might affect value. In his second article he defined stigma as "any residual loss in property value from an uncontaminated condition beyond the cost to cure the contamination." (Patchin, 1988,1991). Mundy (1992a, 1992b, 1992c), in The Appraisal journal dealt with many of these same issues, identifying a number of stigma-related factors that affect losses. He differentiated between real risks which relate directly to the cost to cure, and perceived risks which affect the marketability and rentability of the property after cleanup, referring to these perceived risks as "Stigma" (Mundy, 1992b).5 Chalmers and Roer (1993) defined stigma as related to "impacts on value stemming from the increased risk associated with the property and the effect of this on marketability and financability."
For purposes of the accompanying analysis, indirect damages (a form of economic loss) is defined as all loss of income and value of a property, from the moment of the discovery of the situation until the property has returned to its nominal market value, excluding only the direct cost of remediation or repair. Based on this definition, indirect damages may be operationally conceptualized as the sum of (1) the differential loss of marketability and other factors, as indicated by the discounted, projected future selling price or reversionary value of the property; and (2) the differential loss in rentability (rent) as indicated by the discounted, projected future rents that the property can command, both appropriately modified by expectation. There is actually no real need for the inflammatory term "stigma;" it is not necessary for an understanding of economic loss. But, if it must be used, it should be used in the commonly accepted sense, as referring to the losses of value of whatever kind after the completion of the program of remediation, much as Mundy's "perceived risks." This is the only sense in which the word will appear in the remainder of this article.6
Expected Discounted Value
A random variable is a numerical variable that takes on certain alternative values according to chance (such as forecasted costs, rents, selling prices, or other economic variables). It is a numerical representation of each element of a set of mutually exclusive and exhaustive possible events or outcomes of an experiment or set of natural occurrences that may obtain in the future. If each of the possible numerical outcomes has associated with it a positive fraction between 0 and 1, which may be conceived as representing the likelihood of occurrence of the associated outcome, and the sum of these positive fractions is l, then the fractions may be referred to as probabilities. The random variable and its associated probabilities, taken together, are referred to as a probability distribution.
The specific occurrence of any particular value of the random variable is uncertain by its nature. The sum of the random variable, weighted by the associated probabilities, is referred to as the expected value of the random variable. Loosely characterized, it is the number that would obtain if we repeated the experiment a very large number of times and took the numerical average of the results. It is a generalization of the concept of average. Even if the experiment in question is only done once, or there is no actual experiment, but rather a set of possible natural occurrences, the expectation concept is still meaningful and useful as a basis for analysis and decision making.
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In the analysis of investment properties, the generally recognized standard for estimating the value (present worth) of a property for an particular holding period is the discounting of projected, future net income and reversionary value. Without loss of generality, let us refer to the moment of discovery (or alternately of occurrence) of the damaging situation as time zero. For any possible discrete holding period, the sum of (1) the discounted, net present value of the projected reversion (sale) at the end of the specified holding period and (2) the sum of the projected, discounted net operating incomes (NOls) over the holding period represent the present worth of the property based on the specified holding period. A sequence of such sums, with the holding period ranging discretely from time zero to infinity, is a random variable to which subjective but empirically supported probabilities may be applied to obtain an expected value. This expected value represents the expected discounted value at time zero, the discovery of the contamination or occurrence of the incident in question.
In applying the concept, say in a situation of serious contamination, we would first use a spreadsheet program to estimate the expected discounted value of the property, based on market data and acceptably supported assumptions about future market and property performance, just before time zero. We would then revise the spreadsheet program to take into account market-based projections of the effects of the contamination on projected, future market and property performance in order to estimate the expected discounted value as impaired. The difference between the two results represents the amount of indirect financial damage, in present worth terms, to the property.
An Example
For clarification, consider a hypothetical parcel of vacant land which is now valued at 100 units and which rents for 10 units at the beginning of the period. Let us suppose that there is no inflation, and that these amounts remain constant. Let us further suppose, for sake of this example, that an appropriate discount rate for the uncontaminated property is 10%, and that the probability of sale in any given period is also 10%. (This assumption concerning the appropriate probability distribution is the equivalent of having no specific information concerning the property other than that market turnover occurs with a uniform distribution with a typical 10year period.) Computation of the discounted expected value for the property, undamaged, yields a not surprising figure of 110.0 (with end-of year lease payments, the result would be 100.0).
Now suppose that, at time zero, serious contamination is discovered on the property, and that it becomes instantly unmarketable at any price. Assume that the cleanup will take four years and cost 10, 20, 20, and 10 units in these years, but that this cost will be born directly by insurance so that direct costs need not be considered in this analysis. Further assume that the property would be unmarketable at any price through the second year and marketable at 50 units at the end of year 3, returning to full, nominal market value at closure, the end of year 4. (Of course, in an actual situation, market data would be gathered to support any assumption made in this model, including any individual, annual value estimates, cost estimates; or probabilities.) This example represents the case of no residual economic effects on the property (no stigma).
