Document View

This article is the fourth of a series that discuss the use of geographic information for market analysis. The objective of the article is to suggest a beginning best practice approach for the valuation of brownfields. The approach makes use of the quantitative tools recommended by the Appraisal Qualifications Board, in the process of valuing contaminated land as is, prior to remediation and subject to stigma. This article summaries research findings presented by the author at the July meeting of the International Real Estate Society.

There is a need for increased capabilities on the part of appraisers and for reliable methods for the valuation of development land and brownfields in particular. Simons1 defines a brownfield as "a formerly industrial or commercial site prevented from attaining its highest and best use as a result of perceived or actual environmental contamination." He estimates that there are at least 500,000 nonresidential, brownfield properties in the United States alone. Accurate valuation of brownfield properties is increasing in importance. Experts have noted that most new development in the Los Angeles basin will occur on brownfields, since there is almost no land in the area remains undeveloped. Institutional investors will be looking for an accurate assessment of risk as they provide financing for some of this redevelopment for brownfields in the lower-risk categories.

Simons notes the lack of expertise in brownfield valuation and appraisers who are ready and willing to place a value on contaminated property `as is':

Nearly all appraisers instead provide a value `as if clean.' Without the valuation as is, which would provide value net of remediation cost and stigma, banks cannot ascertain a property's value for consideration in the loan-to-value ratio, and loans become even more difficult to obtain.

The 2001 version of the Uniform Standards of Professional Appraisal Practice (USPAP) states that regulators notified the Appraisal Standards Board that some appraisers were not providing an adequate scope of market analysis.

An acceleration of international investment has resulted in a need for global uniform valuation standards. This increase in real estate investment was the primary reason for development of International Valuation Standards 2000.(2) The standards were introduced at the Valuation 2000 Conference in July, 2000, in Las Vegas, Nevada. One of the papers prepared for this conference was by Edge,3 who stated:

What investors, regulators, and users of valuation services require is consistency, clarity, reliability, and transparency in valuation reporting worldwide...A single international standard has to encompass or recognize property laws, tenures, accepted rules of conduct, languages, concepts, and "best practice" benchmarks.

Both the International Standards and the USPAP in the U.S. call for the use of present value techniques to identify, quantify, and analyze both market and financial risk. Both also note that there are "recognized methods and techniques" that should be used for valuation. In reality, there were no universally recognized techniques found for some of the more complex valuation problems that need to be solved.

A Review of the Literature

A comprehensive search of the literature by Syms and Weber4 has found that there are no definitive Best Practice standards regarding the analysis of risk, and/ or market analysis, especially as they relate to the valuation of brownfields. This review of the literature was commissioned by the Royal Institution of Chartered Surveyors to enable practitioners to understand some of the implications involved in the valuation of contaminated land and to compare United Kingdom research and practice with the situation in the U.S.

The literature suggests the use of comparable contaminated sales, calculation of stigma based on a percentage of the value of a property as if unimpaired, opinion survey research, direct capitalization, and discounted cash flow analysis. Many calculate the present worth of the cost to remediate plus a percentage for stigma and then deduct this amount from the unimpaired value of the property. Another approach used in the U.K. is the use of an "all-risks yield approach," discounting for anything that could go wrong.

One of the problems noted as part of this review is that methodologies suggested for use in arriving at values are not in compliance with the requirements of the Daubert decision.5 In Daubert, the Supreme Court established guidelines related to whether or not expert testimony will be admissible in federal court, where brownfield issues often are decided. The Daubert guidelines also have been implemented by many state courts. CERCLA issues are tried in federal courts, where compliance with Daubert is mandatory. CERCLA is an acronym that stands for the Comprehensive Environmental Response, Compensation, and Liability Act that establishes liability for the remediation of contaminated properties.

Hoyt and Aalberts6 note that Daubert and subsequent cases now require judges to act as "gatekeepers," by considering some or all of the following four factors when deciding whether or not to admit expert witness testimony:

1. Whether the theory can be and has been tested.

2. Whether the theory has been subjected to peer review and publication.

3. Whether, as to a particular scientific technique, there is a known rate of error the court should consider.

4. Whether the technique is generally accepted in the relevant scientific community.

It is not enough that an appraiser "has a feel for the value" or has a subjective opinion about the valuation of a property. Judges will look at the empirical model used by the appraiser before the testimony will be allowed into court.

