The risk approach: A step-by-step plan for a clean valuation. (International Appraising).
Contaminated property depresses prices, carries financial risks, and can influence the size of the market, that is, the marketability of immovable property, land, and buildings. Three issues in particular that play key roles in this respect are the probability and financial consequences of
* The existence of soil contamination
* Decisions about whether or not to remediate
* Adverse effects on use value
Is the soil contaminated? Should it be remediated? Will its contamination have an adverse effect on the use value of the site? These are questions that the property valuer needs to answer before he can ascertain the value of a contaminated object. The valuer's main problem is twofold: he is neither sufficiently versed in soil contamination nor can a soil consultant be of much assistance since in most cases no adequate soil survey has been conducted--at least in the mind of the soil consultant.
With the aid of the risk approach, however--a methodology for valuing contaminated property (1)--it is possible to determine at an early stage in the soil survey how much environmental damage to deduct from the definitive value of the contaminated property. This valuation method differs from the commonly used "traditional" cost approach by considering not only the survey and clean-up costs but also assessing the need for remediation and the risks closely linked to soil remediation. This is illustrated by the following example.
It is the year 2000. The object being valued is a garage with a service and repair shop and a showroom with the accompanying warehouse. The valuation is to determine the proper amount of financing in light of plans for expansion and added construction. However, the exact date for these plans has not yet been set; construction will probably not start until five years down the road.
Preliminary and detailed soil surveys are available for the location. These show serious contamination and an urgent need for cleanup. However, calculations and an order from the provincial authorities show that remediation is not required until 2015 (after 15 years), according to the Dutch Soil Protection Ace (2) [Wet Bodembescherming Wbb].
Notional Clean Soil. Property Valuer A appraises the value of the object on the basis of "notional clean soil." He arrives at an open or fair market value of [euro]500,000 when sold by private treaty and a liquidation or forced-sale value of [euro]425,000. Since he has indications of soil contamination but does not know how to value this "environmental damage," he establishes that the aim of the valuation will be unachievable unless a separate survey is conducted on the quality of the soil. He advises his client to have the soil quality surveyed by way of obtaining the relevant environmental information (possibly including information on environmental law).
Traditional Cost Approach. Property Valuer B asks a soil consultant how much the necessary remediation would cost. Assuming--given the current Dutch laws and regulations (4)--that all the pollution is removed from the soil, it would cost some [euro]200,000 according to the consultant's estimates. The valuer takes these costs as a "technical defect" that needs to be remedied and subtracts them from the value of the site in clean condition ("notional clean soil") by giving them a cash value. He uses a "traditional" cost approach where:
[FMV.sub.contaminated] = [FMV.sub.remediated] - [K.sub.f]/[1.04.sup.t]
[FMV.sub.contaminated] = fair market value in contaminated condition
[FMV.sub.remediated] = fair market value after remediation or on the basis of "notional clean soil"
[K.sub.f]/[1.04.sup.t] = "net present value" of the estimated remediation costs over t years at a net interest rate of 4% in this case
He, therefore, comes to a value of [euro]388,950 rather than [euro]500,000 when sold by private treaty.
Risk Approach. Property Valuer C takes account of the revised Dutch soil remediation policy (5) with function-oriented and cost-effective remediation as its premise, meeting the criteria relating to the purpose for which the soil is to be used ("suitable for use") (6) This is much more economical than multifunctional remediation: [euro]75,000 instead of [euro]200,000 according to the soil consultant's report. Moreover, he also values the uncertainty and risks that are closely linked to the present soil contamination, (1) including for this case:
* Measuring risk--The chance that the amount of soil and groundwater that needs to be remediated is more (or less) than estimated or calculated. The measuring risk depends on the amount and quality of the information available.
* Norm risk--This risk has to do with the aim of the cleanup and the rededication levels--what may not be cleaned up on the basis of certain functions but rather is subject to multifunctional remediation (or vice versa)? This can make a big difference in the costs.
* Time risk--The risk of remediation needing to take place earlier than planned (or that may be left for later). Plans for expansion and construction may be one reason.
