Document View

The first known systematic nationwide survey of appraisers known or reported to have experience in valuing contaminated real estate is described. With a response rate in excess of 43%, the results provide information on how experienced appraisers value contaminated properties, what analytical procedures they use, and how they identify and measure post-remediation stigma. The findings from the survey are also compared with recommended procedures found in the contaminated property valuation literature published over the last decade. Finally, the implications of these findings for developing standards on valuing contaminated properties and measuring stigma impacts are explored.

Since 1984, a rich and diverse body of literature has developed in U.S. and Canadian journals suggesting how properties with known or suspected on-site contamination should be valued. Only a few papers have also shown the application of the author's recommended methodology, using case examples based on actual market data, however.1

At the same time, a parallel series of papers has appeared on the subject of stigma.2 They contain multiple and wide-ranging definitions of stigma, but generally agree on the procedures appropriate to identify its existence and measure it.3 Two general sources of stigma have been identified in U.S. and Canadian research, as well as in work from New Zealand and in the United Kingdom: (1) uncertainty and risk of diminished property value after completion of any required program of remediation applied to on-site contamination, and (2) uncertainty and risk of diminished property value from proximity to any perceived hazard to human health and safety, or to property value, from an offsite source.4

In valuing properties with on-site contamination that require remediation, or properties stigmatized either from being designated as a contaminated site or from proximity to off-site contamination (or both), appraisers are confronted with a two-part problem: Is there a verifiable negative impact on the value or market price of any such property? If so, how can that negative impact be measured?

The literature on valuing contaminated properties reflects primarily what author-researchers say should be done, might be done, or (occasionally) has been done in one or a few cases. To date, however, no known study has systematically surveyed the actual practices of appraisers experienced in the valuation of properties known or suspected to contain on-site contamination. The only published methodological reviews have reported how analysts do identify and measure the impact of proximity to known or suspected sources of contamination, on nearby property value.5 The survey results reported in this article identify what U.S. and Canadian appraisers currently do when confronted with an assignment to value a contaminated property or a property that is formally and officially declared to have been remediated. It is important to understand that remediation is rarely a synonym for "cleanup." Under Environmental Protection Agency (EPA) regulations, and those of most state departments of environment protection (DEP) regulations, remediation is activity designed to reduce the actual level of specified on-site contaminants to or below the maximum contaminant level (MCL) established by the EPA for the contaminants in question. On the other hand, cleanup would be the result of removing virtually all contaminants from the site and reducing its presence to approximately zero parts per milllion. This is frequently not technically possible, and usually not financially feasible.

OBJECTIVES OF THE CURRENT RESEARCH

There were three related objectives to this survey research:

1. To summarize the major U.S. and Canadian literature that addresses recommended valuation procedures for estimating the market value of some specified ownership interest (most commonly, the unencumbered fee interest) in either a property known or suspected to be contaminated, a property known or assumed to have been remediated, or a property near a known or suspected source of contamination

2. To identify valuation procedures and techniques actually applied by U.S. and Canadian appraisers experienced in the valuation of properties affected by contamination

3. To compare actual practice with recommended valuation procedures and techniques contained in the literature

CONTAMINATED PROPERTY VALUATION LITERATURE

The literature on the effects of on-site contamination on real property in the United States dates from approximately 1984, when Joseph Campanella's article was published in The Appraisal Journal.6 Thereafter, only a handful of articles and papers appeared before 1991. In one of them, Peter Patchin first introduced the concept of stigma to the valuation of properties with on-site contamination, and noted a dearth of comparable sales of contaminated properties:

Corporate real estate personnel...were practically unanimous in voicing the opinion that a seriously contaminated property will not sell at any price...More than one stated the old adage "Don't buy trouble"...The first thing I concluded from the series of interviews was that seriously contaminated properties are generally unmarketable.7

Thus, the importance of marketability, especially when market value is to be estimated, was recognized and introduced.

Patchin also indicated that "lenders are understandably wary of contaminated properties...There is virtually no chance of obtaining mortgage financing for a seriously contaminated property." This finding was reinforced by Bill Mundy9 in his first reported survey of institutional lenders. Respondents generally reported aversion to and avoidance of lending on properties either known or suspected to be contaminated. Such market behavior indicates the existence of elevated levels of risk perceived by market participants, especially potential buyers and lenders.

