Environmental issues have become a key concern in real property
transactions. One particularly difficult issue is the question of how
contaminated or formerly contaminated properties should be valued for
sale, lease, or financing transactions, as well as to determine loss or
damage in litigation cases. The following seemingly simple equation has
emerged for valuation of contaminated properties:
I = U - C - S
Where:
"I" = impaired value
"U" = unimpaired value
"C" = remediation cost
"S" = stigma
This equation has been refined in the literature to break down the
cost ("C") factor into three sub-factors, including: 1). the
cost to implement an applicable remediation plan; 2). the cost of any
applicable use restrictions; and 3). impaired financing costs. Thus, the
equation can include more elements, but only as a variation on a theme.
Stigma ("S") can be defined as the incremental loss in
value beyond the cost factor due to market perceptions arising from
uncertainty and fear associated with the actual or potential presence of
contamination.
Unimpaired value ("U") is determined as if there were no
contamination, utilizing any of the customary valuation methods: 1). the
comparable sales approach (based on recent sales of like properties,
with adjustments relevant to the property being appraised); 2). income
approach (based on capitalization of income or discounted cash flow); or
3). replacement or reproduction cost.
This equation only refers to the negative or aggravating factors to
be deducted from unimpaired value. As a result, mitigating factors that
may offset the negatives are often overlooked. Mitigating factors should
be considered when using the basic or refined formulas mentioned above,
to derive net values.
Both aggravating and mitigating factors generally concern technical
and legal aspects of environmental risks and solutions, which likely
fall beyond the expertise of an appraiser alone. Thus, it may be
necessary to assemble a multi-disciplinary team of environmental
consultants, legal counsel, and other relevant professionals to generate
the information and analysis necessary to assist an appraiser in placing
a value on various aggravating and mitigating factors. The Appraisal
Standards Board has approved the use of multi-disciplinary teams for the
valuation of contaminated real property, expressly recognizing that
appraisers may rely on the professional work of others, as long as each
professional acts within the scope of his or her expertise and
acknowledges the contributions of the others. [1]
LIMITING COSTS TO FUTURE OWNERS
A basic premise of value is that it represents the value to a
future owner. Contamination affects market value primarily due to
environmental liability and costs that maybe incurred by future owners.
If a future owner may incur little or no cost or loss, there may be
little or no reduction in market value.
Cleanup prior to sale.
In many cases, owners clean up sites before sale, as is the general
policy of the major oil companies in selling service station sites. This
reduces the uncertainty of cleanup costs, hence mitigating or
eliminating possible discounts.
Cost recovery from responsible parties.
The market value impact of contamination may be limited by the
identification of liable parties, especially those with deep pockets,
who may bear remediation costs so that future owners will not be
affected or may recover such costs. To illustrate, there may be little
or no impact on the value of a property due to contamination from
formerly leaking underground storage tanks at a gasoline service station
where the responsible parties include a major oil company, but there may
be greater impact where the responsible parties are defunct or have
limited financial resources.
Environmental laws impose liability on a number of parties. For
example, the Comprehensive Environmental Response, Compensation and
Liability Act of 1980 (CERCLA), 42 U.S.C. $$ 9601 et seq., generally
imposes strict liability on present and past owners and operators of
contaminated property, as well as on the generators and transporters
responsible for the disposal of hazardous waste, subject to limited
defenses. It is therefore appropriate to consider the potential for cost
recovery from responsible parties.
According to some commentators, "[g]enerally, anticipated
recoveries are not considered in the property value estimate." [2]
This may be the case when an appraiser acts alone, without the expertise
necessary to estimate cost recoveries, or where estimation would be
purely speculative, in which case the appraisal opinion is subject to an
important limitation and may not reflect economic reality. If possible,
cost recovery should be considered in order to enhance the validity of
the appraisal.
The cost recovery factor may be considered by a multi-disciplinary
team including environmental consultants and counsel who can identify
potentially responsible parties and advise as to the extent of their
potential liability under applicable legal remedies. The availability of
such responsible parties and their ability to bear their liability
should also be considered.