Hoyt and Aalberts conclude that the manner in which judges treat the specialized knowledge of expert appraisers is entering a new era. They believe that the fourth factor, regarding the general acceptance of the evidence in the relevant scientific community, will be increasingly emphasized:

Both the technical aspects of real estate appraisal as well as compliance with USPAP must be scrutinized. Only then can judges be assured that the testimony presented in their courtrooms are credible... This requires appraisers to go back to the basic body of knowledge and USPAP By doing so, appraisal experts will ensure consistent presentations between their written report and testimonies. It is also important that appraisers keep up with the generally accepted body of knowledge as it evolves and get acquainted with new theories, techniques, and methodologies as they appear in peer-reviewed publications.

Kinnard and Worzala7 provide a systematic survey of appraisers in Canada and the U.S. who are known to have or reported to have experience in valuing contaminated real estate. They note that few papers apply the authors' recommended methodology using case examples based on actual market data and that appraisers use whatever data is available. They find that while numerous methods are used, data is not available to show which of these techniques, if any, produce results that are reasonably accurate.

The theories in the literature mainly appear to be subjective judgments. The courts view these approaches as intuitive and unable to provide the specificity needed under Daubert, in that they have not been backed up by empirical data.

Jackson8 starts his literature review on environmentally impaired land valuation methods by noting that practitioners and academics are having difficulty in arriving at consistent findings as to the effect of environmental contamination on real estate. He notes that the literature deals with appraisal methods, but does not develop a consensus view. He also echoes the findings of Kinnard and Worzala that valuation literature has offered few empirical studies of contaminated real estate, but rather has focused on existing appraisal methods that can be adapted to estimate the impacts of contamination on market value.

Research discusses the probabilistic approach to valuing contaminated properties. Probabilistic risk assessment is discussed extensively in a number of chapters of The Handbook of Real Estate Portfolio Management, the counterpart of the Appraisal of Real Estate for portfolio managers and other institutional investors.

Swaroop and Carter9 have been using probabilistic risk analysis to consult buyers regarding the financial risk of contamination. Their work includes Bayesian Analysis and Monte Carlo methods. These might be suitable risk analyses that USPAP 2001 would require appraisers to provide for lenders providing loans on brownfields.

Birdsall10 noted that his firm has used decision tree and probabilistic risk analysis in 500 cases and that it has been their main tool in estimating costs at superfund sites. A major reason for its use in consulting for major corporations is that can give a client a quantified answer regarding:

* The type and extent of contamination

* Selection of remedial alternatives

* Technological performance, and

* Liability share

Birdsall also notes that the development of a widely used decision analysis model has helped attorneys determine, on a case-specific basis, whether to accept settlement offers or pursue litigation at Superfund sites.

Monte Carlo methods are capable of quantifying the differing financial risks of brownfields and also the market's reaction to these risks. It is also a tool recommended for the analysis of land development by institutional investors. Bayesian Analysis can quantify the financial risk from soil sampling procedures. The USPAP now requires appraisers to quantify risk for lenders. For this reason, these two risk assessment techniques are suggested as a starting point for brownfield valuation.

No matter what valuation approach is used, the highest and best use of a brownfield must be feasible. Schmitz and Brett have noted that "feasibility studies can vary dramatically in length, scope, and cost" and that "a market study is a crucial item in a feasibility study."11 They note that sensitivity analysis is required to quantify risk for lenders. The authors also note that:

Market research can identify an appropriate selling price for a completed project or a parcel of land. The value of raw land is determined by constructing a market analysis of a likely completed project, then extrapolating the value of the land based on the value of the completed project.

Anna Frej et al suggest the use of a developmental analysis in project feasibility. A land residual analysis is used to value the land based on prospects for income and the most likely cost of developing a site.12

Coughlin,13 an institutional investor at Copley Real Estate Advisors, recommends thorough market analysis that is followed by probabilistic land development analysis that makes use of Monte Carlo methods in order to analyze the range in probable results and the risk of a proposed development. Other portfolio managers in Coughlin's handbook also recommend the use of GIS and probabilistic conclusions. Sweet, president of Amli Institutional Advisors, notes 14:

Land investment should tap the power of state-of-- the-art computer software specifically designed to track information based on geographic location. Economic growth, population growth, and job growth are the three driving forces of improving land value.

