Working RE News: Calculating Diminution of a Contaminated Property

"If you are appraising an environmentally contaminated property, you may need to consider more than just the cost of remediation (cost to cure). The property may suffer from stigma associated with the contamination. Stigmatized properties can take months and even years to recover from a blighted image. "

Editor’s Note: If you are appraising an environmentally contaminated property, you may need to consider more than just the cost of remediation (cost to cure). In this story excerpted from the upcoming print edition of Working RE, Finigan explains what to consider when appraising stigmatized properties.

If you are appraising an environmentally contaminated property, you may need to consider more than just the cost of remediation (cost to cure). The property may suffer from stigma associated with the contamination. Stigmatized properties can take months and even years to recover from a blighted image.

The Uniform Standards of Professional Appraisal (USPAP) describe stigma in the A09 provision (2012-2013)... “Environmental Stigma: An adverse effect on property value produced by the market’s perception of increased environmental risk due to contamination...When the appraiser addresses the diminution in value of a contaminated property and/or its impaired value, the appraiser must recognize that the value of impacted or contaminated real estate may not be measurable simply by deducting the remediation or compliance cost estimate from the opinion of the value as if unaffected (unimpaired value).”

At first glance most real estate appraisers don't appear to be prepared for the type of assignment contaminated properties present. Every appraiser utilizes the same methodologies when they are developing an opinion of value. The most common and usually the most reliable method for appraising contaminated residential properties is the market approach, but we may also need to consider the cost and income approaches in developing an opinion of value. All three may come into play when calculating diminution caused by stigma.

Assignments of this nature require considerably more research. To effectively complete an assignment of this sort may cost thousands of dollars. They typically cannot be priced as a flat fee but should be charged based on an hourly rate with a cost range indicated.

Market Approach and Stigma Factor
The most common method used for residential real estate is the market approach. The three rules of real estate value typically come into play during the market approach. They are location, location, and location, but these rules go out the window when appraising a contaminated property. The most significant factor in choosing comps lies in the type of contamination. In choosing comps you should choose those that have sold with the same type of environmental contamination. Today, mold is a very common environmental contaminant impacting the value of properties everywhere. For this reason we will use mold contamination as our example.

The first question to ask is how many homes in your neighborhood are contaminated with the same type of environmental contamination? In reality, the search for properties contaminated by mold may take the appraiser to other neighborhoods or even other geographic regions. An appraiser may need to conduct as many as four different appraisals in trying to accurately derive the value of a property rendered uninhabitable by fungal contamination. All comparables may be in different geographic markets and require assistance from appraisers in those regions.

First, the appraiser will need to locate similar properties suffering from the same type of contamination. Factors to consider include but are not limited to the type of contamination, the habitability restrictions specifically attributable to the contamination and the cost of remediation to cure the defect. This is not as difficult as it sounds- as more and more contaminated homes emerge, more information regarding remediation costs is becoming readily available.

The next step is to establish a baseline value for each property (subject and three comparables) by performing a hypothetical appraisal and developing an opinion of value as if the properties are not contaminated. Obtain estimates for the cost to cure the contamination at the subject property. Research is necessary to determine how much buyers spend to remediate the environmental conditions. I have found that most people are quite forthcoming and willing to brag about the good deal they got on the property and what they spent to remediate. This number represents the actual cost to cure.

The sale price of the comp as it sold in the contaminated state plus the new owner’s cost to cure is then subtracted from the comp's uncontaminated hypothetical value (baseline). The resulting number is an indication by the marketplace of the stigma suffered by that property. We can call this the stigma factor.

Divide the stigma factor by the hypothetical value of each comp to create a percentage ratio. This is the diminution ratio suffered by each comparable sale.

A weighted average for the percentage of loss is created from the three diminution ratios derived from the three comps. The average must be weighted based on similarities in property styles, neighborhoods, or size to the subject property. You have now created a diminution factor.

Diminution Factor/Impact on Value
The diminution factor is then factored against the uncontaminated theoretical value of the subject property (e.g. 30 percent of $240,000 equals $80,000). Add the dollar amount calculated by the diminution factor to the cost to cure estimates. We will call this the impact on value. Subtract our impact on value (cost to cure plus diminution factor) from the hypothetical value of the subject property and, bingo, we have a defensible opinion of value.

Confirming Stigma
Stigma can last for months or even years. An appraiser can confirm stigma by asking lending institutions if they would be interested in providing for a theoretical "virtual contaminated subject" similar to the subject property. Another way is to contact local Realtors to ask if they are interested in listing the "virtual contaminated subject" property. I have even contacted insurance companies regarding the feasibility and cost of insuring the "virtual contaminated subject."

I was appraising a mildly contaminated commercial property in Vermont. To test my belief that stigma existed, I contacted three lending institutions asking if they would be interested in exploring a loan with my financially sound client who wanted to buy this property. Although the responses were polite, they all declined the opportunity and gave no indication of how much time would need to pass before they might be interested.

I have used this market methodology successfully in court cases and have had it accepted by probate courts, the IRS, and heirs to property. This methodology employs sound appraisal practice in accordance with USPAP and is highly defensible in the event of litigation.

The beauty of this method of calculating stigma is that it employeessimple appraisal technologies that every professional appraiser is familiar with. It doesn’t rely on complex algorithms or regression tables and when presented to a layperson, a judge, or a jury it’s easy to understand.

There are assignments especially for commercial properties when calculating diminution may include the cost approach and the income approach. I’ll share those methodologies with you in a future article.

Of course, another way to calculate diminution is to use the SWAG theory (scientific wild ass guess). My recommendation is don’t guess; attend our Environmental Hazards Impact on Value seminar now available online at CalypsoContinuingEd.com and learn to be accuarte and how to use all your options. Good luck doing good work.

Class Available in Florida
Finigan will be teaching the class Environmental Hazards Impact on Value in Tampa, Fl on November 12th and in Jacksonville, FL on November 13th for 7 hours of continuing education credit in Florida. Please visit www.CalypsoContinuingEd.com to sign up now.

>>Introductory Webinar: Partnering with Working RE, Rich Finigan will be hosting a webinar for appraisers this November 13th. In Environmental Hazards Impact on Value, Finigan will share key strategies for environmental due diligence, making the right disclosures, and dodging the inevitable liability bullet. Click here to Sign-Up.

About the Author
Francis Xavier (Rich) Finigan is Educational director for ACEI Calypso Continuing Education. Finigan has decades of real estate appraisal, environmental science, and residential and commercial construction. Since 1993 he had has provided continuing education seminars to real estate appraisers in many states. Rich formerly served as President of the Indoor Environmental Standards Organization, an ANSI standard setting body. He shares this unique and court proven methodology with appraisers at his Environmental Hazards Impact on Value seminar now available online at www.CalypsoContinuingEd.com.