Finally, Patchin identified the causes of price-value loss experienced by contaminated properties as falling under three broad categories: cost of cleanup, liability to the public, and 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.10

Reiterating the virtual lack of market sales transactions data for contaminated properties, Patchin concludes:

A valuation tool that utilizes all of these [foregoing] factors is the capitalization rate, [which] is dependent on three major factors: (1) equity yield rate, (2) mortgage terms available, and (3) anticipated future appreciation/ depreciation.11

Reliance on Income Capitalization Analysis

The early valuation literature of 1990-199212 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 impaired market value of contaminated property. That general framework persists as of this writing. An appraiser estimates unimpaired market value of the property and then deducts the following elements:

The present worth of the estimated cost to remediate (typically obtained from environmental engineers or technicians);

The present worth of reduced revenues, stemming from a combination of reductions in occupancy and rentals;

The present worth of increased operating expenses, including increased insurance premiums, increased interest on debt, and monitoring costs anticipated after remediation; and

The present worth of holding costs (e.g., insurance, property taxes, repairs, and maintenance) that would otherwise have been covered by the reduced revenues.

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 total 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 that increased risk is associated with the existence, or even suspicion, of on-site contamination. These risk 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 (which requires a higher rate of return). Negative cash flows associated with anticipated losses or necessary expenses, on the other hand, are appropriately discounted at an applicable safe rate.

A further deduction from impaired market value is then made for post-remediation stigma. Initially, stigma was reflected in further increases in the risk rates applied to the reduced revenue.'3 In more recent years, sales transaction information has become available to indicate the percentage difference between the sales price of a remediated property with "closure" from a regulatory body (or indemnification from a reliable, financially responsible seller) and the estimated unimpaired market value of that property, as of the same date. Thus, contaminated property market sales transactions data have become sufficiently numerous and available as direct market evidence to be utilized in estimating post-remediation stigma.14

Therefore, there is growing evidence for, and emphasis on, the use of sales of similarly contaminated properties following completion of remediation (with and without indemnification and/or closure) to identify and measure post-remediation stigma. Nevertheless, most U.S. authors still recommend increasing the capitalization rate or discount rate. This latter procedure recognizes the increased risk associated with marketing a property known to have been contaminated (for sale or lease). However, as the volume of available sales transactions data increases and becomes generally known, it is anticipated that this more "objective" evidence will become the major source of identifying and measuring post-remediation stigma.

Alternative methods of identifying and quantifying stigma continue to be suggested. For example, Bruce Weber utilizes Monte Carlo techniques to develop a probability estimate of post-remediation stigma.ls

In addition, there are situations in which neither market sales nor market rental information relating to contaminated properties is available. In those circumstances, some authors (academics and practitioners alike) recommend the use of opinion survey research.16

SURVEY OF APPRAISER PRACTICE

During the summer of 1998, a four-page mail questionnaire was sent to a targeted, preselected group of 208 appraisers in the United States and Canada. The target group consisted of 192 appraisers in the United States and 16 in Canada. After five mail packages were returned as undeliverable, and nine were returned blank, a total of 194 potential respondents remained (183 in the United States and 11 in Canada). From this group, 86 usable responses were received: 81 from U.S. appraisers and five from Canadian, resulting in a 43% response rate. The survey questionnaire (see figure 1) was adapted from a lengthier, more detailed interview form developed by Paul J. Kennedy of Nottingham Trent University in England. The Kennedy questionnaire also served as the basis for a slightly shorter survey questionnaire developed by S. G. Bond at Massey University in New Zealand.17

Characteristics of Respondents

The first few survey questions identified the respondent's professional background and level of experience. Responses came from 29 U.S. states and two Canadian provinces. All but two of the U.S. respondents were licensed or certified in one or more states. Sixty-three (73%) of the respondents held the Appraisal Institute's MAI designation, followed by 43 who held the Counselors of Real Estate designation, 11 with the Appraisal Institute's SRA designation (some of whom were dually designated as MAIs), nine with the American Society of Appraisers designation, and three with the AACI designation conferred by the Appraisal Institute of Canada. Over half of the respondents (54%) reported more than 10 years' experience in appraising contaminated properties. Moreover, approximately 40% indicated more than 10 years' experience in identifying and measuring stigma. In brief, the respondents were both professionally qualified and experienced appraisers of contaminated property. It was therefore concluded that the sample of respondents and their responses could reasonably be accepted as representative of current practice in the United States (and Canada).