Lieblich recommends a probability matrix of expected returns for an asset, noting15:

Similar benefits can be obtained by using a Monte Carlo simulation approach to generating returns under uncertainty for which the mean return, standard deviation, and correlation parameters can be estimated. Fundamentally similar to scenario-based approach, Monte Carlo simulation requires the portfolio manager to estimate the distribution of each significant variable (rental rates, vacancy, growth rate, etc.) to the return-generating process. From these distributions, a series of simulated 'draws' are recorded and used to create a distribution of returns.

Conclusions From the Literature Review

Literature research suggests that different appraisal approaches may be appropriate based on the specific contamination situation. Different valuation techniques could be required for each of the following scenarios:

1. Contamination is considered to be likely, but has not been investigated.

2. Contamination is known based on preliminary soil investigation.

3. Contamination has been confirmed by extensive soil borings and other methods.

4. Contamination has been found in the potable groundwater at the site.

5. Contamination has been remediated, but subsurface contaminants still exist, but are below No Further Action (NFA) requirements, meaning they can legally remain for the time being. Pre and post-remediation levels are often checked by monitoring wells.

Soil Contamination Case Study Exemplifying Scenario Two

The review of the literature shows that it is critical that the appraisers understand both the type and extent of soil contamination when dealing with scenarios 2-5. Both Wilson16 and Weber,17 who demonstrated a technique dealing with Scenario 2, note that the health risks, uncertainty, and financial risks can become exponential in above Scenarios 4 or 5 if contaminants have migrated to a potable aquifer beneath the site. In contrast, many leaking fuel tanks have only resulted in a few feet of soil being affected by a spillage. Excavation of soil in such a situation may result in little financial risk and, in all likelihood, no residual risk.

The comments of Dr. Kinnard regarding the lack of case study support by authors for their opinions clearly creates problems from a Daubert perspective. It is considered a major shortcoming in most of the articles found in appraisal publications. Many appraisers have opinions, but few seem to have backed up these opinions with empirical results that show the reliability of their methods in estimating values. Simons provides good examples of other brownfield case studies. A case study was included by Weber, above, and another follows below.

A Voluntary Cleanup Program was not an issue with either of the case study sites. These are programs, issued in the 1990s, that provide incentives to owners to initiate the remediation of their sites by working with regulators.

Soil Contamination Case Study Exemplifying Scenario Three

A case study is presented to show how appraisal techniques recommended in the literature can fail in valuing a brownfield with contamination as described in Scenario 3. The following discussion is patterned after another case study of a contaminated property by Hall.18 In a similar fashion, the identity of the property has been changed, but the facts are true.

This case study property was a brownfield that had been used from 1905 to 1988 for the manufacture of clay pipe, ceramic tile, and dinnerware. A number of contaminants were found when site work was being done for the new shopping center. Excess unfired glazing material containing hazardous concentrations of lead and zinc were discarded on low-- lying areas of the site. Some concerns were the possibility that future expense may be required to keep these heavy metals from being ingested via breathing dust or by finding leached lead in drinking water below the site.

A number of appraisals were available from the bank that provided the construction financing. They were very limited in scope and confirmed the developer pro-forma. An appraiser that valued the property for the bank valued it at $46 million as-if not contaminated, after the contamination was found. It was at a time when the remedial cost was thought to be about $6 million. The appraiser concluded that the value for the property was $40 million "as-is" by subtracting the $6 million from value as if clean, concluding that there would not be a loss in value due to stigma.

The reason given was that the appraiser knew of another contaminated site that was developed with a shopping center that subsequently sold at a low capitalization rate, suggesting that the market did not discount such properties for "stigma." The use of "comparable" sales has been advocated in the literature, as long as these comparables have similar risk. The problem is that most appraisers have not been trained to discern differences in financial risk that can result from varying contaminants, their locations in the soil, and distance to potable groundwater.

The initial remedial treatment was to use a soil washing technique, with the soil put back in place after removing the heavy metals. It was later found that the soil-washing method, which had been approved by regulators, would not resolve the problems. Another method had to be tried, at an additional cost of $20 million. This remedial method required the construction of a "capped area," which is an asphalt covering that is designed to keep the contaminants from being carried by the wind or traveling through the soils to nearby "receptors" via the groundwater. "Receptors" are people whose health could be at risk by living and working in the adjacent areas and inhaling the dust or drinking contaminated water. A worst-case scenario would have required the excavation of all of the soil and its transport to a different part of the state at an additional cost of $43 million.

