LESSON 7. Valuation Techniques for Impaired Properties

Transcription

1 LESSON 7 Valuation Techniques for Impaired Properties Assigned Reading All assigned readings are available under "Online Readings" on your Course Resources webpage. 1. UBC Real Estate Division BUSI 452 Course Workbook. Vancouver: Real Estate Division. Lesson 7: Valuation Techniques for Impaired Properties 2. Syms, P.M. and Weber, B.R. "International approaches to the valuation of land and property affected by contamination" RICS Foundation, Research Review Series, August, Outlines issues in contaminated property valuation in the UK, USA, and Pacific Rim. 3. Jackson, T.O "The Effects of Environmental Contamination on Real Estate: A Literature Review". Journal of Real Estate Literature. 9(2). pp Outlines appropriate methods for valuing contaminated property from studies, showing inconsistent opinions on the price impacts, persistence, and other environmental contamination factors. 4. Jackson, T.O "Mortgage-Equity Analysis in Contaminated Property Valuation". Appraisal Journal. 65(1). pp Measuring value diminution through the Ellwood and DCF procedures considering the unique risks associated with environmental contamination. 5. Public Works and Government Services Canada (PWGSC) Valuation Guidelines, IC4 Environmental Impacts. Website publication posted by the Office of the Chief Appraiser, PWGSC. Explains the roles and responsibilities of the appraiser, environmental liability law, methods for valuation of contaminated properties, and reporting results to limit the appraiser's liability. 6. UBC Real Estate Division Microsoft Office Excel "Mortgage-Equity Analysis.xlsx". Recommended Reading Selected recommended readings can be found under "Online Readings" on your Course Resources webpage. 1. Epley, D.R "Reconsidering the Definition of Highest and Best Use: The Case for a Post- Disaster Highest and Best Use". Real Estate Issues. 35(2). pp Discusses a new disaster HBU concept and use of contingent valuation in post-disaster appraisals. 2. Jackson, T.O "Real Property Valuation Issues in Environmental Class Actions". Appraisal Journal. 78(2). pp Discusses the scope of work and recommended methodology in environmental class actions. 7.1

2 Lesson 7 3. Mitchell, P.S "Estimating Economic Damages to Real Property Due to Loss of Marketability, Rentability, and Stigma". Appraisal Journal. 68(2). pp Provides a simple statistical model to estimate financial or economic damages to impaired real property. 4. Jackson, T.O "When Good Things Happen to Bad Properties". Appraisal Journal (2). pp Discusses the recovery of market value as contaminated properties move through the remediation process, and environmental risk and stigma are reduced or eliminated. 5. Weaver, W. and Michelson, S "A Practical Tool to Assist in Analyzing Risk Associated with Income Capitalization Approach Valuation or Investment Analysis". Appraisal Journal. 71(4). pp Presents a simple Excel model that provides a measure of the risk in a discounted cash flow model. 6. Healy, J.J. Jr. and Teetsel, J. "Unbundling the Cash Flow: Beyond the Property Internal Rate of Return". Appraisal Journal. 60(3). pp Provides analysts with a method to develop a risk-adjusted rate of return. 7. Hayse, J.W. "Using Monte Carlo Analysis in Ecological Risk Assessments". Argonne National Laboratory, October 27, Introduces the use of Monte Carlo Analysis in ecological risk assessments which can also be applied to financial risk assessments for contaminated property valuation. 8. Anderson, O.C "Environmental Contamination: An Analysis in the Context of the DC Matrix". Appraisal Journal. 69(3). pp Bond, S.G; Kinnard, W.N. Jr; and Worzala, E.M "An International Perspective on Incorporating Risk in the Valuation of Contaminated Land". Appraisal Journal. 69(3): pp Examines the uncertainty of the effect of contamination on property values, from an international perspective. 10. Jackson, T.O "Environmental Contamination and Industrial Real Estate Prices". Journal of Real Estate Research. 23(1/2). This paper examines the effects of environmental contamination on the sales prices of industrial properties. Data in this study indicated that the price effects of contamination do not persist subsequent to remediation and cleanup. 11. Jackson, T. and Bell, R "The Analysis of Environmental Case Studies". Appraisal Journal. 70(1). pp Due to growth in the number of sales of environmentally impacted properties, there is now sufficient market sales data for use in estimating effects of environmental contamination of real property value. This article maintains that, when properly selected and analyzed, case studies can provide useful information for analyzing environmentally impacted properties. 12. Sanders, M.V "Value Diminution as a Measure of Real Property Damages". Orange County Lawyer. February pp.8-9. Illustrates the practicality of measuring value diminution resulting from impairment using market-based information. 7.2

