Document View

Uncertainty exists as to what effect contamination will likely have on property values. Despite subsequent revisions to legislation, uncertainties remain in the jurisdictions of some of these acts. An international perspective of approached used in practice by valuers when valuing contaminated land and property is provided. Providing evidence and lessons for valuers on the narrower, more precise issue of how valuers account for the financial risks associated with investing in land and property affected by contamination is discussed.

The late 1980s and early 1990s saw the development of concern surrounding the ownership and investment value of sites affected by contamination. This was prompted by the discovery of problems associated with a number of high-profile sites around the world. For example, Lekkerkerk (Netherlands); Love Canal, New York (United States); and Times Beach, Missouri (United States). Owners of properties in or near these sites suffered substantial financial losses as a result of the contamination identified.

Concerns about contamination land issues were reinforced with the introduction of legislation governing the environment: for example, the 1986 Superfund Amendment and Reauthorization Act (SARA) in the U.S.; the 1986 Environmental Protection Act (EPA) in Western Australia (States enacted); the 1991 Resource Management Act (RMA) in NZ., and the 1995 Environment Act in the U.K. Together, these statutes have brought contaminated land issues to the attention of valuers, and have highlighted the need for them to take contamination and stigma into account in calculations of worth.

However, uncertainty exists as to what effect contamination will likely have on property values. This is due mainly to the difficulty in determining the existence and extent of contamination on or nearby a site, the likely duration and costs of remediation, and the lack of clarity within some of the legislation over legal liability for polluting.

Despite subsequent revisions to legislation, uncertainties remain in the jurisdictions of some of these acts. Those uncertainties include: who is responsible for the contamination; who is to pay for the risk assessment and clean-up costs; who is responsible for "orphan" sites; who is responsible for selecting appropriate remedial solutions; who will determine that a site is "clean enough;" and how will that be done?

In this arena of uncertainty about on-site contamination, together with the market reaction to those uncertainties and associated risks, it is the daunting task confronting a minority of the valuation profession both to account for and to measure these factors. While it is recognized that valuers do not necessarily have the requisite skills to determine the existence and extent of contamination, or to estimate the costs involved in remediation, it is not appropriate for them to simply decline instructions to value property where contamination may be an issue. The resultant perceived financial and investment risks must be accounted for in their estimates of value.

The objective of this paper is to provide valuers with an international perspective of approaches used in practice by valuers when valuing contaminated land and property. Specifically, this paper focuses on providing evidence and lessons for valuers on the narrower, more precise issue of how valuers account for the financial risks associated with investing in land and property affected by contamination.

Literature Review

Background: Accounting for Risks and Uncertainties

Many of the difficulties valuers have faced when attempting to value land and property affected by contamination are the numerous risks and uncertainties confronting buyers and investors. Scientific knowledge emerges over time about the safety of various substances and materials. Even where a risk is known to exist with the use of a particular substance it is sometimes not clear to what extent the substance is hazardous and how far one should go to avoid its use.

Moreover, detecting the presence of the hazardous material can be difficult and extremely costly as can the measures taken to control it, should this be required. Further, the extent of control required often varies depending on the property's use, as do the methods available for controlling the associated hazards. Government-imposed "safe" or "acceptable" levels may change, creating further uncertainty for potential buyers, lenders, tenants, sellers, and their financiers. These factors often result in both difficulties with obtaining debt financing and reduced saleability, thereby compounding the risks and uncertainties involved.

There is an inherent fear of the unknown and the market reaction to this is often referred to as stigma. The extent of stigma surrounding ownership and occupation of a property is usually directly related to the availability of information about the risks involved. Even where research concludes that no risk exists, fear, often initiated by media-induced public hysteria, may remain. Remediated sites may still suffer from this market-imposed penalty.

Thus, people's perceptions are largely responsible for determining the extent of loss in value caused through stigma. How valuers account for risks and uncertainties or stigma is the valuation issue focused on here.

A body of literature recommending and illustrating appropriate procedures and techniques to follow in valuing both property with on-site contamination or proximate to sources of known or suspected contamination has emerged. Nevertheless, little systematic research into how valuers identify and quantify the effects of perceived environmental risks on the value of contaminated property has been conducted to date.

