APPRAISAL INSTITUTE: Best Practices Emerge in Accounting for Environmental Contamination in Appraisals

A speaker on a recent EDR Insight webinar, titled An Inside Look at the Challenges Facing Appraisals and Lenders Today, warned attendees that bank regulators are being “very outspoken” about the appraisal-environmental functions and how they relate to each other. The impact is being felt in the lending world. At the June Environmental Bankers Association meeting in Seattle, Partner Engineering’s Joe Derhake shared: “Bankers noted recent occasions where the appraiser came back and said, ‘There’s a significant environmental issue at the site. I need to see the Phase I environmental site assessment before I go on.'”

Regulator scrutiny is bringing the need to give special consideration to the specific impacts of hazardous substances on the valuation of real property. But how? The Appraisal Institute recently took on the task of providing guidance on this front, and outlining early best practices in its Guide Note 6: Consideration of Hazardous Substances in the Appraisal Process. This EDR Insight brief highlights the framework established by the Appraisal Institute, and addresses some of the pain points being felt in the field.

Push from Regulators Taking Root

Under the latest Commercial Real Estate Lending guidance of the Office of the Comptroller of the Currency, banks regulated by the OCC should:
–    establish criteria for considering environmental contamination in the appraisal process; and
–    have an effective environmental risk program that includes “appraisal requirements for disclosing and taking into consideration any environmental risk factors.”

The FDIC, SBA and MBA are expected to issue similar guidance to emphasize the importance of appraisals that consider environmental risk. In the field, however, there is a great deal of uncertainty about how exactly known or suspected environmental risks can be accounted for during a property’s appraisal.

Accounting for Contamination in Appraisals: Best Practices

As presenter Bill Garber, Director Government and External Relations at the Appraisal Institute, noted during our webinar, “The goal of a bank should be to make informed decisions in the lending process. My view is that if the information on environmental risks is sound in an assessment and would improve the appraisal, then the appraiser ought to be provided that information for their review to determine if there are other issues involved.” But how? The market is in the early stages of getting comfortable with the process and early best practices are emerging.

The purpose of the Appraisal Institute’s Guide Note 6 is to address the confusion in the industry and “provide guidance in the application of the Uniform Standards of Professional Appraisal Practice (USPAP) to the appraisal of real property affected by or potentially affected by environmental contamination and, in particular, to the consideration of environmental contamination in the appraisal process.” The note is a valuable starting point for professionals in this space to come up to speed on how lenders can, and should be, establishing policies to address environmental risks in the property valuation process.

This is the three-point framework in the Appraisal Institute’s Guide Note 6 for proper valuation of properties that may be impacted by environmental contamination:
1.    Estimate the unimpaired value (e.g., appraise as if the property is not contaminated).
2.    Estimate property value diminution (i.e., cost effects, use effects and risk effects).
3.    Estimate the impaired value of the subject property. This value can usually be derived by deducting an estimate of diminution from the unimpaired value. These estimates must be appropriate and well supported by market data typically involving actual transactions by market participants.

From Guidance to Real Life: The Challenges

As regulator pressure to integrate appraisals and environmental risk management continues, it is not without its challenges (see table). For one, bank appraisal and environmental departments are under increasing pressure. There is also the difficulty associated with completing cost to cure calculations. “Cost to cure calculations can be a touchy subject,” Garber noted. “There are new services and technologies available to help with the cost analysis done by environmental professionals or appraisers, and the body of knowledge in that space is evolving. Not all appraisers are competent to assess environmental impacts, but they should be market analysts and they can gain new competencies. There is a lot of training out there on the subject and it’s important to seek out qualified experts. There are experts who can knowledgeably estimate the impact a leaking UST might have on a property and we have the ability to grow out that knowledge as people ask more questions.”

 

So where does that leave a lender? For integrating the environmental and appraisal functions, Garber outlined these suggested best practices:
– Commission appraisal and environmental together
– Have the appraisal prepared for “as-is” market value
– When environmental assessment is returned to bank, provide information to appraiser to determine value “as impaired”
“As-is impaired” may not equal “as-is clean.”

There are challenges associated with commissioning the appraisal and environmental assessment together, including the pressures banks are under internally, volume pressure and timeliness pressures. Also, the appraisal and environmental departments operate traditionally in silos, so many banks view this as a workflow process issue (see shaded text box for relevant Q&A). Yet there are appraisers who are already starting to say they need to see the property’s environmental data before conducting the appraisal.  Garber predicted that we may soon reach a point when appraisals routinely start to incorporate a Transaction Screen or desktop screen.

QA
On integrating the appraisal and environmental functions:

“There has been a recent trend for the appraisal department and the environmental department to be working together, often under one roof. In most cases, it’s the appraisal department taking on the environmental responsibilities because the appraisal function is more established by regulations, though I’ve also seen instances where the environmental department takes over the appraisal function. There’s obviously a learning curve associated with taking on those new responsibilities.”
—Bill Garber, Appraisal Institute

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While many appraisers do not account for environmental issues in valuations, plenty do. And more likely will. The Appraisal Institute’s guide is a good starting point for understanding the process and the inherent challenges.
What is clear is that banks are under increasing pressure to adopt a more holistic risk management process that brings the environmental and appraisal functions closer together. Banks regulated by the OCC need to integrate the processes in accordance with the latest guidance. The good news is that expertise in these areas will only improve as more data on the impact of contamination on properties becomes easier to access. As this happens, perhaps it will make the job of appraisers in the face of growing regulator pressure a little easier.

FOR MORE INFORMATION

There is a growing body of knowledge on the subject of how environmental contamination is being considered during the appraisal process, including:

The Appraisal of Real Estate, 14th Edition, Chapter 12, Land and Site Description which includes a discussion of specialized methodologies.

Presenters’ slides from EDR Insight’s Webinar, titled “An Inside Look at the Challenges Facing Lenders and Appraisers Today”

Appraisal Institute. Guide Note 6. Consideration of Hazardous Substances in the Appraisal Process.

USPAP Advisory Opinion 9: The Appraisal of Real Property That May Be Impacted by Environmental Contamination, by the Appraisal Standards Board.