Approaches Used

As shown in table 1, a large number of respondents (65, or 80%) reported that they used the sales comparison approach whenever required data were available. (The percentage reported here and shown in the tables are calculated as the number of "yes" responses divided by total responses (n) to each particular question.) Moreover, respondents' comments indicated that many felt that the required data were generally available. Many respondents also indicated that they supplement the findings based on sales comparison analysis with opinion survey research, preferably with buyers and lenders.

Enlarge 200% Enlarge 400%

Enlarge 200% Enlarge 400%

Enlarge 200% Enlarge 400%

A large number of respondents reported using the income capitalization approach (64, or 79%). When asked for more details, 56 respondents (72%) reported that they used the direct capitalization technique, while 50 (64%) indicated that they applied discounted cash flow (DCF) models. Nearly 60% (49) reduced rental income to account for on-site contamination. At the same time, however, some comments indicated that a noticeable number of respondents found no impact on the rental income of contaminated properties that were used for commercial, retail, or industrial purposes. Several additional comments indicated that some respondents also used increased operating expenses when valuing a contaminated property.

Finally, the consensus of respondents (including information provided in the "Comments" section) was that it is most appropriate to value a contaminated property both with and without contamination present (unless specifically requested by a client not to do so).ls Most respondents (51, or 63%) calculate and deduct from unimpaired value the present worth of the cost to remediate plus a percentage deduction for stigma. At the same time, 42 (52%) indicated that on occasion they have deducted the total estimated cost to remediate without any discount. However, the latter procedure has been disfavored by state courts in the United States. One example is the Inmar decision in New Jersey.19 The comments of several respondents indicated that a property would not be marketable, and therefore have market value of zero, if the present worth of the cost to remediate exceeded the estimated market value as if uncontaminated.

None of the respondents indicated that they would refuse an assignment to value a contaminated property, reflecting their experience with such properties. Nearly 55% (45 of 82) indicated that they sometimes valued a property as if uncontaminated only, while including a disclaimer to this effect.20 The great majority (82%) stated that they applied "as if contaminated" procedures to only those properties known or suspected to be contaminated. Most striking was the fact that 71 respondents (87%) indicated that they would value the property "as contaminated."

Most respondents indicated that they use as many sources of information as are available to them (see table 2). The most frequently mentioned source of information about on-site contamination (74, or 90%) was reported to be the property owner or tenant, with the state list of contaminated properties second (70%).

Treatment of Disruptions in NOI

Table 3 indicates that 60 respondents (85%) reported on-site remediation activities as the major cause of any reduction or disruption in net operating income (NOI). This answer was followed by legal actions (69%) and post-remediation marketing (50%).

In measuring anticipated temporary gaps or interruptions in NOI, 77% of the respondents indicate that they would enter a reduced or zero NOI for specified periods in their DCF models. Less than half indicated that they usually increase the capitalization rate or discount rate (or both). This was substantially less than the number who indicated that they would increase one or both rates in valuing a contaminated property.

Treatment of Remediation Costs

All but one of the respondents said they would not ignore anticipated or forecast remediation costs in valuing contaminated properties. Some 60% indicated that they would deduct the present worth of total remediation costs estimated by environmental experts. That is reasonably consistent with the earlier answer to a similar question, in which 63% gave the same answer. Also, slightly over half of the respondents (52%) indicated that they occasionally deduct total estimated remediation costs from unimpaired value without taking into account the duration of the remediation process.

Enlarge 200% Enlarge 400%

Only about one-fourth of the respondents indicated that they can or would develop their own independent estimates of remediation costs. Indeed, nearly 80% reported that they accept, without independent verification, the estimates provided by licensed environmental engineers and technicians.

Identification and Measurement of Post-Remediation Stigma

While 73% of respondents report that they occasionally make a separate deduction for stigma, only 26% indicate that they do so as often as 75% of the time. The uncertainties and risks associated with cash flows from a contaminated property are most frequently reflected in decreased estimates of value via sales comparison analysis (73%), followed by an increased capitalization rate (66%) or an increased yield, or discount, rate (61%)-see table 3.