Insurance recovery.
The costs of remediation may be covered by liability or property
damage insurance. While current forms of commercial general liability
insurance policies may contain "absolute" pollution
exclusions, coverage may be available under older policies that were in
effect when contamination occurred. Furthermore, at some cost, it is
possible to purchase insurance specifically addressing environmental
risk (e.g., pollution liability coverage, first party property damage
insurance without a pollution exclusion, and coverage for costs
associated with contamination not discovered during a site assessment by
qualified environmental consultants). Stop loss/cost cap insurance may
mitigate the risk associated with cost overruns in a remediation
program. Costs associated with a leaking petroleum underground storage
tank may be covered from a state fund for the cleanup of such sites.
Thus, the availability of past or present insurance coverage or similar
funding sources should be considered as a mitigating factor, and the ad
vice of qualified insurance professionals and legal counsel may be
helpful.
Cleanup by the government without recovery.
Due to a perceived threat to public health, a governmental agency
may clean up a site at the cost of the public even though there may be
no viable responsible parties. For example, remediation of the Ralph
Gray Trucking Site in Westminster, California, was undertaken by the
U.S. Environmental Protection Agency at a cost of millions of dollars
with apparently little prospect for significant cost recovery. The site
was used for the disposal of petroleum waste, with the parties known to
be responsible for the contamination either no longer in existence or
with little resources. The site is occupied largely by a residential
tract with the residents benefited by the homeowner's exemption.
Thus, the cost of remediation should not be a charge against the value
of the homes in that area. To the contrary, not only was the Ralph Gray
Trucking Site remediated at no cost to the residents, many homes and
yards were renovated at taxpayer cost, a probable windfall to the
residents enhancing the appeal and value of the neig hborhood as a
whole.
Environmental liens.
A governmental agency may seek to recover cleanup costs by imposing
a lien against the real property. However, such a lien is a regular
priority lien under both CERCLA and the California analogue. Thus, the
environmental lien may be wiped out through foreclosure by a senior
lienholder, with only partial or no net proceeds remaining for junior
lienholders. Several other states, including Connecticut, Louisiana,
Maine, Massachusetts, Michigan, New Hampshire, New Jersey, and
Wisconsin, have adopted various "superlien" laws pursuant to
which an environmental lien may be given priority as of a time earlier
than its actual recordation, with the potential for "priming"
otherwise earlier recorded liens. This may alter the valuation analysis
in such a state.
Thus, property may be cleaned up entirely at taxpayers'
expense without a viable responsible party or lienable equity in the
property. Where governmental cost recovery is frustrated, the value of
the cleaned up property could be restored without discount for cleanup
cost. In any case, the imposition of an environmental lien would affect
the amount of the landowner's equity, not necessarily the value of
the cleaned up property itself.
Environmental risk allocation by private agreement.
The potential costs of remediation may be tempered by private
agreements, such as through indemnification by the seller or other
responsible parties, or by new insurance products as mentioned above.
Contaminated properties that may be seemingly unmarketable for sale or
lease, or which would otherwise incur a significant discount, can be
made viable by such private agreements. Some entrepreneurs have
developed alliances with insurance companies and developers to assume
environmental risks associated with the acquisition and redevelopment of
contaminated property. The value of the property should be restored to
the extent that environmental risk has been shifted to such parties,
particularly insurers or other creditworthy parties, and away from the
property itself.
Environmental cleanup not required or unlikely.
In SDC/Pullman Partners v. Tolo Inc. (1997) 60 Cal. App. 4th 37, a
landlord sought to require a tenant to remediate toxic materials that
were present in the soil at trace levels, not high enough to pose a real
increased risk of heath problems or to trigger any cleanup order by
regulators. The court ruled that the tenant was not obligated to clean
up trace or de minimis amounts of toxic materials to avoid purely
speculative rather than real environmental liability.
The nature and extent of the contamination, the applicable
regulatory standards, and the extent of any cleanup obligation should be
considered in the valuation process. Where contaminant levels are low or
de minimis, such that remedial action is not required or is not likely
to be required, there should be no remedial cost to present or future
owners, and therefore no charge to property value under the cost
("C") factor. Without cost, the remaining factor is market
stigma (discussed below).
