Valuation Of Contaminated Properties Published


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Valuation Of Contaminated Properties Published

  1. 1. Valuation of contaminated properties: a Canadian perspective Overview to become a concern for appraisers in Canada as outlined in the Issues related to the contamination of real estate in Canada con- Toxic Mold Alert1 prepared by Marsh Canada Ltd., which states tinue to evolve and society is becoming more aware of these envi- that “toxic mold losses grow into a billion dollar problem.” ronmental challenges. The political and regulatory framework as it It is apparent that contamination can affect the market value pertains to the environment are constantly evolving, as evidenced by of property due to potential environmental liability, which may the adoption of the Kyoto Protocol and ongoing changes to federal be incurred by past, present and future owners. This, in turn, will and provincial environmental legislation. Contamination can be a have an obvious impact on obtaining financing and, ultimately, the result of manmade or naturally occurring elements within the envi- marketability of the property. ronment or a combination of both. Radon and mold are examples As such, contamination of real estate raises an interesting of naturally occurring contaminants, whereas manmade sources challenge for the real estate appraiser. The purpose of this article may include lead, PCBs, asbestos, UFFI, electromagnetic radiation is threefold. First, it is to provide the appraiser with some insight (EMF), hydrocarbons from leaking underground storage tanks, waste on real estate contamination and ideas on how to deal with these sites (landfills), noise and odours. challenges from a valuation perspective. Second, it is to intro- Contamination could affect the duce terminology adopted by our American counterparts for the quality of soils, groundwater, sur- valuation of contaminated real estate and face water, air, building materials recommend that real and any combination thereof. It is worth noting that mold is starting B Y G O R D O N E . M A C N A I R , A A C I , P. A P P , S R / W A
  2. 2. estate appraisers in Canada adopt this but remediation is not required for the cur- the present utilization can be significant terminology. Third, to provide information rent use since there are no off-site issues for the owner, especially for an operating on additional valuation techniques that (regulations permit the existing use since facility that is in legal compliance. While can be used for appraising contaminated the contamination is contained on site). primarily an issue relating to industrial property. The estimated impaired value 3 based on properties, value in use considerations can the current use is $1,000,000. However, come into effect for many different kinds of Appraisal principles based on the highest and best use analy- property. Before moving on to some of the valuation sis, the site could be rezoned to residen- This difference is explained in the Con- issues involving contaminated real estate, tial and realize an estimated unimpaired taminated Property Valuation Guideline7 it is important that we review some of the value4 of $1,600,000. However, since the prepared by the Arizona Department of basic concepts of real estate. The rights remediation costs for residential use are Revenue which states: “Value in Exchange of ownership are often referred to as the $750,000, the value would be reduced to is the price that would tend to occur as Bundle of Rights Theory 2 and contamina- $850,000 (assuming there is no envi- a result of the interaction of the market tion can affect the right to use, lease and ronmental stigma). Based on this simple forces of supply and demand. Value in Use sell, which is an inherent part of this theory. analysis, the highest and best use of the takes valuation to an added step by saying The highest and best use of a property subject site is limited to the continuation that, if a property fulfills a utility, it has can also be affected by contamination, of the existing industrial use. value despite the traditional theory of the since it could have a potential impact on Another important principle to con- market being the indicator of value. Value the land use. The purpose of the highest sider with contaminated properties is the in Use suggests that a property which is and best use analysis is to provide a basis Principle of Substitution5. The underly- still in use, or which can be used in the for evaluating real property, which takes ing premise with this principle is that the near future, has a value to the owner. into account factors such as physically purchaser has choices as recognized in In the case of contaminated properties, possible, legally permissible, financially the Tridan6 case. The trial judge, Justice the concept of Value in Use is important feasible and maximally productive. Since Binks, is quoted as follows: “Given two because it challenges the claim that a contamination could have an affect on uncontaminated properties, one of which property has no value if the cost of reme- potential uses now or in the future, the had previously experienced a spill and had diation exceeds its market value. If the value of the real estate could suffer as a been cleaned, an informed and willing cost of remediation exceeds the replace- consequence. The following example will buyer would prefer the property that had