The bank that provided the construction financing became insolvent in the mean time and two more appraisals were obtained from independent appraisers. Both appraisers valued the property at exactly $29,275,000. In their valuations, these appraisers assumed that the second remedial plan would solve the contamination problem. They also assumed that the area in which the buried contaminants were capped would be developable and that tenants would not object to being in stores above the asphalt cap. The only added construction cost that the appraisers thought would reduce the value of the site would be the result of the need for special foundations that would be required in order to develop over the capped area.

Both appraisals simply used the land value by comparison technique to arrive at the same values for the land as if it were unimpaired by the contamination. One appraiser formed the opinion that there should not be a deduction for stigma as a result of the contamination. The other appraiser took a deduction of 20% of the unimpaired value for stigma-without any support whatsoever. This was a situation similar to another reviewer's findings that an appraiser used a 40% deduction for stigma-- based solely on an article in an appraisal publication that came out some years ago. Both appraisals also simply assumed, as had the bank appraisers, that over 500,000 sq. ft. of retail space proposed by the developer would be the highest and best use of the site with no supportive analysis whatsoever. Both of the above appraisals were rejected as a result of their lack of analysis.

A statement of work was written to order two more appraisals. The statement of work is a document that states the scope of analysis that is to be used in an appraisal, the level of market analysis to be included, and methods of valuation that are to be contained in the report. The scope of work called for C-Level market studies and for the appraisers to value the property by a developmental, or land residual approach, taking into consideration any risk posed by the contamination issues, in addition to valuing it by whatever other methods they considered appropriate.

The Appraisal Institute defines a C-Level market study as one that incorporates "future-oriented forecasting techniques."19 A D-Level market study is more advanced, in that it can call for the use of probabilistic risk assessment techniques-techniques that were found to be even more appropriate for this property.

Results of the Market Studies and Appraisals

Neither of the latest appraisers thought that the total 45 acres would sell due to financial risk that some refer to as "stigma." This was the reason for their conclusion that the value of the property was "zero" in its "as is" condition. One appraiser contacted an insurance company that dealt with environmental liabilities, but they declined to insure the site-due to the reported financial risk of groundwater contamination. Both appraisers were subsequently asked to value the property subject to a lot split whereby 27 of the acres that were not contaminated could be split and sold separately.

The value estimates were reconciled upon appraisal review, with the appraisers agreeing to revise their opinions of value to $8.29 million and $9 million respectively. These were "as-is" valuations, which included discounted values that took into consideration a 2.5-year period that would be required to obtain approvals required for the parcel's development (versus $12 million future values after obtaining developmental approvals and a lot split that would take about 2.5 years to accomplish).

Results of Marketing

The marketing of this asset became the highest priority. Over 500 developers and potential users were contacted. Brokers met with over 50 developers. The site was also multiple listed for a time with over 1,300 brokers.

The results of the marketing show that the vast majority of potential buyers expressed extreme reservation due to the onsite encapsulation and the ground water issues. Entitlement risk (the risk of not obtaining development approvals) was also a concern. There was a complete lack of development capital; possibly because the bank that provided the construction financing became insolvent as a result of this property.

Brokers, once highly optimistic, finally recommended reducing the asking price. The property was offered to the city for $9 million for a new police academy, prior to the lot split, but they declined. The site finally sold for $12,125,000 more than two years later as the result of a sealed bid that involved a number of potential buyers.

Results of Development

The land was developed after the property obtained entitlements, which are the city approvals that were required for the (re)development of the site with a shopping center. The final site development was significantly different from the original plan. It was developed with two big-box retailers. The acreage at the frontage was marketed for smaller users. The owners were unable to pre-lease the space after three years of marketing the site at a time that was locally very good for retail development.

Analysis of the market area via GIS, as well as by market studies, showed that there was a lack of nearby population that would be required for smaller retailers. Both appraisers confirmed that "big-box" retailers were needed to draw distant customers.

Lessons Learned

The major lesson learned is that environmental risk can often drive the financial risk of a brownfield. The financial risk of this site was created by rising groundwater. A cross-sectional view of the case study site shows that the ground water is quite high in this area, and had been rising because other wells in the area were being shut down due to their contamination. There was a risk that water would rise to the level of the buried contaminants, causing them to leach into the ground water and, eventually, into drinking water.

Contaminants in the groundwater can result in serious health risks and also be very expensive and time-consuming to remove. If this were to happen, it would trigger a requirement to remove all of the soil and transport it to an approved landfill at an added cost of $43 million, even if this site received a letter of NFA at one point in time.