Time value of money.
To the extent that remediation costs ("C") will be
incurred over a long period of time into the future, it would be
inappropriate to deduct the full amount up front in an appraisal. The
projected costs should be discounted to present value.
THE UNCERTAINTY AND LIFE CYCLE OF REMEDIATION COSTS AND STIGMA
The costs of remediation are often uncertain. Significant variables
include the scope of contamination, the alternative remedial strategies,
and the degree of regulatory enforcement. These variables, and
associated stigma, may have different impact over time.
Valuation model v. life cycle.
The valuation model summarized above operates at only one point in
time, whereas the impact of contamination actually changes over time, as
to both remedial action cost and stigma factors. Typically, the life
cycle of environmental risks, and its costs and discounts, begins with a
phase where there is significant fear--possibly irrational--arising from
uncertain knowledge of the scope of the problem. When little is known,
speculation is rampant, and the emotional impact (stigma) may be
greatest at this point in time.
The level of uncertainty frequently changes over time, however, as
studies proceed, the contamination is better characterized, the history
of the property is ascertained, potentially liable parties are
identified, and remedial strategies are developed and effectuated. The
unknown becomes known, costs are better defined and fear subsides or
becomes contained and focused. (Of course, if it is found that the
contamination is more extensive than anticipated, the impact may
continue.) The parties often come together to find solutions, including
appropriate remedial action, which can allay concerns and reduce the
emotional component associated with the impact of the contamination.
Accordingly, the effect of the presence of contamination on value
may be reduced over time simply due to changing perceptions as the facts
and costs associated with the property are clarified. The outcome may be
the redevelopment of the site, in which case the past presence of the
contamination may no longer be a factor. For example, when a shopping
center is built over a contaminated or formerly contaminated site, the
presence of any residual contamination encased beneath the structures
might not influence the rents being paid by the tenants, and hence the
value of the property may no longer be affected by the presence of the
contamination (i.e., if unimpaired value of such an income producing
property is based on the income approach, and if the net income stream
is not affected by present or former contamination at the site, the
calculation of value could be unaffected).
Remediation technology.
There may be alternative environmental engineering solutions to a
given contamination problem, with widely divergent costs. New and more
cost-effective cleanup techniques are being developed continually, and
as the technology improves, remedial costs could be reduced. The timing
requirements for remedial action may also have a significant impact on
costs, whether the timing is transaction-driven or imposed by
regulators. In general, expedited remedial action usually increases
costs greatly. Unless immediate action is required for business reasons
or to abate an imminent health hazard, it is usually possible to design
more cost-effective remedial measures, spreading out and marginalizing
the cost overtime. Thus, a wise choice among available remediation
options may significantly reduce costs and, concomitantly, mitigate the
impact on property value. Of course, the technical advice of qualified
environmental consultants is critical to this mitigating factor.
Enforcement and cleanup standards.
Regulatory standards vary between governmental agencies. Where more
than one agency has jurisdiction, remedial action methods and costs may
depend on which agency becomes the "lead agency." Moreover,
applicable standards may differ based upon the circumstances. Of
particular significance is the potential impact of the contamination on
groundwater, especially groundwater that is a source of drinking water.
The risks and costs of two otherwise identical sites may be vastly
different if the contamination of one affects sources of drinking water
but the other does not. Similarly, concern may vary depending upon the
natural background level of the contaminant. Accurate estimation of
remedial cost should involve the assistance of qualified professionals
to assess the risk of exposure to human health or the environment and
the remedial standards to be applied by the lead regulatory agency as a
result. Remedial costs can be controlled, and hence the impact on
property value mitigated by the application of reasonable risk
assessment and cleanup standards.
Political backlash.