Let us further suppose that the property is unrentable during the cleanup period (ongoing litigation, men in moon suits working, dump trucks loading, warning signs on chain link with 3-strand razor wire, and other such stigma creating activities), and that the reversionary value will return to 100 and the rent to 10 units immediately at the end of year 4, with rent in year 3 of 5 units. These suppositions are embodied in Table 1. (Please note that these are only examples, and definitely not recommended.) We note that the expected discounted value of the property is 44.6 units, indicating an expected discounted percentage loss, from the base case, of 65.4% of value. The loss is due to the loss of marketability and rentability during the cleanup period only, and not to subsequent stigma, as here defined. (Remember that this result does not include the cost of cleanup. If the direct costs were born by the property owner and thus were included in the calculation, the value loss would likely be near the undamaged value of the property.)
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Stigma damages may be added to this example calculation by including market based estimates of diminished market value and rent after the end of the 4-year cleanup period. In the example of Table 2, we have assumed residual indirect damage effects lasting through the end of year 6, affecting both rental income and reversion. As before, the insurance company is dealing directly with the cleanup costs. The expected discounted value in this case is 42.1, yielding an estimated loss of 67.9% of base case value, a difference of 2.5 percentage points relative to the no stigma case. Thus, in this hypothetical example, the residual, indirect effect (or stigma) is small relative to the damage (economic loss) due to lack of marketability and rentability during the cleanup period.
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In Table 3, the impact of a small but permanent indirect effect is estimated. The result is a small further reduction in value. In Table 4, an initial 1-year delay in taking action toward restoration (a failure to mitigate damages) is analyzed with an implied loss due solely to this delay. In Table 5, damages in a simple case of a minor construction defect are estimated, and in Table 6 a worst case scenario is displayed.
Extensions of the Technique
Adding inflation, depreciating the wasting portion of the asset, factoring in the cleanup costs, varying discount rates, or using the model in conjunction with regression or other statistical data analyses, would be straightforward. It could also be extended to the analysis of other, non-fee, simple-ownership interests and could be used as a basis for bankruptcy or other corporate decisions. If the cleanup costs are born by ownership, these costs can be used directly in the analysis, including financing. Other applications include condemnation and inverse condemnation, as well as any type of damage or encumbrance that affects marketability or rentability. Further, if the costs and timing were taken as random variables, the exposition would be only somewhat more difficult. Alternately, use of three distinct cases (nominal, optimistic, and pessimistic) and their associated probabilities, is practical.
Conclusions
The expected discounted value method estimates the economic losses resulting from a loss of marketability and rentability, with the possibility of some residual (stigma) damages after the complete restoration of the property to a good approximation of the status quo ante. Analysis of a hypothetical but not unrepresentative example of a major contaminated property indicates that most of the loss in property value is due to the loss of marketability and rentability, with loss due to subsequent stigma representing only a minor fraction of the loss in value. We can also conclude that an early delay in taking action to remediate the property may have quite a significant effect on value.
Use of expected discounted value can easily be adapted to any damage calculation and utilized in a variety of situations, including corporate decision making, condemnation and inverse condemnation, and the estimation of tort related damages. It is market based, disaggregative, and satisfies scientific standards of proof. In a legal venue, testimony in support of the .method can and should be based on market data as to periodic values, rents, costs, sale probabilities (when available), and explicit assumptions. Such market data clearly come under the heading of facts commonly and reasonably relied upon by experts in real estate, thus satisfy the reasonable reliance requirement as to the formation of opinions or inference upon the subject at issue.