ment cost (unimpaired value), the Value in demonstrate this point: never been contaminated. This certainly Use concept can be applied. Value in Use A one-hectare site is improved with an would devalue the fair market price of the states that value lies in utility.” older industrial building and the site is con- once contaminated property relative to This concept was demonstrated in the taminated with hydrocarbons as a result of one that had never experienced a spill.” Montague 8 decision. The case involved a leaking underground storage tank. The Other appraisal considerations are a division of assets between spouses. cost to remediate the site is $750,000, Value in Exchange vs. Value in Use, as One of the assets was an operating gas they are two distinct terms. For many station with an estimated market value contaminated properties, it is of $175,000 and the remediation costs critical for the appraiser for removing the contaminated soil and to distinguish between groundwater were estimated to exceed these two terms. $200,000. The trial judge held that, since While there the land was polluted and the cost of may be little cleanup exceeded the value of the land, demand in the land was worth nothing, even though the mar- the husband continued to operate the ketplace for business from this location. Therefore, the a contami- Value in Exchange in this case was ruled nated site, if to be zero with respect to the distribu- contamination tion of the matrimonial assets. However, is not severe, it the husband ends up with a Value in Use, is quite possible since there is still utility and he is able to that the present use continue operating the business from this can continue safely and property, which would obviously have a legally. The contribution for value to that particular user. 38 A PPRAISER C A N A D I A N WINTER . 2004 . HIVER EVALUATEUR C A N A D I E N
  3. 3. Legal Terminology for A primary concern for an owner or poten- contaminated tial purchaser of a contaminated property sites is the issue of liability, which can occur in The specialized many forms. terms and defini- The first source of liability is common tions for contami- law rules or judge made law, which nated sites are addresses such things as trespass and found in USPAP nuisance. Causes of action under common 2003, ©The law can be made for contamination Appraisal Foun- under the following headings: Negligence, dation, Advisory Nuisance, Trespass and Strict Liability Opinion 9 (AO-9) (Rylands v. Fletcher 9). (lines 68 – 108), Damages are awarded to make the SUBJECT: The Appraisal parties whole and the measure of com- of Real Property That May Be pensation is usually the lesser of the Impacted by Environmental Con- cost to repair/correct, or the difference tamination, revised June 11, 2002. between the before and after value. As a For real estate appraisers in Canada, it is factors, as may be relevant. (Author’s general rule, claimants are not awarded recommended that we adopt this terminol- comments: this definition does not apply compensation for both items as noted ogy so that we will have consistency when to the science of environmental risk above. Otherwise, it would be a form of dealing with the valuation of contaminated assessment, which addresses such topics double recovery. sites within our country. as human and ecological health. Rather, it A second source of liability falls under Diminution in Value (Property Value relates to environmental risk perceived by liability in contract. Examples include agree- Diminution): The difference between the real estate market perception.) ments of purchase and sale, and leases unimpaired and impaired values of the Environmental Stigma: An adverse and issues rising from those contractual property being appraised. The difference effect on property value produced by the documents relating to representations and can be due to the increased risk and/or market’s perception of increased environ- warranties, covenants, and caveat emptor. costs attributable to the property’s envi- mental risk due to contamination. (See The third source of liability is derived ronmental condition. Environmental Risk above.) from law or regulations typically imposed Environmental Contamination: Adverse Impaired Value: The market value of by the Federal and Provincial levels of gov- environmental conditions resulting from the property being appraised with full ernment. The legislation and regulations the release of hazardous substances into consideration of the effects of its envi- also provide these authorities with the the air, surface water, groundwater or soil. ronmental condition and the presence of right to enforce contamination compliance Generally, the concentrations of these environmental contamination on, adjacent standards and hold property owners liable substances would exceed regulatory limits to, or proximate to the property. Concep- for the costs of reducing contamination to established by the appropriate federal, tually, this could be considered as the acceptable levels. Examples of environ- state, and/or local agencies. (Author’s ‘as-is’ value of a contaminated property. mental legislation are the Ontario Environ- comment: this information will have to be (Author’s comment: simply put, this is the mental Protection Act10, the Ontario Water revised to reflect Canadian governance contaminated site in the ‘as-is’ condition Resources Act11, the Fisheries Act12 and structure.) given its