As indicated by almost daily coverage in the news media during the
1990s, environmental programs have been under attack at federal and
state levels, impelled by the perceived adverse impact of environmental
regulation on the nation's economic malaise in the early to
mid-1990s. The cost of compliance bites harder during recessionary
times, especially when the regulations and their enforcement are seen as
unfair by the regulated community. Along with other social programs,
agencies charged with enforcing environmental laws and regulations have
been affected by budget cuts at all levels of government. This political
backlash has reduced the real and perceived power of those agencies.
Thus, the impact of contamination on property value may be affected by
prevailing political forces and the extent to which the applicable
agencies are exercising their enforcement powers rigidly or reasonably.
Judicial backlash.
Similarly, after many years of largely unquestioning deference to
environmental regulators, the courts in the 1990s began to make
decisions curtailing what some judges perceived as excessive application
of regulatory authority.
Response of regulators to the backlash.
Regulators are not insensitive to the backlash, and policies have
been modified to make the enforcement of environmental laws more
reasonable and consistent among agencies. Many "brownfield"
initiatives have been adopted to facilitate the cost-effective
resolution of environmental problems and to return contaminated sites to
productive use. For instance, California's State Water Resources
Control Board has adopted an number of initiatives including,
significantly, a December 1995 guidance letter to the Regional Boards
supporting cessation of remedial action in some cases and, in general,
an enhanced consideration of risk assessment-based closure of low-risk
sites contaminated by leaking fuel tanks. This represented a major
departure from previous views of the threat of leaking USTs, and was
based on the Lawrence Livermore National Laboratory report of October
1995 finding that the environmental impact of leaking USTs is not as
severe as previously thought, and that natural bio-remediation should be
a primary remediation tool in most cases once a fuel leak source has
been removed. Although this attitude shift has been controversial in
some quarters, it has dramatically reduced remedial costs at UST sites
around the state as literally hundreds of sites have been closed. Such
initiatives may reflect an attempt by regulators to blunt the general
political backlash in hopes of avoiding wholesale legislative reversal
of environmental laws.
In the face of political and judicial backlash, it is no wonder
that the attitude of the regulators has changed. A stronger economy has
apparently not reversed that change in attitude. Many regulators realize
that cooperative efforts can return idle properties to productive use
providing jobs and improving the tax base while still preserving public
health. The interested parties, including regulators, tend to work in
concert for the efficient remediation of a property, reducing costs
where possible and serving both public and private objectives. More
reasonable enforcement of environmental laws should have a significant
effect on the extent and cost of remedial measures, mitigating the
charge to property value.
STIGMA
Trend toward risk-assessment.
Part of the political backlash has been against the arbitrary
application of stringent cleanup standards developed in the abstract
seeking zero risk regardless of cost and utilizing unrealistic
assumptions such as lifetime exposure to minute levels of pollutants.
Now, the trend is toward risk assessment-based decisions focusing on the
actual risk posed by a given situation. This significant change in
approach can be expected to have a mitigating impact on perceptions, in
many cases ameliorating the uncertainty and fear of health risk and
potential regulatory requirements, and, hence, reducing the stigma
associated with contaminated or formerly contaminated property.
Stigma diminishes over time or may be noncompensable.
As noted above, customary valuation methods "take a
picture" of value as of a given time, whereas the impact of
contamination on value actually varies over time. Studies have shown
that stigma dissipates, and value eventually returns to, or nearly to,
unimpaired value.
Post-cleanup stigma claims appear to be based on the fear that
there may be some unknown or residual contamination, or that cleanup
standards may become more stringent in the future, leading to additional
liability even after sign-off by regulators. Some courts have allowed
claims for post-cleanup stigma damages, but other courts have denied or
limited such claims. Other cases have considered stigma associated with
proximity to contaminated sites or fear of toxic impact from nearby
operations. Again, some courts have allowed such claims and other courts
have rejected them. Accordingly, it remains controversial whether and
under what circumstances post-cleanup or proximity stigma damages are
recoverable, and, if recoverable, the extent of the residual damage.
Thus, the analysis should include consideration of the law in the
applicable jurisdiction. If stigma damages have been rejected as a
matter of law, or only narrowly permitted, the application of that
factor may be eliminated or mitigated at the time of a property
appraisal.