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| [Footnote] |
| 1. Guntermann (1995) correctly indicated that "One consequence of this (Superfund) legislation was an increase in empirical studies that attempted to measure the external costs of Superfund and other wastedisposal sites on surrounding property values. A substantial literature now exists that documents numerous situations where property values have been adversely affected, at least temporarily, as well as situations where adverse affects have not been detected. A second line of research, primarily in the appraisal field, has addressed the issue of stigma-related damages. Stigma might be referred to as the loss in value of a contaminated property that cannot be directly attributed to remediation or indemnification costs or risk, i.e. it is a loss in value because of unspecified, greater perceived risk associated with a property. In fact, the primary type of external damage in certain cases may be stigma-related damage." |
| [Footnote] |
| 2. Marketability (salability) is "the probability of selling property, goods, securities, services, etc., at a specific time, price, and terms." Marketable title is "free from encumbrances and any reasonable doubt as to its validity..,.one which readily can be sold or mortgaged to a reasonably prudent purchaser or mortgagee ...(and) free from material defects, or grove doubts, and reasonably free from litigation." (Blacks Law 6th ed.) Although not defined in Blacks, rentability is clearly similar in meaning, applying to rent, the "consideration paid for use or occupation of ... any rental property, land, buildings, equipment, etc." (Emphasis added.) |
| [Footnote] |
| 3. The costs of remediation often receive the bulk of professional and legal attention, perhaps because they are far easier to understand and quantify and have less inherent uncertainty than the indirect, residual effects. (We do, after all, look to where the light is.) The indirect effects, and in particular those due to loss or diminution of marketability, are considerably more difficult to understand and quantify, and have yet to be adequately and fully dealt with in the literature or court system. Some courts, filling the vacuum, have rejected indirect costs outright, thinking them to represent "double counting," which they do not. The New Jersey Supreme Court addressed the issue in 1991 in T 6r A Industries Inc. v. Safety Light Corp. (587A.2d 1249 (NJ 1991)). The court held that an owner of contaminated property that established the liability of the former property owner under theories of abnormally dangerous activity and negligence was entitled to recover cleanup costs and the value of the structures on the property that would be demolished in the cleanup, but not the diminution in the value of land resulting from the contamination. The (incorrect!) reasoning was that any award in excess of the remediation cost would represent double compensation. The court indicated that, "When the property has been decontaminated, it will be restored to full value. Plaintiff will then be able to sell the property at market value." |
| [Footnote] |
| 4. When the market perceives a property as a problem, value will be significantly affected in several ways. "... Concern on the part of the lender, and appraiser uncertainty, all may have a noticeable effect on the marketability of the property. When a property loses its marketability, it also loses its value. Considerable uncertainty may occur at this (early) stage as people involved in the transaction attempt to understand the magnitude of the problem. When the problem is understood, uncertainty is lessened and the value of a property should then increase..." (Mundy, 7992b). Mundy further noted that, "When the contamination is controlled, the value of the property would be expected to increase to full market value if the public believes scientists and public health experts. Whether this actually occurs is debatable, however, because the public does not necessarily agree with the scientific community. This difference between cured value and full market value is the residual uncertainty caused by stigma, and should decrease with time as the public's perception of risk subsides-assuming there is no further contamination. The length of time is a function of the severity of the problem and varies with the type and amount of contamination, time to cure, as well as how the cure is accomplished, media exposure, real and perceived health risk, and visibility, among other things." (Mundy, 1992b) (Emphasis added.) |
| [Footnote] |
| 5. Risk varies with the type and nature of negative outcome (contamination, construction damages, etc.), the potential impact, and its estimated likelihood. In one fundamental approach to risk analysis, the risk function is defined as R (a) = E(1(x, a) where x is a random variable indicating a future occurrence or unknown state of nature; a is an action selected from a set of mutually exclusive and exhaustive actions A by, say, a property owner or potential buyer; function 1 indicates an estimated loss which will obtain if action a is selected and x is the actual state of nature or future occurrence; and E is the expectation operator. In the discrete case, R (a) is simply the summation of 1(x,a) p(x) over all possible x, where p is the probability of occurrence of x. The risk function simply represents the expected loss associated with any action a. The common choice criterion is the selection of the alternative o' which minimizes the risk function (that is, the expected risk). There are other common formulations and conceptualizations in risk analysis, but without further constraints the minimization of expected risk appears the most acceptable, if "gambler ruin" is not a consideration. |
| [Footnote] |