3 Valuation Techniques for Impaired Properties 13. Sanders, M.V "Post-Repair Diminution in Value from Geotechnical Problems". Appraisal Journal. 64(1). pp A framework for the valuation of properties damaged by geotechnical or related defects, specifically residual stigma after repair. 14. Flynn, J "A Survey Approach for Demonstrating Stigma Effects in Property Value Litigation". Appraisal Journal. 72(1). pp Advice on providing court-acceptable valuation analysis and survey techniques. 15. Greenberg, Michael; Hollander, Justin "Neighborhood Stigma Twenty Years Later: Revisiting Superfund Sites in Suburban New Jersey". Appraisal Journal. 74(2). pp Illustrates the need to monitor over time for signs of change in stigma effect. 16. Jackson, T.O "Case Studies Analysis: Environmental Stigma and Monitored Natural Attenuation". Appraisal Journal. 72(2). pp Showcases the use of case studies in the valuation of impaired or contaminated properties. 17. Jackson, T.O "Evaluating Environmental Stigma with Multiple Regression Analysis". Appraisal Journal. 73(4). pp Alleged odour impacts on residential properties. 18. Siemens, H "Stigma of Contaminated Land Difficult to Tackle". Appraisal Journal. 71(2). pp Examines stigma in the context of the Netherlands. 19. Mathews, K.E "Under the Microscope: Dissection of a Contingent Valuation Survey". Appraisal Journal. 76(3). pp An evaluation of the contingent valuation approach "a survey-based approach that attempts to create a hypothetical market for a good or service" in the valuation of contaminated properties. 20. Roddewig, R. and Frey, J.D "Testing the Reliability of Contingent Valuation in the Real Estate Marketplace". Appraisal Journal. 74(3). pp Outlines the strengths and weaknesses of contingent valuation. 21. Wilson, A.R "Contingent Valuation: Not an Appropriate Valuation Tool". Appraisal Journal. 74(1). pp Debates the relevance of the contingent valuation approach for contaminated properties. 22. Fishman, K "Comments on 'Contingent Valuation: Not an Appropriate Valuation Tool'". Appraisal Journal. 74(3). p The debate on the relevance of this valuation approach continues. This reference also includes letters to the editor from Simons, R.A. (pp ) and Austin, G.W. (pp ) and a response from Wilson, A.R. (pp ). The footnotes in this lesson provide additional recommended readings you may wish to review. 7.3

4 Lesson 7 Learning Objectives After completing this lesson, students should be able to: 1. explain the rationale underlying the valuation analysis of impaired property; 2. discuss the methods available for the valuation of impaired property; 3. review an impairment situation and determine an appropriate approach to following in valuing the property; and 4. carry out the proper steps to value an impaired property using the cost approach, direct comparison approach, and income approach, applying a variety of applicable techniques within each. Instructor's Comments Real estate values can be estimated through the application of the three traditional approaches to value. However, when real estate is impaired, additional and often more complex analysis is required. Before considering the specific valuation techniques, it is first important to consider the concept of fee simple ownership and the principles of conformity and regression, as these concepts form the theoretical base for valuation of impaired properties. Fee simple is the most complete form of ownership that includes all of the bundle of rights, subject only to the limitations imposed by the governmental powers of taxation, expropriation, police power, and escheat. 1 Regression. Property values are negatively affected when surrounding properties are of lesser value. It is not a good idea to develop your property into the most expensive property in your neighbourhood because you will usually suffer financially upon sale. Conversely, property values are positively affected when surrounding properties are of greater value. Conformity. Optimal property values occur when properties within a neighbourhood conform to each other. There is a significant market for both impaired and remediated properties. Points to consider include the following: General market conditions are significant. Reaction is different in buyers' and sellers' markets. If impaired, the path to successful remediation must be predictable and reasonably certain. Organic impairments are usually less expensive to control or remediate than are inorganic impairments. The market's perception of acceptable risk may differ from numeric standards. 1 Appraisal Institute (US) and Appraisal Institute of Canada Appraisal of Real Estate, Third Canadian Edition. Vancouver: UBC Real Estate Division. p

5 Valuation Techniques for Impaired Properties Purchasers behave logically. Many purchasers are experienced in remediation sites and they believe that costs will be considerably less than that estimated by consulting engineers. If the remediated property meets all standards that either presently or are expected to exist and if contamination is not likely to recur on the remediated property, then financing can normally be obtained with standard terms although a loan origination fee may be higher. Evaluating Market Behaviour: Valuation Methods There is no clear answer as to which valuation approach is most appropriate in any given situation. The appropriate methods for valuing contaminated property continue to be debated in the appraisal literature. This debate is illustrated in the reading "The Effects of Environmental Contamination on Real Estate: A Literature Review", as well as the RICS research paper "International Approaches to the Valuation of Land and Property Affected by Contamination". The two readings give context for the valuation discussions in the rest of this lesson. The following valuation methods will be explored in this lesson: Cost Approach Direct Comparison Approach Paired sales analysis Impaired sales comparables Sale/resale analysis Environmental case studies Multiple regression analysis (MRA) Income Approach Direct capitalization - Band of investment analysis Discounted cash flow - Mortgage-equity (DCF) analysis Monte Carlo-Based Method (probabilistic risk analysis) Market Surveys Formal and Informal surveys Contingent valuation, conjoint analysis, and perceived diminution 7.5

