Valuation of investment interests in contaminated properties in Romania

University of Greenwich School of Architecture and Construction

VALUATION OF INVESTMENT INTERESTS FOR CONTAMINATED PROPERTIES IN ROMANIA

By George Dorian Gherman

Except where stated otherwise, this Dissertation is based entirely on the author’s own work 2011

Valuation of Investment Interests in Contaminated Properties in Romania

Abstract This paper seeks to investigate the opportunities of investing in contaminated properties in Romania. The indicator which reflects the investment’s potential is the internal rate of return and it is produced by using two valuation models, both taking account of the impact of stigma. It was acknowledged that stigma quantification plays a relevant role in valuations.

Literature review has revealed that for investment purposes, stigma has been usually quantified by making an upward adjustment in the yield (here and after called stigma premium). This constituted the technique used in the first valuation model. A different approach has been adopted in the second model, based on stigma perceptions which reduce the final value of the property (here and after called stigma reductions).

The inputs for the models (stigma premium and reduction) were derived from a questionnaire survey based on the experience of 81 property professionals in Romania.

The model and results of the survey were applied into a hypothetical case study. Using the stigma reductions a higher value of the property was obtained compared with the stigma premium based model. However the validity of the stigma premiums is questionable since the survey revealed that stigma yield adjustment technique for quantifying stigma is not commonly used by the property professionals in Romania.

The investment valuation for the case study proved that the project was worthwhile, meeting the target rate of return using the values from each of the two models. However, in the case of the stigma reduction model the internal rate of return was 25 base points below the target rate and almost 5% less than internal rate of return when using the stigma premium method.

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Valuation of Investment Interests in Contaminated Properties in Romania

Acknowledgements The author is grateful to David Isaac, his Dissertation supervisor and mentor who offered valuable support and advice, especially in some particular key moments. His recommendations with regards on chapters 3 and 4 must have contributed greatly in receiving an invitation from the Managing Director of The Valuation Journal in Romania, to publish the results of the survey.

The author wishes to thank his family for the continuous encouragement and for providing him with that extra impulse which sometimes was needed; he found the support extremely beneficial and he is grateful for it.

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Valuation of Investment Interests in Contaminated Properties in Romania

List of figures FIGURE 2.1: VARIABLE STIGMA PREMIUMS CHART, ADAPTED AFTER CHALMERS AND ROHER (1993, P.35) FIGURE 4.1: PROPORTION OF TECHNIQUES USED FOR STIGMA QUANTIFICATION (RESULTS FOR QUESTION 4) FIGURE 4.2: ARY STIGMA PREMIUM RELATIVE TO THE LEVEL OF CONTAMINATION (RESULTS FOR QUESTION 5) FIGURE 4.3: THE EXPECTED STIGMA IMPACT ON VALUE BEFORE & AFTER REMEDIATION (QUESTIONS 7 AND 8) FIGURE 5.1: CORRESPONDANCE OF VARIABLE IN THE TWO SENSITIVITY TESTS

20 35 36 37 49

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Valuation of Investment Interests in Contaminated Properties in Romania

List of tables TABLE 2.1: EXAMPLE OF ‚SHORT-CUT’ DCF, ADAPTED AFTER KENNEDY (1996) TABLE 2.2: TERM AND REVERSION ARY APPROACH, ADAPTED AFTER RICHARDS (1996, P13) TABLE 3.1: ARY ADJUSTMENT MODEL TABLE 3.2 : RISK ASSESSMENT APPROACH TO QUANTIFYING STIGMA TABLE 3.3: THE RISK ASSESSMENT MODEL TABLE 4.1: OVERVIEW ON EXPERIENCE OF VALUERS TABLE 4.2: PERCEIVED STIGMA EFFECT BY INDUSTRY (RESULTS FOR QUESTION 9) TABLE 4.3: PERCEIVED STIGMA EFFECT DEPENDING ON TREATMENT METHODS (RESULTS FOR QUESTION 10) TABLE 5.1: VALUATION OF THE CONTAMIANTED PROPERY USING THE ARY ADJUSTMENT MODEL TABLE 5.2: VALUATION OF THE CONTAMIANTED PROPERY USING THE RISK ASSESSMENT MODEL TABLE 5.3: INPUTS USED IN THE CASE STUDY TABLE 5.4: IRR VARIATION, RELATIVE TO THE EXIT YIELD AND STIGMA PREMIUM TABLE 5.5: IRR VARIATION, RELATIVE TO THE EXIT YIELD AND STIGMA REDUCTION