| 6. In Aos v. Superior Court, (64 Cal.App.4th 916) 75 Cal.Rptr.2d 581 the Court of Appeal, Fourth District, Division 1, California (June 11, 1998, as Modified June 12, 1998.), consolidated writ proceedings were brought by plaintiffs in two separate construction defect actions. The third issue presented was whether homeowners associations and individual homeowners could recover damages for post-repair injury to the reputation of real property (stigma damages). For policy reasons the court concluded that such stigma damages are not recoverable. The court stated that post-remediation stigma damage is an emerging theory of property damage (Miller, California Construction Defect Litigation, supra, 10.7, p. 384.) and defined stigma damage as the residual loss of market value of damaged property after repairs have been made. (Ibid.; see also Stott, Stigma Damages: The Case for Recovery in Condominium Construction Defect Litigation (1988-1989) 25 Cal. Western L.Rev. 367, 374). Courts in California, as elsewhere, allow stigma-type damages in |
| [Footnote] |
| personal-property cases. (Merchant Shippers Assoc. v. Kellogg Express Fr braying Co. (1946) 28 Cal.2d 594; Byrne v Western Pipe br Steel Company(1927) 81 Cal. App. 270). Perhaps the court was expressing a conservative dampening of such damage estimation, which appears to be somewhat speculative or, worse, represents "double counting," or perhaps the court just didn't understand the concept. The agreement that indirect damages are somehow double counting is economically specious. And why damage to real property is somehow inherently different from damage to personal property is also difficult to understand from an economic viewpoint. Further, stigma is real, although difficult to quantity. (For example, given a choice between an undamaged property and an adjacent property having the same utility that was damaged but repaired, buyers will choose the undamaged property without hesitation; a discount is generally required to close the repaired property deal. This case presented a good definition but represents an unfortunate decision: stigma deserves to be confronted and dealt with in both case law and economic theory. |
| [Reference] |
| Bleich, D., M. Findlay, III, and G. Phillips, "An Evaluation of the Impact of a Well Designed Landfill on Surrounding Property Values," The Appraisal journal. (April 1991): 247-52. |
| Calvanico, "Modified Expected Value Methodology," The Appraisal journal. (January 1991). 121-125. |
| [Reference] |
| Chalmers, J. and S. Roehr, "Issues in the Valuation of Contaminated Property," The Appraisal Journal. (January 1993): 28-41. |
| Chalmers, J. and Jackson, T, "Risk Factors in the Appraisal of Contaminated Property," The Appraisal Journal. (January 1996): 44-58. |
| Edelstein, M., Contaminated Communities: The Social and Psychological Impacts of Residential Toxic Exposure. Boulder & London: Westview Press, 1988. |
| [Reference] |
| Guntermann, K., "Sanitary Landfills, Stigma and Industrial Land Values," Journal of Real Estate Research, v. 10, no. 5 (1995): 531-541 |
| Jones, E. E., et al., Social Stigma: The Psychology of Market Relationships. New York: WJ. Freeman and Co., (1984): 4-7. |
| Mosier, R., "Expected Value: Applying Reason to Uncertainty," The Appraisal Journal. (July 1989). 293-296. |
| [Reference] |
| Mundy, B., "Stigma and Value," The Appraisal Journal. (January 1992a): 7-13. |
| Mundy, B., "The Impact of Hazardous Materials on Property Value." The Appraisal Journal. (April 19926): 155-62. |
| Mundy, B., "The Impact of Hazardous and Toxic Material on Property Value: Revisited," The Appraisal Journal. (October 1992c): 463-71. |
| Patchin, P, "Valuation of Contaminated Properties," The Appraisal Journal (January 1988): 7-16. Patchin, P, "Contaminated Properties-Stigma |
| Revisited," The Appraisal Journal. (April 1991a): 162-72. |
| [Reference] |
| Patchin, P, "The Valuation of Contaminated Properties," Real Estate Issues. (Fall/Winter 1991 b): 50-54. |
| Patchin, P, "Contaminated Properties and the Sales Comparison Approach," The Appraisal Journal. (July 1994): 402-409. |
| Rinaldi, A., "Contaminated Properties-Valuation Solutions," The Appraisal Journal (July 1991): 377-381. |
| [Reference] |
| Sanders, M., "Post-Repair Diminution in Value from Geotechnical Problems," The Appraisal journal. (January 1996): 59-66. |
| Wilson, "The Environmental Opinion: Basis for an Impaired Value Option," The Appraisal journal. (July 1994). 410-423. |
| [Author Affiliation] |
| Phillip S. Mitchell, PhD, is a real estate consultant and economist based in Southern California. His practice includes a broad range of consulting types, including financial analysis for real estate acquisitions, development and disposition in both public and private venues, and other services for developers and public agencies, often in support of litigation. He has been involved in such high visibility cases as the Keating/ACC and Exxon Valdez oil spill litigation. He was educated in the University of California System, receiving his M.S. in Business Economics and Finance and his Ph.D. in Business Administration from UCLA. He taught business and real estate subjects for many years as a professor in the California State University system, and has been a full-time real estate consultant for over 20 years. |
| [Author Affiliation] |
| Mitchell has authored a number of articles in The Appraisal Journal, Real Estate Issues, Valuation and other real estate journals and was active in the Appraisal Institute at the national level, having chaired the Research Committee and served on the Editorial Board of The Appraisal Journal for many years. He received the Armstrong award for the best article appearing in the 1992 Appraisal journal, "The Evolving Appraisal Paradigm," and the Editors Choice award for Best Residential Article in the 1997 Appraisal /ournal for "Due Diligence in the Single-Family Residential Review Process." He is also the recipient, along with William N. Kinnard, Jr., CRE, of the IAAO's Bernard L. Barnard Award for the Best Article in the Property Tax Journal (1991) for their article "Market Reactions to an Announced Release of Radioactive Materials: The Impact on Assessable Value." |
| [Author Affiliation] |
| Dr. Mitchell resides in Glendale, California with his wife Camille. |
My Research