environmental condition as of the others. This could involve the imposition of Environmental Risk: The additional or date of value.) orders, prosecutions and resulting fines. incremental risk of investing in, financing, Remediation Cost: The cost to cleanup The above demonstrates the impor- buying and/or owning property attributable (or remediate) a contaminated property tance in transactions of obtaining environ- to its environmental condition. This risk to the appropriate regulatory standards. mental information in the form of audits is derived from perceived uncertainties These costs can be for the cleanup of and assessments as part of the due dili- concerning: (1) the nature and extent of on-site contamination as well as mitiga- gence process. It is critical to understand the contamination; (2) estimates of future tion of off-site impacts due to migrating the environmental risks and to minimize remediation costs and their timing; (3) contamination. the environmental uncertainty associated potential for changes in regulatory require- Remediation Lifecycle: A cycle con- with any property and this can be accom- ments; (4) liabilities for cleanup (buyer, sisting of three stages of cleanup of a plished through completion of environmen- seller, third party); (5) potential for off-site contaminated site: before remediation or tal audits and assessments. impacts; and (6) other environmental risk cleanup; during remediation; and after A PPRAISER C A N A D I A N WINTER . 2004 . HIVER EVALUATEUR 39 C A N A D I E N
  4. 4. – An Appraisal Institute Anthology13. 5. Adjustment of income and yield In a recent article14 published in capitalization rates to reflect environmen- The Appraisal Journal, Thomas O. tal risk premiums in an income capitaliza- Jackson, PhD, MAI outlines five tion analysis methods and techniques for With the income and yield capital- valuing contaminated prop- ization rate analysis, the appraiser can erty: account for the effects of contamination by increasing the income capitalization 1. Analysis of environmen- rate by an appropriate environmental risk tal case studies premium, which must be derived from the The additional elements market place. affecting the value of contami- nated properties may make it A formula for difficult to identify and research contaminated real estate sales of properties in a similar envi- A formula for valuation of contaminated ronmental condition and in the same property was presented on April 5, 2002 in market area as the subject property. In Toronto at The Centre for Advanced Property remediation. A contaminated property’s this situation, the appraiser may need to Economics and Appraisal Institute (U.S.) remediation lifecycle stage is an important analyze comparable impaired sales from symposium entitled Environment & Property determinant of the risk associated with outside the subject property’s market area. Damages: Standards, Due Diligence, Valu- environmental contamination. Environmen- ation and Strategy. The formula is outlined tal risk can be expected to vary with the 2. Paired sales analysis of potentially below and the terminology is consistent with remediation lifecycle stage of the property. impaired properties USPAP 2003, ©The Appraisal Foundation, Source, Non-source, Adjacent and This is part of the sales comparison Advisory Opinion 9 (AO-9): Proximate Sites: Source sites are the sites approach and can be used to estimate the Impaired Value = Unimpaired Value on which contamination is, or has been, effects of contamination when there are – Cost Effects (Remediation and Related generated. Non-source sites are sites onto fairly recent sales of properties in a similar Costs) – Use Effects (Effects on Site which contamination, generated from a environmental condition as the subject Usability) – Risk Effects (Environmental source site, has migrated. An adjacent property, paired or matched with otherwise Risk/Stigma) site is not contaminated, but shares a similar but uncontaminated properties. common property line with a source site. Cost effects are costs that affect prop- Proximate sites are not contaminated and 3. Multiple regression analysis of erty cash flows and are recognized by the not adjacent to a source site, but are in potentially impacted neighbourhood areas market, as opposed to all possible costs. close proximity to the source site. or properties in proximity to a contamina- Generally, costs necessary to achieve Unimpaired Value: The market value of tion source regulatory compliance are recognized by a contaminated property developed under A multiple regression model can be the market, but costs for remediation the hypothetical condition that the prop- used to analyze the impact of environmen- beyond regulatory requirements would not erty is not contaminated. tal contamination on the sale prices of be recognized by typical market partici- properties in an allegedly impacted area. pants. Use effects are presented as the Valuation of impacts on the utility of the site as a result contaminated property 4. Use of market interviews to col- of the contamination, and as the result of In the past, real estate appraisers have lect data and information used in other a limited future highest and best use. Risk relied on the three standard approaches to approaches or to support and supplement effects are presented as being derived value when appraising contaminated real the results of other analyses from the market’s perception of increased estate. However, there is a new genera- Market interviews are not methods or environmental risk and uncertainty. tion of techniques under these approaches techniques for valuing contaminated prop- which has been published extensively in erties, but are useful for collecting and Environmental stigma the U.S. and a summary of this literature understanding the data and information Environmental stigma, as mentioned can be found in the Appraisal Institute necessary to apply the other methods and earlier, can be defined as an adverse (U.S.) Valuing Contaminated Real Estate techniques discussed herein. effect on property value produced by the 40 A PPRAISER C A N A D I A N WINTER . 2004 . HIVER EVALUATEUR C A N A D I E N