This comes down to the following deductions for remediation costs and risks: (7)
[euro]75,000/[1.04.sup.15]= [+ or -][euro]41,645
- measuring risk
0.30 x [euro]75,000/[1.04.sup.15] = [+ or -][euro]12,495
- norm risk
0.10 x ([euro]200,000 - [euro]75,000)/ [1.04.sup.15] = [+ or -] [euro]6,940
- time risk
0.90 x [euro]25,000/[1.04.sup.5] = [+ or -][euro]18,495
Total [+ or -][euro]79,575
The valuation of the direct remediation costs takes place as set out above. They are then converted into cash values. The valuation of the measuring risk is based on the accuracy (or lack thereof) of the estimated cleanup costs, which are also connected with the amount of information available-a preliminary and a detailed soil survey. They are estimated at 30% in accordance with a risk analysis method for certainties and doubts in surveys and estimated remediation costs (8) (see pages 27 and 29 below). Given the site's use and in light of the revised soil remediation policy, the chance of multifunctional remediation being mandatory-with no option for a function-oriented and cost-effective remediation (norm risk)-is virtually nil: 10%. On the contrary, it is almost certain (90%) that the plans for expansion and construction will be realized between now and five years and that at least a partial cleanup will, therefore, have to take place earlier than calculated (time risk). By modifying certain aspects of the plans and bringing them into line with the contamination situation, a partial cleanup will suffice: one third of the total remediation, thus [euro]225,000 rather than [euro]275,000. Property Valuer C, therefore, comes to a deduction of [euro]279,575. That is a difference of [euro]231,475 from Property Valuer B's total.
Which Valuation Is Right?
That depends on the aim of the valuation and the way in which the job is formulated. A valuation report is made to inform the client about the value of the property. (9) The client or a third party uses this information to make a decision, e.g., to buy or sell. In this case the aim is to determine how much financing would be appropriate for the garage's plans to expand. Rather than being an island unto itself, the valuation is a link in the client's decision-making process. (9) The valuer will, therefore, project himself into the client's situation and will need to know what role the report--and in this case about the soil contamination--will play in the decision-making process. Property Valuer C goes even beyond that in his thinking as he also offers room for alternatives.
The risk approach that he applies creates space for the input of others--in this case from a soil consultant. That input is necessary since now and in the future, clients will no longer accept having property valued on the basis of "notional clean soil." Given the change in direction in the Dutch remediation policy, (5) nor will they be likely to take a maximum deduction from the cleanup costs using multifunctional remediation ("traditional" cost approach) as the basis. The valuation of contaminated property requires tailored work in which the appraiser takes into account uncertainties in the surveys and in the estimated cleanup costs. The risk approach, therefore, constitutes an important instrument and is indispensable for a clean valuation.
How Does the Risk Approach Actually Work?
The risk approach is a step-by-step plan that serves as a practical guide for establishing the value of contaminated property. It includes five different steps: (1)
* Step 1 Valuation of the immovable property on the basis of "notional clean soil" using traditional valuation methods. This could be the sales comparison approach, income approach, or cost approach.
* Step 2 Valuation of the direct damage, including building damage and damage as a result of use restrictions. Soil contamination can be a reason for limiting the property's uses temporarily or for longer periods of time, which can lead to lost income. It also can be a cause for damage to the underground infrastructure, cables and pipes, sewer system, and foundation. Building damage and damage as a result of use restrictions are valued using a simple environmental risk checklist (ERC) as part of the risk approach.
* Step 3 Valuation of liabilities and obligations with respect to the contaminated soil and/or groundwater. This may have to do with one's duty to conduct a survey or undertake remedial action. It is important in this respect to differentiate between legal and contractual liability.
* The legal liability is based on the Dutch Soil Protection Act [Wet bodembescherming Wbb]. One of the main questions concerned with soil pollution is whether or not someone can get a survey and/or cleanup order. The latter can be given to only polluters and so-called guilty owners and long leaseholder (10) (Figure 3).
* The position between buyer and seller is not only settled in a contract but also based on the Dutch Civil Code [Burgerlijk Wetboek BW]. It concerns, for example, their mutual obligation to inform each other about possible soil contamination. Conformity and nonconformity of the property plays a major role.
Furthermore, questions are raised, such as whether or not a building licence and/or a permit will be given according to the Environmental Management Act. If not, there are additional use restrictions.
* Step 4 Valuation of the costs and risks of soil survey and remediation. This has to do with the costs of field and lab work--removing, transporting, and processing contaminated soil and pumping up, treating, and discharging contaminated groundwater. Furthermore, uncertainties in the survey and in the cleanup, as well as related financial and other risks, play a role. Differences can be drawn between the measuring risk, cost risk, norm risk, residual risk, and time risk--a few of which were described above.