Contaminated Property Valuation Literature

As noted by Elliot-Jones,2 in the context of commercial and industrial contamination, the concept of stigma stems from risk that did not exist prior to the appearance of environmental laws. Similarly, since the initiation of these laws, a growing body of literature has emerged dealing with the valuation of contaminated land. This occurred sooner and has been more prominent in the U.S. than in the U.K., New Zealand, or Australia due partly to the much earlier introduction of environmental legislation in that country.

It was Patchin3 who first publicly introduced the concept of stigma to the valuation of properties with on-site contamination. He also noted a dearth of "comparable sales" of contaminated properties. Indeed, he reported that "corporate real estate personnel.. were practically unanimous in voicing the opinion that a seriously contaminated property will not sell at any price." Patchin identified the causes of market-value loss experienced by contaminated properties as falling under three broad categories:

1. Cost of cleanup [sic]

2. Liability to the public

3. Stigma after cleanup

In discussing "Stigma After Cleanup," Patchin observed that "a physical cleanup does not usually eliminate the value loss resulting from stigma...I have observed several cases in which...potential buyers remained reluctant. This reluctance has to do with all the risk and financing problems previously discussed. The result is that even a cleaned-up property may suffer from reduced marketability."

The valuation literature of the early 1990s emphasized the necessity to use the framework of income capitalization to identify the deductions from unimpaired market value (i.e., market value as if noncontaminated) in order to estimate the market value of a contaminated property.4 That general framework persists to the present, with very few exceptions. From the survey results of Richards5 "... the discounted cash flow technique (DCF) was found to be the most appropriate method to produce a calculation of worth of a property."

The general framework that is identified is to estimate unimpaired market value of the property, and then to deduct the following elements:

* Present worth of the estimated cost to remediate (typically obtained from environmental engineers or technicians)

* Present worth of reduced revenues, stemming from a combination of reductions in:

- Occupancy

- Rent

* Present worth of increased operating expenses, including:

- Increased insurance premiums

- Increased interest on debt

- Monitoring costs anticipated after remediation

* Present worth of holding costs otherwise covered by revenues (which have been reduced):

- Insurance

- Property taxes

- Repairs, maintenance

Present worth is calculated as a function of the anticipated duration of the remediation period, plus the marketing period (for sale or rental) anticipated when remediation is completed. Over that period of time, the discount rate (or, sometimes, the capitalization rate) that is applied to the anticipated income is adjusted upward to reflect the perception of increased risk associated with the existence (or suspicion) of onsite contamination.

Those rates are further increased by the likelihood of having to pay higher interest on debt (when debt financing is available at all) or relying on a higher proportion of equity investment, with its requirement of a higher rate of return. Anticipated losses or necessary expenses, on the other hand, are discounted at an applicable "safe rate."

Finally, from the unimpaired market value estimate minus the present worth of the sum of 1) estimated cost to remediate, 2) estimated reduced revenues, and 3) estimated increased operating expenses and holding costs, a further deduction is made for post-remediation stigma.

Initially, that was recommended to be reflected in further increases in the risk rates applied to the reduced income stream. However, "it must be remembered that this is a highly subjective adjustment to make and should therefore always be conducted with extreme caution," according to Richards.6

In more recent years, sales transaction information has been available from several sources to indicate the percentage difference between the sales price of a remediated property with "closure" from a regulatory body and the estimated unimpaired market value of the property, as of the same date. Thus, market sales transactions data have become sufficiently numerous and available in the U.S. (and, reportedly, Canada) for direct market evidence to be utilized in estimating post-remediation stigma. Valuers in the U.K.,7 Australia and N.Z.,8 however, have yet to enjoy this growth in market data availability.

In the absence of market data, some authors recommend the use of opinion survey research. The great majority of these surveys have focused primarily on the attitudes and perceptions of "professionals" in real estate markets: lenders, real estate agents, and valuers. In the U.S., at least, most opinion survey research involving potential buyers or tenants (or sometimes sellers) has focused on stigma from proximity impacts.

As the volume of available sales transactions data increases and becomes generally known, it is anticipated that this more "objective" evidence will be the major source of identifying and measuring postremediation stigma.