  5. 5. market’s perception of increased envi- post-remediation, the stigma lessens even decision, the Courts have ruled that an ronmental risk due to contamination. The more since there is little to no uncer- innocent neighbour whose property is theory for stigma is that remediation costs tainty. These three stages have also been contaminated is entitled to the entire cost do not fully account for the loss in value to referred to as before, during and after of remediating its property to a pristine the property owner. remediation16. condition, noting it was not enough to For valuation purposes, the matter It is important to note that not every clean the site to MOE guidelines. Prior of environmental stigma is addressed in contaminated site will result in environ- to the Tridan decision, it was common CUSPAP under Environmental Impacts, mental stigma and any adjustment for this to rely on guidance from the Guideline which states, “The value of an interest in feature must come from the marketplace. and remediation would typically occur to impacted or contaminated real estate may For instance, the City of Ottawa has been generic contaminant levels. Clearly, the not be measurable simply by deducting the dealing with a contaminated site (a closed Tridan18 decision has made the standard remediation or compliance cost estimate municipal landfill) for the past three years, more onerous for remediating contami- from the opinion of value as unaffected. where there is off-site contamination. nated sites. Other factors may influence value, includ- Studies have been completed which have It should also be noted that the nature ing any positive or negative impact on confirmed that there is no environmental and extent of contamination will vary marketability (stigma) and the possibility of stigma in this instance to the impacted and is site specific. As well, remediation change in highest and best use.” surrounding properties. There are a methods and costs will vary depending on The Tridan15 case dealt with the matter number of reasons for this outcome. First each situation. As an example, the City of environmental stigma. At the trial judge and foremost, the City has been front and of Ottawa is currently looking at reme- level, the ruling stated that there was centre with this project and has kept the diating a site with hydrocarbons in the stigma (17% to 18%) of the unimpaired public informed throughout this process. soil and groundwater. Our environmental value. However, the decision also ruled As well, a human health risk assessment consultant has advised us that we have that Tridan was responsible for clean- was completed which confirmed that there six available remediation options based on ing up the site to pristine standards. The was no potential risk to the residents in the existing use. The options range in cost Ontario Court of Appeal (OCA) dismissed the area. Finally, the City has undertaken from $240,000 for a one-time capital cost stigma since it was of the opinion that remediation at the source of contamina- with ongoing monitoring costs estimated there would be no stigma if the site were tion within the closed landfill to decrease at $60,000 per annum for basically a to be cleaned up in a pristine fashion. The potential long-term migration of contami- containment option, to $6,500,000, which Supreme Court of Canada declined to hear nation leaving the site. involves tunneling underneath the build- the appeal of the OCA decision, which in ing. The recommended option will involve essence agreed with the OCA decision. What is clean? a one-time capital cost of $525,000 for The theory behind environmental It is important to understand that reme- an angled extraction system with annual stigma is that, typically, stigma is consid- diation is rarely a synonym for absolute operating costs of $110,000 for approxi- ered to be at its highest during the first cleanup. Remediation is the activity mately seven years. stage of the remediation cycle, when the designed to reduce the level of con- There is also the challenge of chang- contamination has been first discovered tamination to meet criteria set forth in ing standards. With improving technology and uncertainty is at its greatest. With the Guideline for Use at Contaminated for remediating contaminated real estate, the next stage, the remediation stage, the Sites in Ontario (Guideline) criteria. Typi- the expectations for remediation could stigma starts to lessen because the prob- cally, cleanup implies that the site will be become more rigorous. The bottom line lem becomes more understood. During the cleaned to pristine conditions. Pristine is that we do not really know when clean last stage, conditions denote that there are no traces is clean or whether a remediation that is of contamination whatsoever within acceptable today will be acceptable some the site that exceed the back- time in the future. ground criteria under the From a valuation perspective, it is Guideline which permits important for the appraiser to understand certain levels of contami- that the estimate of remediation and nants. compliance cost estimation is beyond The Tridan17 deci- the expertise of most appraisers and, as sion has created some such, environmental consultants typically interesting problems provide these estimates. This is captured in this area. With this in CUSPAP, Lines 6360 to 6369. A PPRAISER C A N A D I A N WINTER . 2004 . HIVER EVALUATEUR 41 C A N A D I E N