Case Study Implications for a Best Practice Brownfield Valuation Model

The poor results that all of the earlier appraisers of the case study property had can be attributed to three shortcomings: a lack of understanding of environmental site assessment and remediation, a lack of understanding of market analysis, and a lack of understanding of probabilistic risk analysis.

The Need for Specialized Training In Environmental Risk

The problems in the above case study provide good support for the concerns expressed by the Appraisal Qualifications Board that were noted earlier. The opinion has been formed that specialized training is required for competency in estimating the value brownfields. There are no specific guidelines from the Appraisal Standards Board that provide a de minimis Competency Provision. Appraisers have concluded that they are competent to appraise brownfields based on reading journal articles. Specific education in environmental impairments would likely result in better quantification of risk. The courses listed below are examples of topics addressed by a university environmental site assessment and remediation certificate program.

Certificate: Environmental Site Assessment and Remediation

* Regulatory Framework for Toxic/Hazardous Materials

* Techniques for Collecting and Analyzing Samples

* Principals of Hazardous Materials Management

* Introductory Chemistry of Hazardous Materials

* Groundwater Hydrology: Monitoring, Protection, and Cleanup

* Environmental Aspects of Soils Engineering and Geology

* The Remediation Process for Contaminated Soil

* Remedial Investigations and Feasibility Studies

* Environmental Risk Assessment and Management

These courses provide a better understanding of the risks involved in the valuation of contaminated land. For example, this material enables the appraiser to understand why contaminants located in the vadose zone, the area below ground that is partially saturated by groundwater, can be more of a financial risk than would otherwise be the case. Monte Carlo methods are used for environmental risk assessment. They are also used by pension fund manages and others for financial risk assessment. They result in probability density functions that show the range in the outcomes of the variables of interest. Figure 1 shows how financial risk can vary significantly due to subsurface conditions.

The Need for Specialized Training In Market Analysis

Specialized training and experience in market analysis can also be critical. HUD may be the first government agency to provide specific requirements that need to be met as part of a market analysis. This agency requires a person to have three years experience prior to conducting a HUD market analysis.

Weber" referred to the stigma as "Unquantified Risk," suggesting that the stigma could be quantified by the use of Monte Carlo methods that could be used as part of a developmental model for the valuation of the property. It can be difficult to explain these concepts to those who are not familiar with the vadose zone, concepts of Monte Carlo risk analysis, and C-Level market studies.

The author was asked to prepare a presentation for the local chapter on the use of GIS to detect mortgage fraud. The presentation since became a study that was done for Valuation 2000,(21) an appraisal conference that was designed to enable appraisers to prepare for the future. This article contains basic information on the use of GIS to quantify demand.

It became the first of a four-part series, summarized in Table 1, that was considered necessary to discuss the specialized areas that need to be dealt with, in the author's opinion, prior to using the land residual approach properly for brownfield valuation.

The second research project, Market Value Without a Market-A Sequel,22 was written as a sequel to an article written for the October, 1990 issue of The Appraisal Journal. The conference paper was prepared for the annual GIS and CAMA conference that is jointly sponsored by URISA and the International Association of Assessing Officers.

The research that was done for this paper dealt with the problems that result from the use of regression to estimate the value of apartments and warehouse buildings that are fairly generic in their design. GIS was used to create variables, such as the distance of comparables from the freeway, to find out of they would provide improved estimates of rental value. This ability could provide objective statistical support for the first step in a feasibility study, since the current rental value of a property today needs to be estimated prior to forecasting its trend, required to estimate value upon completion.

Enlarge 200% Enlarge 400%

Enlarge 200% Enlarge 400%

The third paper23 was written to suggest how GIS could be used to provide greater accuracy in market studies that are prerequisites for a brownfield feasibility study. This paper was presented to the American Real Estate Society, which has recognized the importance of both market and business cycle analysis. The economic contraction in the Bay Area that started in 2000 was used to provide an example of the importance of business cycle analysis for feasibility studies. This paper also points out why the ASB also needs to provide specific guidelines for the scope of market analysis. Schmitz and Brett noted in their description of "The Feasibility Study" that:

The results of the market analysis lead to the core assumptions used in the financial feasibility analysis for a real estate project. A developer must be able to defend cash flow projections with a rational system of analysis and data inputs to legitimize the project's feasibility, demonstrating that there will be tenants, or buyers, that rental rates or sales prices will return a sufficient cash flow, and that the type of product proposed is what the market really desires.