Risks are thereby defined as "the undesirable effects of a certain activity or event connected to the chance that this will happen." (11) For the distinguished risks and the risk approach, the following questions are always asked, based on regular risk analysis: (12)
1. What could happen? (scenario s)
2. How likely is it that it will happen? (probability p)
3. And if it happens, what would be the consequences? (effect e)
As such, it is a very technically-oriented definition. Psychological research, however, shows that in many cases it is not probability but controllability that is the key to determining the risks of executing or undergoing certain activities and events. (11)
* Step 5 Valuation of the stigma-effect. This is the drop in value of the property compared with the same property in a non-contaminated condition, in so far as that is nor caused by recognizable costs and risks that occur in response to the contamination. The stigma-effect (SE) is considered to be a multiplier for the risks (R) involved:
SE X ([R.sub.m]+[R.sub.c]+[R.sub.n]+[R.sub.r]+[R.sub.t])
In many cases, however, stigma has little relationship to cleanup costs. (13)
Real and Perceived Risks
The step-by-step plan above shows that the risk approach takes into account both real damage and risks (e.g., survey and remediation costs) and perceived damage and risks (e.g., stigma-effect). The literature indicates, however, that a mathematically-derived conclusion on the effect of soil contamination often does not correspond with the opinion of the public at large (14) and that the damage or difference between the value before and after contamination does not equal the costs to cure.
Adverse public perception about a property is intangible or not directly quantifiable (15) but has an additional impact on value over and above the costs and risks of survey and remediation. (16) Damage, therefore, is the sum of the costs for soil survey and soil remediation, loss of income due to use restrictions, plus a stigma-effect. It can be described mathematically by:
[V.sub.d] = [V.sub.c] - [C.sub.s] - [C.sub.r] - restrictions - stigma where
[V.sub.d] = Value dirty
[V.sub.c] = Value clean
[C.sub.s] = Costs for soil survey
[C.sub.r] = Costs for soil remediation
Practice in the Netherlands indicates that stigma plays a major role, especially for housing where, in extreme situations, stigma-related losses can virtually destroy a property's value--for example, when a polluted residential quarter attracts large media attention. In the case of commercial real estate (e.g., business parks and industrial sites), stigma seems to play a minor role. For most private companies the main problem is whether they can bear and/or finance the costs involved with the soil contamination. It can be the reason for a higher interest rate and/or a lower loan-to-value ratio and consequently cause additional financing costs and risks. (16)
At the moment stigma, risks, and risk-defining factors concerning remediation costs are subject to further scientific research. Although the risk approach may not be completely finished yet (as mentioned in the introduction, it is a first move in a new direction), it has proven to be an important instrument for valuers, as well as for soil consultants. It helps them to communicate with one another.
The soil consultant's task is not only to estimate the costs for soil survey and remediation but also to determine the financial risks involved because the original costs are often exceeded. The valuer's principal task may be to provide an opinion of the additional impact, if any, arising from the stigma-effect associated with the site in the marketplace before, during, and after the cleanup process.
In the Netherlands the risk approach is more and more accepted by valuers, real estate agents, bankers, and lawyers for valuing, buying and selling, financing, and contracting. The main reason is that it not only takes costs for soil survey and soil remediation into account but also the financial risks closely linked to soil contamination, as well as legal and contractual liabilities.
In the future it may become an indispensable tool when urban redevelopment becomes one of the main issues for the Dutch real estate market. That means buying, selling, and deliberately redeveloping more or less contaminated sites in accordance with the revised Dutch soil remediation policy which no longer requires removing all pollution in all cases. A valuation of contaminated property on the basis of "notional clean soil" will, therefore, no longer be accepted despite the risks involved. This demands further knowledge of the market, the value, and valuation methods for contaminated property.
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[FIGURE 2 OMITTED]
[FIGURE 3 OMITTED]
Table 1 Damage Through Soil Contamination 1. Direct damage and costs, * Removing, transporting, including: and processing contaminated soil * Pumping up, treating and discharging contaminated groundwater 2. Indirect damage and costs, * Soil survey including: * Procedures, fees and permits * Demolishing and reconstructing buildings * Use restrictions 3. Immaterial damage (stigma), * Annoyance and fuss including: * Image * Uncertainties * Market resistance
(1.) J.S. Van de Griendt, Waarde Vervuild Vastgoed--Stappenplan voor een Zuivere Taxatie [The Value of Contaminated Property--A Step-by-Step Plan for a Clean Valuation] (Amsterdam: WEKA Law & Finance Publishers, 1999).