  6. 6. CUSPAP considerations Failure to address known contamina- to, or proximate to the property. Conceptu- for appraising an impaired tion in an appraisal could result in a mis- ally, this could be considered the ‘as-is’ property leading report (lines 6357 – 6358). value of a contaminated property. USPAP Ethics Standards An example of an Extraordinary 2003, Advisory Opinion 9 (AO-9) It is unethical for a member to act in a Assumption is the absence of contamina- 4 Unimpaired Value – The market value manner that is misleading or fraudulent tion where such contamination is probable of a contaminated property developed (lines 110 – 115). It is unethical for a (lines 6499 – 6502). under the hypothetical condition that the member to develop, use or permit others property is not contaminated. USPAP to use, for any purpose, any report which Conclusion 2003, Advisory Opinion 9 (AO-9) the member knows, or ought to know, is Appraising contaminated real estate 5 Principle of Substitution, Basics misleading (lines 426- 428). Competence creates interesting challenges for the of Real Estate Appraising, 3rd Edition, provision (lines 644 – 654): The appraiser real estate appraiser. With this type of Appraisal Institute of Canada, pg. 88, “The must have the competence to perform this appraisal, it is important for the appraiser principle of substitution states that when type of assignment or disclose otherwise. to remember the basic appraisal principles several similar or commensurate com- in determining how the bundle of rights modities, goods or services are available, Appraisal Standard – Rules can be affected by contamination. the one with the lowest price attracts the In the report, the appraiser must identify From a valuation perspective, the three greatest demand and widest distribution.” all assumptions and limiting conditions approaches to value can be used in this 6 Tridan Developments Ltd. v. Shell (line 1029) and any hypothetical condi- type of assignment, but there is a new Canada Products Ltd. (2000), 35 R.P.R. tions (line 1031) generation of valuation options that should (3d), 141 (Ont. S.C.J.) revd 57 O.R. (3d) be considered in this type of valuation. 503, 154 O.A.C. 1 (C.A.) Appraisal Standard – Comments The valuation of contaminated real estate 7 Contaminated Property Valuation Characteristics of the Property – consid- also creates its own terminology and it is Guideline, Arizona Department of Revenue, eration of known environmental impacts/ recommended that Canadian appraisers revised September 1, 1998 hazardous substances must be analyzed adopt the terminology (to be modified to 8 Montague v. Montague (1996), 92 (line 1480). reflect Canadian content), as demon- O.A.C.202, 23 R.F.L. (4th) 62(C.A.) Assumptions and Limiting Conditions, strated in this article, to create consis- 9 Rylands v. Fletcher (1868), Extraordinary Assumption, Extraordinary tency to approaches and expression. L.R.3H.L.330, affg (1866), L.R.1 Limiting Condition and Hypothetical Condi- 10 Environmental Protection Act, R.S.O., tions (lines 1491 – 1544). End Notes c. E.19, Amended 2002 1 Toxic Mold Alert – Toxic Mold Losses 11 Ontario Water Resources Act, Practice Notes Grow into Billion Dollar Problem, prepared R.S.O.1990,c.O.40, Amended 2002 Environmental impacts, recognition of by Marsh Canada Limited, November 10 Fisheries Act, R.S.C. 1985 c. R-14 contamination, remediation and compli- 2003 13 Valuing Contaminated Properties, An ance cost estimation and Value Opinions 2 Bundle of Rights, Basics of Real Appraisal Institute Anthology, Richard J. of Interests in Impacted Real Estate (lines Estate Appraising, Appraisal Institute of Roddewig, MAI, CRE, Editor, 2002 6335 – 6381). Canada, 3rd Edition, pg. 23, “The theory 14 Methods and Techniques for Con- affirms that ownership of property involves taminated Property Valuation, Thomas a bundle of legal privileges. Like a O. Jackson, PhD, MAI, Appraisal Journal, bundle of sticks, each one repre- October 2003, pg 311 sents a distinct and separate 15 Tridan, ibid right or interest that can 16 Jackson, T., Environmental Risk be dealt with separately Perceptions of Commercial and Indus- or together as the case trial Real Estate Lenders, Journal of Real might be.” Estate Research, 2001, Vol. 22, No. 3, 3 Impaired Value pgs. 271-88. – The market value 17 Tridan, ibid of the property being 18 Tridan, ibid appraised with full con- sideration of the effects of Gordon MacNair, AACI, P. App is its environmental condition Manager, Appraisals, Environmental Remediation and Special Projects, and the presence of environ- City of Ottawa. mental contamination on, adjacent 42 A PPRAISER C A N A D I A N WINTER . 2004 . HIVER EVALUATEUR C A N A D I E N