6 Lesson 7 Cost Approach In applying the cost approach for an impaired property, the appraiser will use data with and without the costs and losses associated with the impairment. The approach deducts costs or losses associated with each stage from the unimpaired value. Table 7.1 shows the basic calculations employed by the cost approach. Table 7.1: Cost Approach and Impaired Property Valuation STAGE POINT RELATIONSHIP Unimpaired value Minus: A Point A relates to the estimate of market value as if unimpaired. Assessment stage value effects: Cost and responsibility B to C Point B relates to the estimate of value upon Use realization that an impairment has occurred. Risk (uncertainty factor) Minus: Repair stage value effects: Cost and responsibility Use Risk (project incentive) Minus: Ongoing stage value effects: Cost and responsibility Use Risk (market resistance) Equals impaired value C to D D to F Point C relates to the estimate of value upon assessment of situation. Point D estimate of value upon the condition being repaired or otherwise resolved. Point E relates to the estimate of value upon considering any ongoing costs. Point F relates to the estimate of impact of any residual market resistance. Each stage requires consideration of costs and responsibility for those costs, effects on use, and risk. These are described in Table 7.2 as they relate to the impaired cost approach. Table 7.2: Costs to Consider ASSESSMENT STAGE REPAIR STAGE ONGOING STAGE Cost and responsibility: engineering studies laboratory analysis legal oversight governmental oversight and fees contractor estimates, etc. Use: many factors e.g., dangerous impairment may prevent use income properties show effect on income, vacancy, operating expenses Risk (uncertainty factor): affected by confidence in above analysis for cost and use Cost and responsibility: direct repair remediation increased expenses additional security moving tenants carrying costs contingencies rebuilding, etc. Use: many factors e.g., disruptive impairment may limit use income properties show effect on income, vacancy, operating expenses Risk (project incentive): affected by confidence in above analysis for repairs Cost and responsibility: monitoring wells additional security operations and maintenance Use: permanent effect altered use income properties show effect on income, vacancy, operating expenses Risk (market resistance): affected by confidence in above analysis for ongoing 7.6

7 Valuation Techniques for Impaired Properties The following example demonstrates the application of the impaired cost approach: A property in an unimpaired state has a market value of $475,000. Assessment costs are $5,000. Repair stage costs are $75,000. Ongoing costs are $4,000. Market resistance (part of ongoing stage) is $15,000 (market evidence is analyzed to estimate this figure). The property owner is not responsible for $50,000 of the costs. Cost calculations are as follows: Unimpaired Value $475,000 Less: Assessment stage (5,000) Repair stage (75,000) Ongoing stage (4,000) Market resistance (risk) (15,000) Plus: Costs owner not responsible for + 50,000 Impaired Value $426,000 This approach is analogous to the land development approach of vacant land valuation where the utility of a specific property, rather than comparison with a group of comparable sales, is analyzed. The underlying hypothesis of this approach is that the value of the subject property at point B is the unimpaired market value of the subject property minus costs of the following stages: Assessment Repair Ongoing Market resistance (stigma) Compare the Bell approach with the land development approach as shown on the following table: STAGE BELL LAND DEVELOPMENT Start Unimpaired Value Gross selling price of lots 1 Assessment costs Marketing and engineering studies, approval costs 2 Repair costs Construction and financing costs 3 Ongoing costs (continuing) Selling costs (finite) 4 Stigma (varies with risk) Entrepreneurial incentive (varies with risk) Direct Comparison Approach The direct comparison approach utilizes market data with and without the impaired condition. Paired Sales Analysis When there is sufficient data, a paired sales analysis can provide a compelling analysis on whether an impairment exists, and the diminution in value, if any, due to an impairment. An example of this method would be a comparison of impacted properties at Points B, C, D, E, or F in the detrimental condition model (paralleling the value stage of interest for the subject property) and unimpaired properties. In the following example, the comparable properties are described as being within the "test areas" and the unimpaired properties are described as being within the "control areas". 7.7

8 Lesson 7 Figure 7.1: Bell's Detrimental Condition Model, expanded Source: Bell (1999) as modified. For example, refer to Property 1 of Table 7.3, one of five sales located in the test area near a sewage treatment plant, to estimate if the presence of the plant has an impact on market value. Property 1 sold for $495,000. Three indices in a control area that is similar in all major respects to the test area except that they do not have the sewage treatment plant impairment of the test area, sold for $600,000, $585,000, and $580,000. The overall indication from these three unimpaired sales is that the unimpaired market value of Property 1 would be +$588,000. The implication of this analysis is that the market value of Property 1 suffers a 15.8% loss due to its proximity to the sewage treatment plant. The overall indication of this study is that properties located near the sewage treatment plant suffer a loss in market value of 11% to 18% due to this impairment. Test Area with Impairment Table 7.3: Paired Sales Analysis Control Area Sales with No Impairment Sale 1 Sale 2 Sale 3 Indication from Control Area Indices % Loss Property 1 $495,000 $600,000 $585,000 $580,000 $588, % Property 2 $525,000 $590,000 $605,000 $575,000 $590, % Property 3 $490,000 $570,000 $600,000 $585, % Property 4 $505,000 $580,000 $605,000 $592, % Property 5 $485,000 $590,000 $590, % With sufficient relevant market data, this analysis can result in a measurable and consistent difference between the two sets of market data indicating that an impairment exists. The absence of a significant difference between the two sets of data indicates that an impaired condition may not exist. Theoretically, the ideal pairs of sales are those that are identical in all respects except for the one characteristic being measured. To be theoretically pure, as in the example above, all five properties within 7.8