Guidelines from Professional Societies

One stated reason for studying the practices of valuers and analyzing available valuation procedures for contaminated properties is the concern that non-standard procedures, techniques and data sources may lead to inconsistent results among valuations produced for similarly contaminated properties under similar market conditions. Bond and Kennedy,9 in particular, argue for the need to standardize valuation techniques and procedures. Further, Richards10," presents a recurring theme of the importance and desirability of developing "best practice" standards for the valuation of contaminated property, as well as the identification and measurement of stigma.

However, guidelines from professional societies in the countries referred to in this paper offer little beyond admonitions to perform competently, acquire technical assistance and expertise from others where necessary, and report fully (in the U.S. and Canada, at least) on what one has done. Generally speaking, the guidelines offer little substantive direction, few or no details on how the existence of contamination is best treated, and only limited illustrative materials.

In the U.S., the Courts are the arbiters of what is acceptable or non-acceptable practice. The difficulty is that there are 50 separate state court systems, plus the Federal court system, plus various quasi-independent systems such as the Federal Bankruptcy Court. Moreover, state courts, in particular, tend to differentiate among standards for property tax valuation appeals, eminent domain (expropriation) cases, civil damage suits, and regulatory agency claims in identifying what is "proper" (i.e., "admissible") procedure. The plethora of court-imposed "standards" has generally led to more diversity and inconsistency than would be the case if U.S. valuers relied primarily on the essays, case studies and illustrative examples contained in the professional and academic literature cited previously.

The Australian Property Institute guidance" at least outlines four main approaches to the valuation of contaminated land. However, it does not provide detailed information on these. Valuers are, therefore, required to interpret the requirements of each method, and from the results of surveys reported here and in Kennedy" it appears they do so in a variety of ways. These variations influence assessments of value.

Although the information within each country's guidance statement is of value, it is suggested that the lack of a recommended methodology has contributed to inconsistencies among techniques used in practice.4 These inconsistencies are reflected in the survey results presented in this paper.

Surveys of Practice: U.K., N.Z., and U.S. Objectives of the Survey

This section of the paper outlines the methodology of surveys of valuation practice undertaken in the U.K (in 1996), and in N.Z. and U.S. (in 1998). The aim of the studies was to identify the approaches used by valuers when providing advice or producing valuations to account for the financial risks and uncertainties associated with investing in contaminated properties. The results provide valuable lessons for Australian valuers involved in this area of work.

The Sample and Survey Responses

Although there is potential for all valuers to be faced with valuing land affected by contamination, it is likely only a fraction of these will become involved in such work. As such, a targeted approach of contacting valuers known to work on contaminated properties was considered more appropriate than attempting to survey all valuers.

To enhance the validity of comparative findings between the studies, a similar survey instrument was used in NZ. and the U.S. that was initiated and adopted by Kennedy in the U.K. For the NZ. and U.S. surveys a simplified and shortened version of the 18-page U.K. survey instrument was adopted. These instruments were further adapted for relevancy to their particular market.

The U.K. survey that was given to 100 potential respondents achieved an overall response rate of 54%. In NZ. questionnaires were sent to the 15 NZ. valuers who replied to a Call for Participation (which was sent to all NZ. IV members)." Seven responses were received indicating an overall response rate of 47%. The U.S. survey that was given to 208 valuers in the U.S. and Canada (192, and 16 respectively) achieved a response rate of nearly 43%.

Comparison of Survey Responses: U.K., N.Z., and U.S.

This section presents a summary of the major findings that emerged from the analysis of the three surveys. In the interest of brevity, responses to only those questions that were contained in each country's surveys relating specifically to how valuers typically incorporate variables relating to investor risk into value estimates of contaminated properties is presented. Moreover, the focus is primarily on how respondent valuers account for risk and uncertainty (including stigma) in valuing contaminated properties.

Professional Background and Level of Experience

In the U.K. the majority (96.3%) were qualified and 75.9% had been for more than five years. As far as experience with calculations of market value involving sites affected by contamination, slightly over a half (55.5%) of the U.K. respondents were responsible for between one and 25 such calculations for the one-year period (1995); 11. 1% for between 26 and 50; and 3.7% for over 100. However, nearly a third (29.6%) had not conducted or supervised valuations of contaminated property.