A problem with typical trend analysis for feasibility is that it does not explicitly take into consideration business and/or real estate cycles. An investor who extracted the rate of growth in rent from Bay Area office buildings in 1997-2000, for example, and used the resultant rate to estimate income for the next few years (the important timeline for redevelopment) would likely be dismayed, to say the least, at the results.

The Need for Specific Training In Probabilistic Risk Assessment

The Handbook of Real Estate Portfolio Management discusses the analysis of land development by institutional investors. These investors are typically very risk averse, but as noted earlier, might be interested in financing redevelopment in long built-up urban areas, which almost necessitates involvement with brownfields. It notes that "real estate development must be carried out with prudent management of the cyclical and secular risks presented in most real estate markets."

Enlarge 200% Enlarge 400%

Figure 2 illustrates the results of the Monte Carlo simulation of a land development that was discussed by Coughlin in order to analyze the range in probable results or risk of a proposed development. It shows the relative likelihood of various levels of profit, given the uncertainty in income and expense of the development.

Applying the Concepts to Brownfields

The graphic labeled Property A in the exhibit titled Relative Financial Risk of Three Contaminated Sites is a probability density function. The entire range of financial risk is displayed under the curve and the probability of having to incur this cost can be estimated by the percentage of the area under the curve at each level of cost. The data shows, for example, that there may only be a 10% chance of solving the problem by an expenditure of $8 million, a 60% chance of doing this by spending $20 million, and close to a 100% chance of solving it forever by spending $43 million to dig it up and move it.

The Bayesian Analysis of Weber's case study property discussed in the Journal of Real Estate Research (footnote 17) showed that the financial risk of the contamination found at Property B in this case study site was nominal. The property has changed hands and redeveloped since then, which shows that this type of analysis provided meaningful results.

If a D-Level market study had been done for the case study property that was the subject of Scenario Three, it would have confirmed the possibility of a new owner having to spend an additional $43 million as the result of the ground water monitoring required by regulators. This probabilistic risk analysis would have provided a much better idea of the value of the property than the two methods used. Both methods were used as described in the literature by the prior appraisers; both failed miserably in estimating eventual sales prices.

If appraisers had such curves for each comparable, they could separate the amount deducted from the price due to the contamination, based on its most likely remedial cost, from the supplemental amount deducted for the uncertainty of the cost. The latter amount can be translated into the percent confidence level for the risk of cost overruns that is required by the local market, which has been referred to as stigma. This method might be important for the International Valuation Standards, since they note that appraisers are expected to reflect the market's reaction to these substances.24

There is still the problem that results from trying to compare property sales that are located in different markets. Seldom would we find a contaminated property selling at one of the "four corners" used in the example in the graphic that could be used as a comparable. Market analysis tells us that acreage at different locations can have very different economic futures, as illustrated in Figure 3.

Evaluation of the Recommended Model In Light of the Literature

As Edge has noted, investors, regulators, and users of valuation services require consistency, clarity, reliability, and transparency in valuation reporting worldwide. A single international standard is required as a result that has to encompass or recognize property laws, tenures, accepted rules of conduct, languages, concepts, and "best practice" benchmarks.

The Appraisal Qualifications Board has effectively put appraisers on notice that higher educational requirements will be required in the future. Examples were provided in the four studies by Weber that include the use of statistical and market analysis, micro and macro-economic analysis, and computer technology for the development of a "best practice" methodology the valuation of brownfields. These analytical tools are all part of the items of specialized knowledge that the AQB expects appraisers to use in the future.

Risk Quantification and Statistics

The literature tells us that banks need accurate assessment of the financial risk of brownfields so they can provide capital for brownfield redevelopment. Literature also indicates that appraisers typically only provide estimates of value "as if not contaminated," and that those who have been providing estimates "as-is" have not demonstrated the accuracy of their methods.

The method that is recommended would be able to summarize the marginal risk of lending on a brownfield by use of a familiar land development model. Developmental models have been used extensively for residential subdivisions and many lenders should be familiar with them as a result.

The result of the risk analysis also can be summarized and communicated very effectively by probability density functions. The examples in this article show various levels of marginal risk due to the cost of remediation and the likelihood of each, so loan officers could quickly understand the marginal financial risk.