9 Valuation Techniques for Impaired Properties the test area were identical in all respects (e.g., sale date, site size, building size, age, condition) except for the single element of the impairment. Absent the purity of this lesson example, the value differences between the pairings may not represent the actual difference attributable to the impairment but may be the result of other attributes unrelated to the impairment issue. Impaired Sales Comparables This tool is useful for determining repaired market value and whether or not stigma exists after stages B to E have been addressed. The technique is illustrated by means of the following example. A former service station site with leaking underground fuel storage tanks has been remediated and a letter of compliance to commercial environmental standards has been issued. An insurer wants to know what the site's market value is, whether or not this remediated and certified site will experience market resistance (stigma) as a result of its impaired history, and what the market value effect of that resistance is, if it exists. This can be analyzed by finding comparable sales (indices) with similar characteristics and history to the subject property. Sales of remediated and certified former service station sites are generally available in most large communities. Let us say that four indices were found that, once adjusted, indicate a market value of $20, $22, $21, and $21 per sq. ft. for the subject property. Therefore, the remediated and certified subject site could reasonably be expected to have a market value of $21 per sq. ft. In order to estimate whether or not stigma exists, indices without a history of the subject impairment would have to be found, analyzed, and the results compared to the impaired valuation of $21 per sq. ft. If such a comparison also indicates $21 per sq. ft., then the conclusion is that no stigma exists after remediation and certification. However, if this analysis indicates an unimpaired history market value, for example, of $23 per sq. ft., then the conclusion is that stigma does exist and the market value effect of the market resistance is ($21 $23) $23 = a decrease of 9% (rounded). Sale/Resale Analysis A type of paired sales analysis is the sale and subsequent resale of the same property. This method is often used to derive a market conditions adjustment because, absent any changes or modifications to the property, the property is virtually identical, other than the change in market conditions. The following example illustrates its application to determine the impact of an impaired condition. The following sales in Table 7.4 that were sold both prior to and subsequent to an impairment, provide data to quantify the effect of the impairment. These indices show that property values decreased in the range of 14.1% to 17.4% as a result of the impairment. As is the case for any impaired condition, be cautious to consider other market factors not associated with the impairment. Sale Before Impairment 2010 Table 7.4: Sale/Resale Analysis Sale After Impairment 2010 % Change % Due to Market % Due to Impairment Property A $482,000 $385, % -5% -15.0% Property B $476,500 $370, % -5% -17.4% Property C $478,000 $376, % -5% -16.2% Property D $477,000 $386, % -5% -14.1% Property E $480,000 $383, % -5% -15.1% 7.9

10 Lesson 7 Using Direct Comparison to Estimate the Market Value of Impaired Properties Adapted from "Issues in the Valuation of Contaminated Real Estate", a paper prepared and presented by Larry Dybvig, AACI, on June 1, 2001, at the Appraisal Institute of Canada National Conference The first step in evaluating the effect that the presence of adverse material has on a property (i.e., the first step in estimating the value of Point B of the detrimental condition model) is to search for market evidence. What is being sought is both direct evidence of value loss and indirect evidence of market value decline. Market forces seek to keep supply and demand at equilibrium through the pricing mechanism. When either demand or supply is not at the equilibrium point for the subject market, prices change. Prices fall when demand decreases at a faster rate than supply does. This demand evidence, while indirect, is strong circumstantial evidence that price levels are either declining or poised to decline. A market analysis that searches for value effects will consider the following: 2 Sales price comparisons. Typically, these are compared on the basis of price per square foot of land or of gross building area and may require adjustments for differences with the subject property. Sales of contaminated properties are few because the properties are largely unsaleable and vendors are apprehensive about retroactive liability. Cleanup before sale is more common. Income comparisons. Direct market data may be more commonly available through analysis of both occupancy costs and net rents. Other indicators include month-to-month leases only lack of tenant improvements municipalities freezing the issuance of building permits, occupancy permits, or business licenses if contamination is suspected. When a property suffers from impairment, analysis of occupancy costs may show extra expenses resulting from monitoring expenses, higher insurance premiums, additional landscaping for screening, or higher maintenance expenses. The impairment may cause the landlord to reduce asking net rent in order to attract tenants who otherwise would not rent due to the impairment. For example, if there is a possibility of intensive soil remediation in the near future, or if tenants are unsure of the effect of the impairment on their business, then this lack of permanence may be reflected in the existence of month-to-month tenure and the reluctance of the tenant to invest in tenant improvements. Sales volumes. To evaluate stigma in non-contaminated properties which are located, for example, beside the site of a major chemical spill, sales volume analysis is insightful. When demand diminishes in real estate markets, it is initially common for sales volumes rather than prices to decline. The price declines follow. This is because price changes are a function of changes in supply and demand, thus they follow, rather than lead, changes in supply and demand. Demographic and socio-economic data. Again, for environmental factors that affect an area or neighbourhood, detection of stigma effects could lie in unusual immigration or emigration trends, and a host of population and other statistics. Statistics Canada data is available for relatively small geographic regions. Data for sub-areas may be available more frequently from municipal and other sources. Indirect evidence, such as income tax filing statistics by postal code region, might also be illuminating. Land use changes. Evidence of stigma can appear in the form of changing land uses, particularly if lower value land usage trends are apparent, such as lower redevelopment densities or a shift from owner to rental occupancy. Neighbourhood socio-economic changes. As the desirability of a neighbourhood affected by stigma diminishes, the appeal of the area also diminishes, as reflected by decreasing prices when compared with a similar neighbourhood without the stigma. 2 Based in large part on Kinnard, W.N. Jr., PhD, MAI "Analysing the Stigma Effect or Proximity to a Hazardous Materials Site". Environmental Watch (December). 7.10

