Is it Worth the Risk? The Impact of Environmental Risk on Property Investment Valuation

Citation

Sheard, M. (1998), "Is it Worth the Risk? The Impact of Environmental Risk on Property Investment Valuation", Journal of Property Valuation and Investment, Vol. 16 No. 1. https://doi.org/10.1108/jpvi.1998.11216aae.004

Is it Worth the Risk? The Impact of Environmental Risk on Property Investment Valuation

Is it Worth the Risk? The Impact of Environmental Risk on Property Investment Valuation

Tim Richards

College of Estate Management Research Report,1997,1-899769-71-4,104 pp.£35 plus p+p

This report is a useful addition to the growing body of publications exploring increasing concern at the implications of ever-escalating environmental regulation affecting land and property. As a glance through the report's bibliography confirms, most of the work published hitherto relates to the USA, and in comparison the UK suffers from a relative dearth of "home-based" studies. This report records the level of UK property market awareness and responsiveness to an evolving body of regulation against an ambiguous legal background during 1996.

The report does not therefore reflect any of the effects yet to be seen of the Environment Act 1995 insofar as it relates to contaminated land. It attempted to assess the extent to which the then current and apparent implications of UK environmental law were being acknowledged and acted upon by participants in the property market. It represents a snap-shot view of what is already a historic situation in the evolution of environmental control and will provide a useful reference point against which to assess any future research into this important area.

It is to be hoped that there will be some change in the property market's awareness and responsiveness, for the report reveals an alarming lack of knowledge and concern in some important quarters. Some market players seem content to proceed in ignorance of the implications of very significant regulatory changes already introduced or pending, while others continue to regard the merest whiff of suspicion of "something nasty down below" as justification for "red-lining" ­ that is, rejecting any possibility of involvement in the subject property notwithstanding realisable potential for profitable investment or development.

The market's valuations of contaminated or potentially contaminated property are therefore not to be regarded as reliable, and arbitrage opportunities seem likely to exist for those who are prepared to accept some risk but to approach valuation in a rational, consistent way on the basis of thorough site-specific research. Not enough appears to be done, even today, to investigate and assess the extent of investors' exposure to environmental liabilities particularly in relation to their existing portfolios. On the other hand, those considering purchase seem to be over-allowing for the potential risks by adopting unscientific adjustments which have little regard to the actual circumstances on site and in the marketplace for the type of property in question.

Tim Richards was guided in his work by a team of professional practitioners from a variety of backgrounds but all involved, day to day, in commercial property. The report reflects practical concerns accordingly. After an executive summary dealing with the main findings, the background to the research, a review of its scope, conduct and results, and a summary of suggested improvements to valuation methodology, the report comprises six chapters. These progress from an introduction, dealing with the nature of the author's concern to establish the property market's response to issues of environmental risks, the nature of those risks including their legal as well as practical aspects, and the scope and conduct of the research, to a more detailed review of the evolution of UK environmental statute and case law and of the response of the valuation profession to it in the shape of RICS guidance, and then to a brief but somewhat academic analysis of the nature of investment decision making, and a review of investment risk-assessment procedures and risk rating, and the impact of environmental liability or the threat of liability including a helpful review of previous research (albeit perforce much of it American). These chapters touch on an important aspect of the research, namely to establish the significance of the effect of "stigma" in property valuation and decision taking, how stigma is generated and how it can be measured and/or assessed: the subject is considered in greater detail later in the light of the research findings.

Chapters 4 and 5 describe in detail the results of the research comprising a questionnaire survey, to which some 67 completed responses were received from a wide spread of market participants, and a series of case studies, of which only a rather disappointing 11 were returned. The questionnaire elicited one or two startling revelations, particularly a worrying proportion (almost a third) who demonstrated no or scant knowledge of, or regard for, the implications of the Environment Act 1995; another worrying proportion (in excess of one third) who were unaware of or had not consulted RICS guidance on land quality and valuing contaminated sites, and an equally worrying eagerness to "red-line" sites offered for sale as soon as there was any hint of any problem. Other topics investigated by the questionnaire included the background of the respondents (i.e. the nature of their property market involvement), the nature of property portfolios held by investor respondents, the extent of such investors' knowledge of the condition of their holdings in terms of exposure to contamination risks or liabilities, their appreciation of environmental risk in comparison with other types of risk including their appreciation of the relative risk arising from different kinds of contamination, and valuation methodologies adopted to attempt to allow for such risks. Particular questions were directed at establishing the degree to which values were being reduced to allow for stigma, and what were thought to be the factors and concerns that gave rise to it.

Some degree of stigma was found to be widely prevalent in the market conditions prevailing in 1996. Tim Richards concludes however that the valuation methods being adopted to estimate or account for it were in most cases flawed, in that they failed to have regard to the magnitude of the risk applicable (or the potential extent of the financial exposure arising from it) and/or took little or no account of the probability of the identified risk occurring. Wide reliance is being placed on subjective and rather unsophisticated judgement. Whether this is to be attributed to a lack of appreciation of the nature and basis of stigma effects, a lack of knowledge of appropriate techniques, or lack of market information from which to derive the necessary adjustments and allowances has not been established. (This reviewer suspects that it is likely to be all three, on the basis ­ if no other ­ that the first two probably prevail in the marketplace, leading inevitably to the last: pity the poor valuer who is supposed to interpret the market and not lead it!)

The research adds to the fund of professional knowledge in one particular respect on this important matter, namely by demonstrating from empirical evidence that the stigma effect associated with remediation diminishes over time ­ the value of a remediated property and an equivalent prime uncontaminated property tend to converge.

The author proposes that the highlighted deficiencies of current valuation practice may be overcome by incorporating probability analysis into the exercise, although recognising the difficulty of obtaining the relevant data. While undoubtedly that would produce more scientifically accurate answers, its use in the assessment of open market, or market, value is likely to be restricted for as long as the market itself continues to display its proclivity for "headless chicken" reactions to the prospect of involvement with anything to do with contamination, and while the necessary skills remain primarily the province of academics. The use of such techniques for Calculations of Worth to an individual investor, potential or actual, is much more likely, and once their use in that context is reflected in investment decisions, valuers are likely to follow suit.

The report concludes with a résumé of the areas of concern arising from the survey, highlighted above, and suggests that further UK research would be appropriate into identifying the nature and extent of stigma effects and changes therein over time, assessing appropriate allowances therefor, and incorporating probability analysis into valuations.

The UK property market has reacted relatively slowly and without much sophistication to the increasing priority of environmental regulation and liability which has been experienced over the last decade and more. As regulation and liability continue to extend, property professionals will have to come to terms with the need more accurately to reflect these concerns in their dealings in that market. This research report underlines that there is a long way to go, albeit while noting that some progress has been made in recent years. Perhaps it will take a number of well-publicised "coups" by developer/traders profiting from under-valuations of modestly contaminated or otherwise remediable sites to bring about wider recognition that current approaches are inadequate.

This report is an extremely useful measures of those inadequacies and its publication could go some way to help to remedy them.

Martin SheardMatthews & Son, Chartered Surveyors, London