Enlarge 200% Enlarge 400%

This type of empirical support is considered to be mandatory in order for opinions of appraisers and other expert witnesses to be admitted in most courts. The use of statistical tools for appraisal is in compliance with Daubert.

Methods described in this paper are just the start. Survey research is another statistical tool that can be used to quantify losses in value. It is also a Daubert-- compliant methodology.

Statistical tools that the board calls for have been used by the assessment community for many years. Market analysis skills have also been acknowledged as critically important for the analysis of highest and best use and for analyzing the feasibility of proposed development.

Market Analysis

The Appraisal Standards Board has issued Statement on Appraisal Standards No. 10 (SMT- 10) for USPAP 2000. This statement notes that:

An appraiser must have sound reasons in support of the scope of work decision and be prepared to support the decision to exclude any information or procedure that would appear relevant to the client, an intended user, or the appraisers peers in the same or a similar assignment. Failing to include in the scope of work sufficient market trend research and analysis to develop credible results violates Standards Rules 1-- 1(a) and (b) and Standards Rule 1-2(f).

Market analysis is a prerequisite for feasibility analysis. Feasibility is, in turn, a necessary component of highest and best use analysis. A large number of market participants the U.K. have stated that financial feasibility is the critical element in redeveloping brownfields.

Professor Paul Syms from the School of Environment and Development at Sheffield Hallam University surveyed more than 200 people that have some degree of involvement with, or a personal interest in, the redevelopment of brownfield land. They included landowners, property developers (residential, commercial, retail, industrial, and leisure), surveyors (involved in both estate agency and valuation), lawyers (involved in property transactions, corporate law, and environmental law), town planners, engineers, and environmental specialists.

The objective of the survey was to obtain the views of people directly involved in the redevelopment or valuation of brownfield land. Respondents were asked to indicate their opinion as to the importance of 44 different factors, in each category, when considered as part of the decision making process.

The most important factor by far was the financial feasibility of redevelopment. Eighty-eight percent of interviewees regarded this factor as being `essential' to the redevelopment process. The second most important factor was a need to obtain clear advice on available remedial methods (including effectiveness and costs) that are easily understood by developers and their advisers. The third most important issues is for land owners to ask reasonable prices for brownfield land in light of risks that are involved in redeveloping it.25

The methodologies being suggested clearly comply with the needs of market participants and required by SMT-10. SMT-10 requires the appraiser to provide any information or procedure that would appear relevant to the client or an intended user. The International Valuation Standards also require appraisers to properly consider and indicate the ranges of risk associated with the development, when valuing development properties for lenders. Brownfields are considered to be development properties as far as highest and best use analysis is concerned.

Another case study was used as part of a paper that was prepared and presented to the American Real Estate Society at their 2000 annual conference.26 This time it was a hypothetical situation of the redevelopment of a brownfield site located in the San Francisco Bay Area.

The hypothesis was presented that the Appraisal Institute did the best job in their delineation of the scope of market analysis by rating studies from A to D, but that the recommendations of NCREIF27 would have done the best job if used in a feasibility study that would be done to test office development as being the highest and best use of the property. This was considered the case because NCREIF recommends that appraisers use econometric modeling that would take into consideration the possibilities of completing the redevelopment at the bottom of the local business cycle.

Enlarge 200% Enlarge 400%

The more typical method is "trend analysis," which would have resulted in taking the rate of growth in rentals in the Bay Area over the past few years and trending rents that were at the top of the cycle into the future, resulting in a major over-valuation of the proposed development upon its completion, as illustrated in Figure 4.

The wide range in published recommendations for appraisers to use in market analysis has created significant confusion. Table 2 lists the costs of what clients and appraisers feel is adequate for use in an appraisal.

Recommendations

Based on the review of research and issues discussed in this article, the following recommendations are made:

1. The Appraisal Standards Board should provide more specific guidance to appraisers regarding the acceptable scope and methods of market analysis it considers appropriate for various types of appraisals. As Fanning noted some time ago28:

Although these standards (USPAP) confirm the need for market analysis in an appraisal, they do not specify the extent to which any given component of market analysis should be developed. The comment to Standards Rule 1-4(g) suggests that there are different levels of study and that some appraisals may require a more detailed study as specified in Standards Rule 4-4.