11 Valuation Techniques for Impaired Properties Using Direct Comparison to Estimate the Market Value of Impaired Properties (continued) Days on the market. A frequent response to a negative market force, particularly for residential real estate affected by off-site stigma, is an increase in the days to sell for the affected area when compared to a similar neighbourhood that is not affected by the impairment. Comparative price trends. For an individual property that has sold under the influence of contamination, indirect evidence of market value loss may be obtained through factoring up the most recent transaction of the property prior to contamination (or knowledge of contamination), using a factor determined from resales of otherwise uncontaminated properties. The variance found relative to similar properties in unimpaired areas provides useful insight into stigma in a never-contaminated property. For example, if contamination were discovered in April this year and the subject property sold as if unimpaired in July four years ago for $200,000 and in May this year for $150,000, then the change in value over the period was minus 25%. If a search for similar sales in an area unaffected by the impairment indicated an overall market value of $200,000 in July four years ago and $250,000 in May this year, the change in market value was plus 25%. Therefore, the market effect of the stigma as at May this year is to decrease market value by 40% [($150,000- $250,000) / $250,000 = 40%]. Time-distance effects. When evaluating never-contaminated stigma, an appraiser can study time/distance relationships. Generally, it is unknown in advance how far from the hazardous materials site the stigma effect is likely to be experienced; thus, analysis of the distance and strength of any impact is important. Comparisons need to be made with measures of proximity impacts at various distances from the source of the impairment, and the resulting pattern should be studied for changes over time. Environmental Case Studies The complex factors affecting the value of impaired properties may make it difficult to identify and research sales of properties that are both similarly impaired and in the same market area as the subject property. In such cases, the appraiser may need to consider impaired sales from outside the subject property's market area. When the appraiser considers sales (including financial information for income-producing properties) of similarly impaired properties, these sales and the impaired circumstances surrounding them are referred to as case studies. The Appraisal Institute 3 lists eleven elements of comparison in the application of an environmental case study. Similar elements of comparison would be applicable to other impaired conditions: Property type, i.e., income-producing properties are not comparable to residential properties General real estate market conditions, e.g., declining, stable Whether the subject property is a source site, non-source site, adjacent, or proximate property with respect to contamination Whether the contamination discharge was permitted or accidental Contamination constituents Conveyance of the contamination, e.g., air, groundwater, soils Remediation lifecycle stage (before, during, or after cleanup) of the property as of the date of value Cost and responsibility for site remediation 3 Appraisal Institute "Analyzing the Effects of Environmental Contamination on Real Property". Seminar Workbook. p

12 Lesson 7 Potential impacts on the use of the property due to the contamination and its remediation Potential or actual off-site impacts due to contaminant migration (third-party liabilities) Environmental insurance and indemnifications The Appraisal Institute recommends that the environmental case study process consist of the following: Gather the information for the elements of comparison. Match the selected case study properties with otherwise similar but uncontaminated comparable properties in their market area in order to determine the extent of any adverse effects attributable to the environmental condition of the case study properties. Compare, analyze, and reconcile the contamination-related impacts derived for each case study property to the subject property. Consider differences in general market conditions, property type, and date of sale among the subject property and the case study properties so that effects are not incorrectly attributed to nonenvironmental influences. Table 7.5 provides an example of a case study comparison chart that includes the recommended elements of comparison. Property characteristics Table 7.5: Case Study Comparison Chart Subject Property Case Study A Case Study B Case Study C Case Study D Property type Industrial Industrial Industrial Commercial Commercial Market conditions Stable Stable Stable Stable Declining Contamination/Discharge Source, non-source, adjacent, proximate Permitted vs. accidental discharge Constituents Source Source Source Source Source Accidental Accidental Accidental Accidental Accidental Chlorinated solvents Hydrocarbon Chlorinated solvents Chlorinated solvents Hydro-solvents Conveyance Groundwater Groundwater Groundwater Groundwater Groundwater Remediation lifecycle Before cleanup Characterized Characterized Characterized Characterized Characterized During cleanup No RAP No RAP RAP No RAP RAP After cleanup No NFA letter No NFA No NFA No NFA NFA Other/Related Issues Costs and responsibility Seller Seller Seller Buyer Buyer Impacts on use Minimal impact Minimal Medium Medium-High Medium Third party liabilities Low risk Low Low Low Medium Indemnification Indemnified Indemnified Insurance Cost cap - reopener No indemnification No indemnification None None None None No indemnification Impact on Value To be determined No impact 5% discount 12% discount No impact 7.12

13 Valuation Techniques for Impaired Properties Multiple Regression Analysis (MRA) Preliminary note: this section illustrates how advanced statistical analysis can aid in impairment valuation. The statistics involved are beyond the scope of the course, so the specifics will not be tested. For more background on statistical analysis and model building, see UBC's BUSI 344 course "Statistical and Computer Applications in Valuation". MRA techniques can be used to more accurately choose the characteristics on which to compare properties. Instead of applying an analyst's opinion on a small number of variables (e.g., building size, site size, age, condition), MRA can be used to more accurately choose the characteristics on which to objectively compare properties. When properly developed, multiple regression analysis can be used to indicate the existence or absence of adverse impacts on sale prices due to impairment. MRA can test for the significance of any impacts after controlling for other influences on value that are unrelated to the potentially adverse impairment. The MRA analysis can also indicate whether there is any statistically significant effect on sale prices that may be attributable to the condition of the impaired properties (i.e., the test areas) relative to an otherwise similar group of properties in an unimpaired condition, i.e., the control areas. The general multiple regression model for analyzing the effect of an impairment (environmental contamination in this model) on sale price is as follows: MV = b0 + (b1 BUILDINGAREA) + (bi IMPAIRMENT_VARIABLEi) + (bj LOCATION_VARIABLEi) Where MV = the estimated market value b0 = constant b1, bi, bj = coefficients of the independent variables BUILDINGAREA = in this model the total gross square feet of the building area or can be any number of non-impaired property characteristics such as building age, lot size, etc. IMPAIRMENT_VARIABLE = any variable indicating the impaired condition of the property LOCATION_VARIABLE = any number of discrete variables indicating the location of the property Other typical variables will include SALE_DATE and SALE_PRICE. When MRA is used to test for the significance of any impacts after controlling for other influences on value that are unrelated to the potentially adverse impairment, it is often developed in a proximity analysis. In this regression model one of the independent variables or a set (vector) of independent variables reflects the distance of each sale property to the source of the impairment, e.g., environmental contamination. These variables can be specified as a continuous distance from the impairment source or as discrete distance bands, or concentric bands, around the source. 7.13