(2.) The Dutch Soil Protection Act speaks of a case of serious contamination when the mean concentration exceeds the so-called intervention value of at least one substance in at least 25[m.sup.3] of soil volume in the case of soil contamination or 100[m.sup.3] pore saturated sail volume in the case of groundwater contamination, If there is a case of serious contamination, the competent authority has to decide whether remediation is urgent and the deadline by which the remediation has to start. The determining factors are the actual risks for humans and ecosystems at the contamination site, as well as the risk of dispersion.
(3.) B. Mundy, MAI, "The Impact of Hazardous Materials on Property Value," The Appraisal Journal (April 1992): 155-162.
(4.) The present Dutch formal policy on cleanup, as set out in the cleanup regulations of the Soil Protection Act, is based on the complete removal of the soil pollution. This means restoring the so-called multifunctionality of the soil for use by humans, flora, and fauna. Only under circumstances specific to a given site is it possible to depart from this cleanup objective and take measures that result in isolation, control, and monitoring of the pollution (ICM cleanup).
(5.) "Cabinet Position on Updating the Dutch Soil Remediation Policy--Based on the Interdepartmental Remediation Policy Study: The Soil Remediation Policy Update," Second Chamber, (1996/1997): 25411, no. 1 d.d. (16 June 1997).
(6.) "Suitable for use" means satisfactorily preventing exposure to contaminated substances and satisfactorily counteracting the spread of contaminating substances, according to "From Funnel to Sieve--The Remediation Goal Appraisal Process," (The Hague: Ministry of Housing, Spatial Planning and Environment d.d., 15 October 1999).
(7.) This example does not take into account the effect of partial remediation over five years on the cash value of the remediation costs and the different risks. However, partial remediation would indeed affect their extent.
(8.) J.S. van de Griendt, "Bodemverontreiniging en Vastgoedontwikkeling--(On)zekerheden in Onderzoek en Geschatte Saneringskosten" ["Soil Contamination and Property Development--Certainties and Doubts in Surveys and Estimated Remediation Costs"] Bodem [Soil] no. 4 (1997): 164--166.
(9.) G.G.M. ten Have, Handboek Taxatieleer Onroerende Zaken [Han dbook on Immovable Property Valuation] (The Netherlands: Houten: Stenfert Kroese/Educational Partners, 1992).
(10.) An order to take remedial action, according to the Dutch Soil Protection Act, shall not be given to the owner or long leaseholder of the property if this person shows that he (a) had no sustainable legal relationship with the polluter or polluters during the period in which the contamination was caused, (b) has had no direct or indirect involvement in the cause of the contamination, and (c) was not aware or in all fairness could not have been aware of the contamination at the moment of acquiring the title to the property.
(11.) J.C. Hanekamp and W. van Haren, Normering en Risico's in Watenschappelijk Perspectief [Normalization and Risks in a Scientific Perspective) (Amsterdam: Stichting Heidelberg Appeal Nederland, 1998).
(12.) S. Kaplan and B.j. Garrick, "Risk Analysis," Journal of Risk Analysis, no. 1 (1981): 11-27.
(13.) P.J. Patchin, MAI, "contaminated Property--Stigma Revisited," The Appraisal Journal (April 1991): 169.
(14.) B. Mundy, MAI, "Stigma and Value," The Appraisal journal (January 1992): 7-13.
(15.) R. Roddewig, MAI, "Stigma, Environmental Risk and Property Value: 10 critical Inquiries," The Appraisal Journal (October 1996): 375-387.
(16.) R. Bell, MAI, "The Impact of Detrimental conditions on Property Values," The Appraisal Journal (October 1998): 380-391.
RELATED ARTICLE: Impact of Soil Contamination on Property Value
The harmful effects of soil contamination occur in phases. In general, an appraiser can distinguish seven different phases ranging from the problem's inception to its resolution: (1,3)
3. Survey I
4. Survey II
5. Coming to terms
In the first phase, the seemingly blissful state of ignorance is cruelly upset upon the sudden discovery of contamination. Even rumors or the suspicion of contamination can give rise to a strike among buyers and form an obstacle for city and rural planning and economic development. In Survey Phase I, contamination is already suspected; this in turn can be either confirmed or dispelled. In Survey Phase II, the nature and extent of the contamination is mapped.