A mechanical application of a stigma discount may be inappropriate.
It should be considered in each case whether stigma is a proper factor
under the circumstances, and if it is, further consideration should be
given to mitigating factors and approaches, and the manner in which the
risk and profit opportunity posed by the stigma element has been or is
being allocated between the transaction parties.
MARKET FACTORS
Highest and best use.
The impact of the presence of contamination may also depend on the
current or changing "highest and best use" of the property.
In circumstances where the contamination is located in a building,
and there is already limited utility to the building, the costs to
mitigate the contamination may exceed the contributory value of the
improvements, in which case a sound economic alternative may be to
remove the improvements, which may cost less than other forms of
remedial action, mitigating net remediation costs.
In cases where the land is contaminated, the regulatory stance and
market response may be affected by the long-term outlook for the use of
the property, so that if the contamination is commonly associated with
the anticipated use, its impact on value may be nominal.
If the market perceives that a property can be reused without
exacerbating or exposing the contamination, or the anticipated use is
consistent with past uses, then liability or stigma may be largely a
moot issue. In contrast, if a change in use is anticipated, a change
where there is less tolerance for the presence of the contamination than
the tolerance existing for the current use, then the presence of the
contamination may trigger a significant impact on the value of the
property.
Sellers' vs. Buyers' Market.
Prevailing economic and market conditions can have a significant
impact on the marketability and value of contaminated properties. The
1990s have seen a dramatic swing of the pendulum from the real estate
recession to a relatively "hot" economy and real estate
market. Many environmentally impacted properties that languished during
the recession are now moving in the marketplace. Governmental brownfield
initiatives, along with better economic conditions, have helped to
stimulate this. In a hot sellers' market, value and price tend to
firm up, and buyers tend to be willing to assume more risk with less
discount than during gloomy economic times. Thus, the place and time of
a transaction in the economic and market cycle is an important factor
that may mitigate (or aggravate) the impact of contamination on value
and price.
No uniform market price discount.
It is a common misconception that there is a uniform market price
discount for contaminated properties. In fact, there are usually few, if
any, comparable transactions, as each may represent a unique condition
and may reflect a wide geographic range. It may not be possible to draw
valid market conclusions from the small sample size. Even if
transactions involving comparable property types and environmental
conditions are available, the pricing may have been affected by business
considerations, such as the need for a particular location, the need to
close the second leg of a tax deferred exchange, or private agreements
between parties for mitigation of contamination costs. It is therefore
necessary in each case to undertake a careful analysis of the applicable
method of determining unimpaired value and the various aggravating and
mitigating factors that are relevant to a determination of the
impairment to value, with the assistance of qualified professionals, as
needed.
LEGAL AND REGULATORY EXEMPTIONS OR DEFENSES
The impact of the presence of contamination may depend, in some
circumstances, on limited requirements for investigation or on certain
legal limitations and exemptions.
No duty to investigate.
While certain disclosure duties apply under applicable law, there
is no general requirement for a seller to undertake an environmental
site assessment prior to sale in order to obtain new knowledge.
Nevertheless, environmental site assessments by buyers have become a
common feature of real property transactions, particularly when required
by lenders, and in some contexts, e.g., for a leased property, existing
legal principles may impose on a property owner the duty to inspect and
be aware of, and to repair or warn of, dangerous conditions. Also, real
estate brokers may have a duty to undertake some investigation. In any
case, if the transaction parties are not aware of existing
contamination, there would be no impact on market value and price at the
time of the transaction. Similarly, in many instances there is no
requirement for remediation even when contamination is known to be
present, again resulting in little or no potential impact on value.
Condemnation.
Some courts have not allowed the presence of contamination to be
taken into consideration when determining the value of property that is
being condemned, but other courts have ruled that remediation costs or
stigma are admissible with respect to determining value in condemnation
proceedings. This may also be affected by applicable statutes. For
instance, California law expressly excludes consideration of the
presence of hazardous substances in determining the appraised value of
property being taken by a school district under the power of eminent
domain. Instead of a price discount, Calif. Code of Civil Procedure
[sections] 1263.740 contemplates that the property will be cleaned up
under the procedure set forth in Section 1263.720, using the full fair
market value purchase monies, with any excess costs recoverable under
Section 1263.730.