14 Lesson 7 The analyst should be cautious in that there may be multiple adverse influences on sale price, e.g., multiple sources of contamination or other disamenities such as proximity to industrial land uses or noxious facilities such as landfills. The MRA analysis can also be used to indicate whether there is any statistically significant effect on sale prices that may be attributable to the condition of the impaired properties (i.e., the test areas) relative to an otherwise similar group of properties in an unimpaired condition (i.e., the control areas). In this analysis, the sale prices of properties in the potentially impacted area (the subject or test areas) are compared to prices of similar properties in a comparable market area having similar characteristics as the subject area but absent the adverse impairment under investigation. In this MRA analysis, it can be informative to compare the control areas with the test areas both before and after the impairment event in order to understand and control for other factors that are non-impairment related. The impairment event may be a specific date such as the actual release of the contamination, public announcement of the contamination, or a range of dates as the knowledge of the contamination grew from an isolated few to that of the typical market participant. Income Approach The income capitalization approach utilizes income and risk factors with and without the impaired condition. This valuation method focuses on the impact that an impaired condition has on income (both short term and in perpetuity) and risk. The relationship between the impaired condition value issues and the effects on value are linked in the detrimental condition model, as shown in Table 7.6. Table 7.6: Detrimental Condition Income Capitalization Approach I R = V Detrimental Condition Value Issues Costs and responsibility Use Risk (uncertainty factor, project incentive, or market resistance) A A Effect on Value Income, or I Rate, or R Direct Capitalization An impairment has the potential to decrease the anticipated stream of future benefits (Income, or I) and/or to increase the return necessary to attract capital (Rate, or R), either or both of which will decrease property value. A preliminary issue for the appraiser is whether the impairment causes a permanent reduction in the net operating income (NOI) (e.g., due to ongoing costs or rental concessions) or the income and expenses are projected to vary from year to year, e.g., declining costs/impacts. In the first instance, direct capitalization may be appropriate and in the latter, discounted cash flow analysis is applicable. 7.14

15 Valuation Techniques for Impaired Properties In the direct capitalization approach for the impaired property the appraiser can estimate the overall capitalization rate from any of the techniques available for the valuation of non-impaired properties, including comparable sales, band of investment, debt coverage ratio, and the residual techniques. In the case of a simplistic textbook example of extracting the capitalization rate from market transactions, assume we are appraising a retail centre that has suffered from severe earthquake damage but is now fully repaired. The analyst researches similar retail centres that were similarly damaged by the earthquake and have also been fully repaired and utilizes both the sale prices and net operating incomes in order to extract the capitalization rates. These capitalization rates are applied to the subject's projected NOI for an estimate of the subject's value. Note that it would be incorrect to report the subject's value as an "impaired" value in the absence of an analysis of similar unimpaired retail centres that indicates a diminution in value due to having been impacted by the earthquake damage. Another note of caution to the analyst, prior to calculating the capitalization rate differential and risk premium for the impaired comparables, the sale prices should be adjusted for remediation costs to be borne by the buyer so as not to mix cost and risk effects in the risk premium. Band of Investment Analysis The use of the band of investment method is appropriately quoted in full from Bell (1999) as follows: The second approach to estimating the impaired capitalization rate uses the band of investment approach to build up a capitalization rate as a weighted average of a debt rate (RM) and an equity rate (RE) where the weight reflects the loan-to-value mortgage ratio (M): RO = (M) RM + (1-M) RE The overall capitalization rate has to reflect its two components, the debt rate and the equity rate, weighted by their relative magnitude in the capital base of the investment. For example, suppose the facts applicable to an unimpaired industrial building are 70% loan-tovalue (M) with a 9% mortgage constant and a 10.5% equity dividend rate (RE). Unimpaired RO = (.70).09 + (.30).105 =.0945 Now, suppose a similar building has been subject to environmental contamination. Assume that the contamination has been remediated and that there is no effect on the use of or utility of the property. There are, however, some significant risk issues because the contamination has migrated off-site and has affected several neighboring properties. By discussing these facts with brokers, lenders, and investors, useful insight can be gained on how they see the financing of the project being affected by the environmental issues. Suppose systematic interviews are carried out with lenders and investors and the results indicate that the loan-to-value ratio would drop to 50%, the mortgage constant would be unchanged, and the equity dividend rate would have to be increased to 11.5% to attract equity capital. Every attempt would then have to be made to verify these opinions based on actual market transactions. The mortgage financing terms on similar properties with similar environmental issues are relatively easy to verify, and once these are known the equity dividend rate can be extracted. Assuming that market data supports the interview results reported above, the impaired capitalization rate can be calculated as follows: Impaired RO = (.50).09 + (.50).115 =