Respondents most frequently base their assessments of risk and uncertainty (stigma) on comparable sales evidence for properties both in similar locations and with similar contaminants (75%), followed by their own experience (55%) and Phase II environmental reports (53%). Further, many respondents' comments indicated that they adjust value for stigma "by all methods that the available data will allow." A substantial minority included comments that reductions in rental revenues were not necessary for commercial, retail, and industrial properties because (in their experience) such tenants are typically not affected by fear of on-site contamination (past or present).

Enlarge 200% Enlarge 400%

Enlarge 200% Enlarge 400%

Finally, only two respondents (3%) indicated that they ignore stigma entirely. The great majority (64, or 83%) rely on market sales transactions data to quantify stigma, while 51% rely on their experience. Over half seek the opinions of buyers, sellers, and brokers. Additional comments indicated that some respondents also rely on the opinions of lenders.

Identifying and measuring stigma was the most frequently mentioned concern of respondents providing comments. Nearly all respondents who made comments anywhere on the questionnaire want more and better market sales transactions data to support their estimates of stigma.

CONCLUSION

U.S. and Canadian appraisers are generally quite experienced in the valuation of contaminated properties. Moreover, they believe that the necessary market data are available to enable them to base their estimates of value as if contaminated (impaired value) on market sales transactions data, market rental data, and market-derived capitalization rates and discount rates. They are also remarkably self-confident about their skills and abilities to estimate the market value of contaminated properties competently and convincingly.

At the same time, respondents are inclined to rely heavily on licensed professional environmental engineers and technicians for estimates of both cost to remediate, and the duration, timing, and magnitude of the remediation process.

Few respondents who are experienced in the valuation of contaminated properties appear to believe that there is (or, indeed, should be) a single, standardized approach that is universally appropriate and recommended. This is indicated by the diversity of methods employed and the differences of opinion about how best to employ them, coupled with comments made throughout the questionnaire responses. 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 any given assignment. Generally, they believe that sufficient transactions data are available for effective use both in estimating the market value of contaminated properties and in measuring stigma. Nevertheless, they would like to see more and better data.

Finally, the U.S. and Canadian respondents generally believe in the existence of post-remediation stigma although many have reservations on specific points. A large proportion believe that stigma declines over time and is greatest when the on-site contamination is first discovered. Many respondents also believe that informed users tend to disregard the risks of post-remediation stigma whenever the property is continued in the same industrial or commercial use after the completion of remediation. Despite these beliefs, respondents mentioned the identification and measurement of stigma most frequently as an issue requiring further investigation and research.

Most appraisal practitioners who responded to the survey questionnaire are reasonably content with the procedural tools and techniques at their disposal. Faced with the necessity to communicate their findings to others (most particularly clients and courts), they appear to recognize that methodological nicety and "sophistication" are often achieved at the cost of reduced understanding on the part of decision-makers seeking to use the results of the appraiser's analyses. The fine and fragile line between statistical, conceptual, and perceptual purity on the one hand and cost-effective usefulness on the other is apparently recognized and acknowledged by those who practice the art of valuation/appraisal. It needs to be appreciated as well by those who critique, evaluate, and add to the ever-expanding kit of tools potentially available to the practitioner.

[Author Affiliation]

William N. Kinnard, Jr., MAI, SRA, PhD, is president of the Real Estate Counseling Group of Connecticut, Inc., and professor emeritus of finance and real estate, University of Connecticut, Storrs. His practice includes valuation of contaminated properties, estimation of post-remediation stigma and proximity impact studies. He testifies frequently on the results of his research findings. Dr. Kinnard has published frequently in The Appraisal Journal, and other professional and academic journals in the United States, Canada, the United Kingdom, New Zealand, and Australia. Contact: recgc@mail.snet.net.

Elaine M. Worzala, PhD, is associate professor of finance and real estate at Colorado State University, Fort Collins. Her research interests include institutional investments, international real estate investments, valuation issues, and the professional behavior of real estate appraisers. She has published on these and related topics in The Appraisal Journal, and other professional and academic journals in the United States, Australia, and the United Kingdom.