Thus, the extent to which loss of value due to contamination may be
considered in condemnation proceedings will depend upon the statutes or
case law of the applicable jurisdiction.
Homeowner's exemption.
The U.S. EPA has adopted a policy statement establishing a
qualified homeowner's exemption declaring that the average
homeowner will not be required to conduct or pay for cleanup when
residential property is part of a federal Superfund site. This seemingly
discretionary policy is, of course, based on the fact that most
homeowners would have the benefit of the third-party defense under
CERCLA in any event, and it would be decidedly unpopular were the U.S.
EPA to begin pursuing homeowners who happen to reside on top of a
contaminated region. Similar homeowners' exemptions have been
adopted under the laws of some states.
Defenses to liability.
Current and future owners may have defenses to liability under
CERCLA and other environmental laws. Thus, the government may have to
pursue other responsible parties, if any, for cost recovery (such as
former owners or operators, or those who actually disposed of hazardous
waste on someone else's property). Even though contamination may
nevertheless have to be dealt with by the owner (e.g., to obtain
financing), the availability of defenses to liability will enhance the
potential for obtaining recovery from other responsible parties.
Thus, to the extent that defenses are available and remedial costs
are not legally recoverable from current or future owners, the potential
charge to the real property should be mitigated.
CONCLUSION
It is not enough to deduct mechanically the costs of remediation or
regulatory compliance, and any presumed "stigma," in
calculating the impact of contamination on the value of real property.
The usual valuation model is, at best, simplistic in making short-shrift
of relevant mitigating factors (such as those discussed in this
manuscript) and may be misleading to the extent that it does not reflect
the market devices and legal factors that are frequently present. The
valuation of contaminated or formerly contaminated property is a complex
undertaking, with a variety of aggravating and mitigating factors.
Accurate appraisal requires careful investigation and assessment of such
factors, with the assistance of qualified environmental consultants and
counsel as to technical and legal aspects. Without a multi-disciplinary
team, an appraiser acting alone probably will lack the necessary
expertise to render anything but an unimpaired value opinion assuming
the absence of contamination. Such an opinion may be of some use, but
would not reflect the actual, impaired value of the property, a serious
limitation that the appraiser would be obligated to disclose under
applicable ethical standards
ABOUT THE AUTHORS
Allan Gluck, MAI, is a member of the Appraisal Institute with his
own appraisal firm in Los Angeles, California.
(Email:agluck@pacbell.net)
Wayne Lusvardi is senior real estate representative, engineering
division, Metropolitan Water District of Southern California. Gluck and
Lusvardi have significant experience in the appraisal and valuation of
contaminated properties. (Email: wlusvardi@mwd.dst.ca.us)
Donald Nanney, Esq., is a partner in the law firm of Gilchrist
& Rutter with offices in Los Angeles and Santa Monica, California,
and heads the environmental law practice of that firm. Nanney is the
author of numerous writings, including the book Environmental Risks in
Real Estate Transactions: A Practical Guide (Second Edition),
McGraw-Hill, Inc./Executive Enterprises, Inc. (Email:
dnanney@grlawyers.com)
NOTES
The authors are expressing views and concerns of general academic
interest, without any reflection as to how they would view any
particular property, situation or case. The views and concerns are those
of the authors, not necessarily of their companies or firms.
(1.) See Appraisal Standards Board Advisory Opinion G-9
"Responsibility of Appraisers Concerning Toxic or Hazardous
Substance Contamination," dated December 8, 1992; see also,
Appraisal Institute Guide Note 8, "The Consideration of Hazardous
Substances in the Appraisal Process," as amended January 28, 1994.
(2.) Colangelo and Miller, Environmental Site Assessments and Their
Impact on Property Value: The Appraiser's Role. The Appraisal
Institute (1995), at p.50.