16 Lesson 7 Thus, the impact of the detrimental condition is to raise RO from 9.45% to 10.25%. If the NOI of the property (both unimpaired and impaired) were $200,000, this would cause value to fall by approximately $165,000. Unimpaired value = $200,000 /.0945 = $2,115,000 (rounded) Impaired value = $200,000 /.1025 = $1,950,000 (rounded) This analysis suggests that potential buyers would require a 5% to 10% discount to purchase the impaired property. The market resistance is due to the fact that the greater risk associated with the property requires a higher rate of return to attract capital to the project. This is because of the requirement by lenders that there be a larger equity investment relative to debt and the requirement by equity investors that their equity return be higher. Higher risk requires a higher return that lowers value. (pp ) Discounted Cash Flow The advantage of discounted cash flow over direct capitalization is greater accuracy when there is an anticipation of an irregular income stream over the holding period. This approach incorporates all costs related to each stage. The following example demonstrates this approach as a means of estimating market value at Point B of the detrimental condition model (moment of discovery of the impairment). Table 7.7 presents the discounted cash flow applicable to an unimpaired income-producing building (growth of income and expenses are excluded for clarity). Table 7.7: Discounted Cash Flow Analysis: Unimpaired Valuation Year Potential gross income $300 $300 $300 $300 $300 $300 $300 $300 $300 $300 $300 Vacancy (10%) Effective gross income Operating expenses NOI R O = j 1 =10% 1800 Cash flow $180 $180 $180 $180 $180 $180 $180 $180 $180 $1,980 Value unimpaired at beginning of year 3: present j 1 = 12% = $1,621,000. [The PV is solved as follows: PV = $180 a[8, j1=12%] + $1,800(1.12) -8 ] Table 7.8 presents the income effects of an impairment, such as discovery of asbestos, on the same building. Impacts from the impairment on net operating income at each stage are: Assessment stage vacancy increases and assessment costs accrue Repair stage vacancy remains high and repair costs accrue Ongoing stage vacancy rates decrease, but remain higher than unimpaired state; ongoing monitoring and maintenance costs accrue 7.16

17 Valuation Techniques for Impaired Properties Stigma remaining is reflected by the increase in the discount rate from unimpaired 12% to impaired 13%. This impaired discount rate, provided here to illustrate the risk effect of impairment on an investor's required return on investment, can be extracted from comparable sales, lender or investor surveys, or the band of investment approach. Table 7.8 shows that the impaired market value of the building due to the discovery of asbestos was $857,000, a decrease of $764,000 from its unimpaired condition, i.e., 53% of its unimpaired market value. Table 7.8: Discounted Cash Flow Analysis: Impaired Valuation Discovery Approved Repair Stage Repair Complete Unimpaired Stage Assessment Stage Repair Stage Ongoing Stage Year Potential gross income $300 $300 $300 $300 $300 $300 $300 $300 $300 $300 $300 Vacancy (10%) Effective gross income Operating expenses Repair costs: Assessment costs Repair costs Ongoing costs NOI R 0 = 10% 1500 Cash flow $180 $180 $40 $40 $0 $20 $40 $150 $150 $1,650 Value unimpaired at beginning of year 3: present j 1 = 13% = $857,000. [PV is the year 3-10 cash flows at 13%] The impaired capitalization rate can also be estimated by means of the band of investment approach to build up a capitalization rate (RO) as a weighted average of a debt rate (RM) and an equity rate (RE) where the weight reflects the loan-to-value mortgage ratio (M): RO = (M)RM + (1 M)RE. Consider that the above unimpaired apartment building can obtain first mortgage financing with loan-to-value ratio of 70% and rate of 9%. Its unimpaired overall capitalization rate of 10% indicates that the equity rate is 12.3%. 4 Once the impairment has been discovered, the lending institution will either reduce its exposure by requiring a greater equity position on the part of the mortgagor, or will require a greater return in the form of a higher mortgage rate, both, or refuse to lend at all. If a lending institution decreases its exposure by reducing the loan-to-value ratio it is prepared to accept, the mortgagor is forced to increase his or her own exposure and will normally require a higher return as incentive for the greater risk. A properly constructed survey of lending institutions and investors can provide an indication of their requirements in impairment situations. 4 The calculation is 10% = ( ) + 0.3y; solving for y yields 12.3% as the equity rate. 7.17