Another distinction between "phases of contamination" can be made by using the various soil surveys, which in the Netherlands are generally conducted in the following order:
0. No Survey (NS)
1. Historical survey (HS)
2. Preliminary survey (PS)
3. Detailed survey (DS)
4. Remediation survey (RS)
5. Remediation plan (RP) and specifications (S)
6. Remediation (R)
The first estimate of the remediation costs often has to wait until a detailed survey has been conducted and the extent of the contamination has been established. Nevertheless, it might be desirable to estimate the costs purely on the basis of an historical or preliminary survey--or even before a single survey is conducted. Each new survey phase that is completed (historical, preliminary, detailed, etc.) can then provide more clarity about the contamination situation and sharpen the estimate on the remediation costs. The question in this respect is what certainties and doubts are at play in the estimated remediation costs.
Certainties and Doubts in Surveys and Estimated Remediation Costs
The first estimate of the remediation costs often has to wait until a detailed survey has been conducted and the extent of the contamination has been established. Nevertheless, it might be desirable to estimate the costs purely on the basis of an historical or preliminary survey-or even before a single survey is conducted. Each new survey phase that is completed (historical, preliminary, detailed, etc.) can then provide more clarity about the contamination situation and sharpen the estimate on the remediation costs. The question in this respect is what certainties and doubts are at play in the estimated remediarion costs?
To answer this question I set out in search of a financial risk analysis method that could be used in the property market-for instance, for property development--and whereby practical, real-life certainties and doubts would be applied. (1,7) I chose a method based on an 80% degree of certainty, which is acceptable for the real estate market, so that the actual remediation costs would fall within the upper and lower limits of the survey estimates. This can be shown in a formula as follows:
P[R[C.sub.e] X 0.5 < R[C.sub.a] < 1.5 x R[C.sub.e]] = 80%
There is thus an 80% probability (P) of the actual remediation costs (RC) turning out more than half; yet less than one and a half times the estimated remediation costs (RC) on the basis of the soil survey. Due to variances in the available information, the reliability intervals may differ from survey to survey. That is the result of different objectives being used and discrepancies in how much has been measured, to mention just a few possibilities. This needs to be taken into consideration in assessing the financial risks. These, in turn, can be formulated as follows:
P[R[C.sub.e] X (1-A) < R[C.sub.a] < (1 + A) x R[C.sub.e]] = 80%
Here A is the factor of certainty and doubt, which not only depends on the kind of soil survey performed, but also on the sort of contamination, soil conditions, and the geohydrological situation. In the absence of a survey, A is up to a maximum. If remediation has taken place, A is down to a minimum. For immobile substances like heavy metals and polycyclic aromatic hydrocarbons, A is much smaller than for mobile substances like mineral oil and aromatic and chlorinated hydrocarbons. The value of A can be determined using expert guesses and/or case studies. (1,8) Figure 1 gives an example graphically.
Bas van de Griendt is a soil consultant for the real estate market at Royal Haskoning in Amsterdam. He is the author of the book Waarde Veruild Vastgoed--Stappenplan voor een Zuivere Taxatie [The Value of Contaminated Property--A Step-by-Step Plan for a Clean Valuation], first published in 1999 by WEKA Law & Finance Publishers, Amsterdam. Last year a second revised edition was published by Ten Hagen Stain, The Hague (ISBN 9044000942). Contact: 00 31 (0) 20 5697796 or 00 31 (0) 6 53576399, fax 00 31 (0)20 5697766, e-mail firstname.lastname@example.org.
George G.M. ten Have edited the above mentioned book and penned the first (and so far only) Dutch handbook on immovable property valuation: Handboek Taxatieleer Onrooerende Zaken [Handbook on Immovable Property Valuation]. He is director of estate agents at Boer Hartog Hooft Makelaardij in Amsterdam. Contact: 00 31 (0)20 5405515 fax 00 31(0)20 6464536, e-mail email@example.com.
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|Title Annotation:||valuation of contaminated property|
|Author:||Griendt, Bas van de; George, G.M.|
|Date:||Jan 1, 2003|
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