In NZ., all respondents were qualified registered valuers, with 85.5% having been so for more than five years. All respondents had carried out at least one and 25 valuations of property where contamination was an issue within the last five years.16

In the U.S. (and Canada), all but two of the U.S. respondents were licensed or certified in one or more states. Over three-quarters (76%) of the respondents held the MAI designation. Over half the respondents (54%) reported over 10 years' experience in valuing contaminated properties. Also, approximately 40% indicated over 10 years) experience in identifying and measuring stigma. The U.S. responses indicate a much higher level of experience than in the other two countries.

Respondents were asked to give examples of types of sites affected by contamination on which they had provided advice. A number of land uses were specified in each country, but virtually all of them were of an industrial nature.

Valuation Methods Adopted

The U.K. survey listed a capital-based method and three income-based methods: income, profits, and residual, whereas the N.Z. and U.S. surveys did not differentiate among the income-based methods and so listed only two: sales comparison and income.

In each country over half reported using more than one method or technique for each valuation. This may be interpreted in two ways: methods employed may differ according to site type; or some respondents may use more than one method for a single calculation. Although such a combined approach is common in U.S. texts and recommended practice in N.Z. and Australia, the U.K. literature commonly recommends valuations by a single method only.

Of note is that most respondents in the U.S. (80%)" reported that they used the sales comparison approach whenever required data was available. This is in contrast to both the U.K. and the N.Z. responses. Moreover, comments made by U.S. respondents indicated that the required data were generally available. Many also indicated that they supplement the findings based on sales comparison analysis with opinion survey research, preferably interviews with buyers and lenders.

The percentage of valuations using full discounted cash flow (DCF) approaches differed by country. In the U.K., only 4 (7.4%) respondents indicated that they used full DCF techniques. In N.Z., 29% use full DCF approaches but only between 5% and 25% of the time. In contrast, 64% of U.S. respondents reported that they used (DCF) models. This confirms expectations that income-- based methods of limited technical sophistication are used to value sites affected by contamination in the U.K. and N.Z. The U.S. respondents appear more advanced in this respect.

Incorporating Contamination Costs into Value Estimates

Over half of the N.Z. (57%) and U.S. (60%) respondents deduct the present value of anticipated costs (24% U.K.). At the same time, a large minority (43% U.K., 43% N.Z., 46% U.S.) use a capital deduction (of the total value, not the present value). The popularity of this simplistic approach should represent a source of concern as it is likely to produce a lower value than if the present value of those costs were deducted. Further, the deduction of total (non-discounted) cost has become disfavored by state courts in the U.S.

An additional source of concern in the U.K. is the fact that 20.4% of those respondents use a yield adjustment to reflect contamination costs. This approach is criticized by several texts. It is heartening, at least, that none of the NZ. and U.S. respondents use the simplistic approach of adopting a discount or yield rate to adjust for contamination costs. In this regard, results produced by the N.Z. and U.S. survey are more positive than those from the U.K.

Information Source for Estimating Environmental Risks and Uncertainties

Typically, information limitations were used to justify the use of simplistic approaches to quantify perceived financial risks caused by contamination in all three countries. Over two thirds (70%) of U.S. respondents (65.6% U.K., 50% N.Z.) typically use comparable evidence from uncontaminated sites in similar locations to the subject property to quantify the value adjustment required for perceived financial risks. It is unclear what useful information may be obtained from transactions where contamination was not an issue."

Over half of the U.S. (59%) and U.K. (53%) respondents (83% of N.Z.) use evidence from sites similar in contamination type but not location. Over three quarters of the N.Z. (83%) and U.S. (75%) respondents but only one third (37.5%) of the U.K. respondents use evidence from sites similar in both location and type of contamination (when available). As stated above the availability of such data is likely to be restricted.

Incorporating Environmental Risks and Uncertainties into Value Estimates

The preferred method reported by respondents in both the UX (84%) and NZ. (83%) to adjust value estimates in order to identify and measure perceived financial and investment risks associated with on-site contamination was to use an upward discount rate adjustment. The figure was 56% in the U.S., while U.S. respondents also indicated that they regularly make adjustments in the one or more components of the income capitalization approach in order to reflect the increased perceived risks of purchasing or investing in contaminated properties. Most commonly, U.S. respondents indicated that they increased the capitalization rate (59%) while 51% reduced rental income.