18 Lesson 7 As apartment buildings are in demand in this example, the only effect on the overall rate is that the lending institution requires the mortgagor to accept a 50% equity position, but will keep the mortgage rate at 9%. The overall rate is RO = (0.5 9%) + ( %) = 10.65%. If NOI is $200,000 and there is no ongoing expense, then the market values of the property before and after discovery of the impairment are: Unimpaired market value: $200,000 10% = $2,000,000 Impaired market value: $200, % = $1,878,000 (rounded) In this instance, it can be seen that potential buyers would require a discount of approximately 6% due to the asbestos impairment. If there had been ongoing expenses associated with maintenance and monitoring, the NOI would be reduced from $200,000 and the discount due to asbestos impairment would increase accordingly. Mortgage-Equity (DCF) Analysis In this section of the lesson, the reader is referred to the Assigned Reading paper entitled "Mortgage-Equity Analysis in Contaminated Property Valuation" by Thomas O. Jackson. A Microsoft Office Excel spreadsheet has been created to parallel the tables and figures in this paper and is available under "Online Readings" on your course webpage. 5 The following summarizes elements of the Jackson paper; however, as in all the papers/readings for this course, it is no substitute for reading the original in its entirety. As has been addressed in prior sections of this course, the costs effects on property value, such as any reduction in value due to remediation costs, is applied by the appraiser as a deduction associated with each stage from the unimpaired value. However, the perceptions of key market participants (i.e., mortgage lenders and equity investors for income-producing properties) can produce a diminution in value cased by stigma. Market participants may face uncertainties regarding: regulatory compliance requirements, current and future strength of the appropriate regulatory framework cost, timing, and duration of the remediation effort loss of property income during remediation and possibly after remediation market for the future use of the property considering any use restrictions that may be imposed as a condition of regulatory compliance An important consideration of both investor return requirements and loan underwriting criteria are the strength of indemnifications that would hold other parties harmless from future remediation costs and other potential liabilities. As Jackson describes, there is a market for contaminated property composed of knowledgeable investors who understand the risks and lenders who are willing to finance transactions involving this property type. An appraiser can quantify the effect of contamination-related risk by understanding the perceptions and reactions of equity investors and mortgage lenders through mortgage-equity analysis. 5 This Excel file is protected so that users cannot accidentally change the formulas. However, to view the formulas and make changes go to Review > and click Unprotect Sheet, and since no password is supplied, any user can unprotect the sheet and change the protected elements. 7.18

19 Valuation Techniques for Impaired Properties For equity investors, in general, "the more uncertainty, the higher the required return, the lower the value, and the greater the diminution in property value due to the contamination" (p. 47.) For mortgage lenders, their underwriting standards may include a reduction in the loan-to-value ratio, increasing the interest rate, shortening the amortization period, and increasing the level of personal guarantees from the borrower and/or increasing the indemnifications from the borrower or other responsible parties against future liabilities. As stated by Jackson: Investor and lender risk adjustments can be reflected in corresponding changes in income and yield capitalization rates. The disaggregation of capitalization rates into mortgage and equity components allows for adjustments in the key mortgage and equity parameters that reflect the increased risk from contamination perceived by these market participants. As capitalization rates are adjusted upward to reflect this increased risk, property value decreases. Investors will pay less for the same cash flow in order to achieve a higher return, or yield, and lenders will seek a more secure position through credit underwriting adjustments, thereby increasing the cost of capital, and reducing property value (p. 48). The appraiser can derive mortgage and equity adjustments from one or both of the following methods: (a) comparison of sales of contaminated property against sales of similar but uncontaminated property to extract market-derived risk adjustments, and/or (b) survey of lenders and investors for the lending and investment criteria for the subject property as if uncontaminated and after knowledge of all key risk factors/assumptions due to the impairment. The market-derived mortgage and equity adjustments can also be applied in the appraisers discounted cash flow analysis. A typical DCF analysis does not estimate property values on the basis of mortgage and equity interests; however, Jackson's DCF analysis has been replicated herein and students may review the Excel tables and figures in the file "Mortgage-Equity Analysis.xlsx" on the "Online Readings" webpage. You will find the Excel files has the following worksheets: Sheet #1 Sheet #2 Sheet #3 Sheet #4 Sheet #5 Sheet #6 Sheet #7 Instructions Baseline DCF Analysis (Table) Valuation Diminution Analysis (Table) Equity Risk Premiums (Figure) Loan-to-Value Ratio (Figure) ERP and Going-in Cap (Figure) LTV and Going-in Cap (Figure) Each of these tables and figures is explained below. The valuation of a contaminated/impaired property is "as if" uncontaminated or clean is often the first step in an appraiser's analysis. Table 7.9 shows the "Baseline DCF Analysis" Excel worksheet. This is a mortgage-equity analysis through a DCF procedure. The assumptions in this example unimpaired or baseline analysis are: 2% annual increase in income and value 9% mortgage interest rate (Ym) 70% loan-to-value ratio (LTVR) 20-year loan amortization period Ye (equity yield) of 17% 10-year holding period Net operating income (NOI) of $600,000 in Year 1, and Going-in and terminal capitalization rate of 10.17%. 7.19

20 Lesson 7 Table 7.9: Baseline (As If Uncontaminated) DCF Analysis Source: Jackson, 1998, as modified The next table on the Excel spreadsheet is the DCF analysis with equity and mortgage contamination risk adjustments with the following two adjustments: Increase in the Ye (equity yield) of 500 basis points from 17% to 22%, and Decrease in the LTVR from 70% to 50%. The following figures are included to illustrate the more generalized relationships between contaminationrelated risk adjustments and property value diminution (PVD). Figure 7.2a illustrates the effect of adjusting equity return requirements on value diminution. In the words of Jackson, this figure: shows the increase in PVD, measured as a percentage and in dollars, corresponding to increases in the equity yield requirement, as reflected in the equity risk premium over the unimpaired Ye of 17%. For example, a 300-basis point risk adjustment to Ye, indicating an adjusted Ye of 20%, corresponds to a 7.2% reduction in the property's unimpaired value. The upper end of this risk range, with a 1,000-basis point adjustment, produces a value diminution of over 20%. (pp ) 7.20