Because current requirements are confusing, the appraiser must remain cognizant of new interpretations of existing standards and of standards promulgated in the future. While a Level A analysis might be acceptable in some cases, Standard Rule 4 implies that a Level B or possible a level C analysis would be the minimum requirement for the majority of commercial appraisals.

2. A beginning "best practice" brownfield valuation model should be developed and patterned after the methodologies that have been recommended by the Urban Land Institute and in the Handbook of Real Estate Portfolio Mangers. In other words, the current value of the property should incorporate substantive market and feasibility studies that suggest an appropriate price to be paid for the land that would be predicated on the developmental and risk analyses that would be done as suggested by these two references.

3. The Appraisal Qualifications Board acknowledges that appraisers will need education in a number of specialized areas to deal with difficult problems in the future. The research that has been done over the past year incorporated the use of computer science, micro and macro-economics, market and statistical analysis. These are all areas of specialized knowledge that other appraisers could also learn on their own if they are financially motivated to do so. Certification such as that which is used by Microsoft could also be used to test appraisers for competency in some of these disciplines and also to make clients aware of the demonstrated skills that they possess.

This certification should also call for demonstrated competency, similar to the use of demonstration appraisal reports. An example would be a reasonably accurate forecast of sub-market conditions that would be required for certification or license as a competent market analyst, in addition to that of a certified general appraiser.

Hopefully, the regulatory appraisal agencies will be more specific in the future when they are describing the scope services that they expect appraisers to provide. The Department of Housing an Urban Services has provided a good example by their list of experience and study-specific requirements for market analysis.

Enlarge 200% Enlarge 400%

Enlarge 200% Enlarge 400%

Conclusions

Both the International Valuation Standards and the Appraisal Standards Board should provide specific guidance in the scope of market, risk, and other types of analysis that the Appraisal Qualifications Board says is "required to provide adequate public protection." These agencies do not want to recommend specific techniques, but they could do a much better job of defining for appraisers and their clients where in the $100-$50,000 range of cost is considered appropriate for various situations. If higher cost market studies are recommended it would motivate appraisers to learn these skills.

The main points included in the NCREIF recommendations have been summarized in Table 4. The points shown here are for an office market study, but the one paragraph discussing office-specific entries could easily be repalced with items the NCREIF recommends for these market studies. If appraisers checked off the NCREIF items that they used within their report, it would be specifically define the scope of work that was used in the market study, clarifying much potential confusion for their clients.

In a similar fashion, an appraiser that would be certified or that would have a supplemental license for the valuation of brownfields may have to demonstrate skills such as:

* Training in environmental site assessment and remediation

* Proven competence in market analysis

* Proven competence in feasibility analysis

* Proven understanding of probabilistic risk analysis

If appraisal clients know that regulators require a greater scope of market, feasibility, and risk analysis, done by an appraiser with the above credentials, they will be able to identify such a clearly "specially-- certified" or " properly licensed appraiser."

Appraisal fees would then become adequate to motivate the best appraisers to learn their skills, whether it be by self-study, an implementation of a Microsoft-type certification program, or completion of university Certificate and/or Doctorate Programs, in order to provide the adequate public protection that is desired.

[Footnote]

8. Thomas 0. Jackson, MAI, "The Effects of Environmental Contamination on Real Estate: A Literature Review," Journal of Real Estate Literature (9: 2).

9. Ram Swaroop and Richard Carter, "Procedure to Assist Decision-Makers in Selecting a Remedial Alternative for Hazardous Waste Sites." Superfund '87, Eighth National Conference, Washington, D.C., 1987.

10. T. H. Birdsall, "Quantifying Environmental Costs and Liabilities." AICPA /IBA, San Diego, 1995.

11. Adrienne Schmitz and Deborah L. Brett, Real Estate Market Analysis: A Case Study Approach (Washington, D.C.: Urban Land Institute, 2001): 9 12. Anne Frei, et al. Business Park and Industrial Development Handbook (Washington, D.C.: Urban Land Institute, 2001): 46.

13. Daniel 1. Coughlin, "Real Estate Development," The Handbook of Real Estate Portfolio Management (Burr Ridge, IL: Irwin Professional Publishing, 1995): 309-339.

[Author Affiliation]

Bruce R. Weber, MAI, is principal at Market Foresight in Newport Beach, California. Mr. Weber received his MBA degree from the University of Michigan and has specialized in the use of Geographic Information Systems for market analysis over the past 3-4 years, with a special interest in forecasting sub-market demand for real estate. Contact: bweber@marketforesight.com