Whenever possible, U.S. respondents rely on sales transactions information to identify the percentage reduction in unimpaired market value that is attributable to post-remediation stigma. Generally, U.S. respondents prefer to use a capital value reduction (75%, as opposed to 44% in the U.K. and 33% in NZ.).

The much heavier reliance on DCF modeling and analysis in the U.S. and NZ. is reflected in the fact that 57% of the respondents in the U.S. and 50% in NZ. specify use of a cash flow adjustment (i.e., a reduction in or omission of anticipated cash flows in specified years, most commonly during the remediation period). Only 9.4% of the U.K. respondents indicated that a cash flow adjustment was in their analysis.

U.S. respondents addressed the difficulties and higher costs of obtaining debt financing more frequently than did U.K. or N.Z. respondents: 60% of U.S. respondents report this type of adjustment, as opposed to approximately one-third in N.Z. and slightly less than 25% in the U.K.

As with the use of comparable sales transactions data to develop measures of stigma, the selection of methods to incorporate perceived environmental risks and uncertainties into value estimates appears to depend heavily on the quantity and quality of information available concerning financial and investment risks. The predominance of the upward yield adjustment approach in the U.K. and N.Z. appears to confirm the need to apply both relatively simple, straightforward approaches to valuation and greater reliance on subjective judgments by valuers. It would appear that responses from U.S. and N.Z. valuers indicates greater reliance on market evidence, not only of sales transactions but also of income variations associated with on-site contamination. These results appear to explain the greater reliance on DCF analysis, particularly in the U.S.

Lessons for Valuers

As the issues relating to contaminated land that face valuers in the countries surveyed are no different to those facing valuers, the foregoing survey results provide valuable lessons for valuers in Australia.

The survey responses show that the approaches adopted by U.K. and N.Z. valuers are "typically simplistic." Most value estimates are underpinned by limited quantitative analysis. In addition, results suggest that some valuers may ignore certain value effects of contamination (e.g., time effects). Further, little regard is given to the analysis of perceived financial risks.

These valuation deficiencies were typically justified on the basis of severe limitations on the availability of market data for contaminated properties. At least the U.S. and Canadian valuers believe that necessary market data are available in their countries to enable them to base their estimates of value as if contaminated on sales transactions data, market rental data and market-derived capitalization rates and discount rates. As more and better data becomes available in Australia relating to contaminated property, valuers here will be in a better position to adopt more rigorous quantitative analysis in their valuations of such property.

There is debate between valuers in the various countries surveyed about which valuation method is best for valuing contaminated property. Few of the U.S. or Canadian valuers surveyed believe that there is (or, indeed, should be) a single, standardized approach that is universally appropriate and recommended. Because of their strong belief in the efficacy of real estate markets, these respondents typically make it clear that they apply whatever methods) or procedures) can be applied by using whatever market data are available to them in each particular assignment.

This is in contrast to the research findings of Kennedy" that variations in methods used, in the U.K. at least, may have substantial impacts on assessments of value. It is uncertain, however, whether, in that country it is a function of the methodological differences employed or the restricted availability of evidence from comparable transactions that the reliability of market value estimates are limited.

However, despite the uncertainty over the best method for valuing contaminated property, respondents in all three surveys believe strongly that some variant of income capitalization analysis is necessary to identify and measure the deductions from unimpaired market value that are appropriate and necessary to estimate market value "as is" of a contaminated property. Both increased discount rates (and capitalization rates) and reduced cash flows are used whenever supported by market evidence and analysis. When sales transaction data for similarly contaminated properties are available, they are relied on to identify both appropriate deductions from unimpaired market value and any post-remediation stigma, in order to estimate market value "as is."

U.S. and Canadian valuers are prone to rely more heavily (than are those in the UX and N.Z.) on licensed professional environmental engineers and technicians for estimates of both cost to remediate and the duration and magnitude of the remediation process. It is recommended, where possible, that Australian valuers follow the U.S. and Canadian valuers' lead in this respect.

The greater awareness of stigma by the U.S. and Canadian respondents compared to those in the U.K. and NZ. was reflected in the numerous comments that highlighted the identification and measurement of it most frequently as an issue requiring further investigation. This is likely to be an issue requiring further investigation in Australia as well.20

In conclusion, the diversity of data availability tends to argue against a single "preferred" valuation method to date, although refinement of recommended techniques is likely to reduce spreads between value estimates "as is" over time.