15 16 28 29 30 34 38 39 44 45 47 48 49

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Valuation of Investment Interests in Contaminated Properties in Romania

List of abbreviations

ANEVAR - NATIONAL ASSOCIATION OF ROMANIAN VALUERS CABERNET - CONCERTED ACTION ON BROWNFIELD AND ECONOMIC REGENERATION NETWORK DCF - DISCOUNTED CASH FLOW EEA - EUROPEAN ENVIRONMENTAL AGENCY ERDF - EUROPEAN REGIONAL DEVELOPMENT FUNDS ESOP - ENVIRONMENTAL SECTORAL OPERATIONAL PROGRAMME FRV - FULL RENTAL VALUE GDP - GROSS DOMESTIC PRODUCT IRR - INTERNAL RATE OF RETURN IVS - INTERNATIONAL VALUATION STANDARDS IVSC - INTERNATIONAL VALUATION STANDARDS COUNCIL NEPA - NATIONAL ENVIRONMENTAL PROTECTION AGENCY NPV - NET PRESENT VALUE NSMCS - NATIONAL STRATEGY FOR THE MANAGEMENT OF CONTAMINATED SITES ROP - REGIONAL OPERATIONAL PROGRAMME SCA - SALES COMPARISON APPROACH

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Valuation of Investment Interests in Contaminated Properties in Romania

CONTENTS ABSTRACT ACKNOWLEDGEMENTS LIST OF FIGURES LIST OF TABLES LIST OF ABBREVIATIONS 1 INTRODUCTION 1.1 1.2 1.3 1.4

INTRODUCTION RATIONALE AIM AND OBJECTIVES RESEARCH METHODOLOGY

2 BACKGROUND KNOWLEDGE ON VALUATION OF CONTAMINATED PROPERTIES 2.1 2.2 2.3 2.4

INTRODUCTION TO BROWNFIELD THE STIGMA APPROACHES TO VALUATION THE ROMANIAN CONTEXT

3 THEORETICAL VALUATION MODELS 3.1 3.2 3.3

INTRODUCTION ARY ADJUSTMENT MODEL RISK ASSESSMENT MODEL

4 QUESTIONNAIRE SURVEY 4.1 4.2 4.3

INTRODUCTION RESULTS AND ANALYSIS CONCLUSIONS OF THE SURVEY

5 HYPOTHETICAL CASE STUDY 5.1 5.2 5.3 5.4

INTRODUCTION PROJECT DESCRIPTION AND ASSUMPTIONS ARY ADJUSTMENT AND RISK ASSESSMENT MODELS AT WORK SENSITIVITY TESTING ON THE INVESTMENT OPPORTUNITY

II III IV V VI 2 2 4 7 7 10 10 11 13 21 26 26 27 29 33 33 34 39 42 42 42 43 47

6 SUMMARY, CONCLUSIONS AND RECOMMENDATIONS

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REFERENCES

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Valuation of Investment Interests in Contaminated Properties in Romania

Introduction

1 Introduction 1.1 Introduction This Dissertation investigates the potential return rates of investing in contaminated properties in Romania. As the core of investigating these rates is a property valuation, any sensible mind will assume the following basic method of valuation: the property is being valued as uncontaminated, after which the costs of remediation are subtracted. The result will be the contaminated value of the property.

The method seems rationale and simple so far. However, does the property market ‘recognise’ this estimated value? Emphasis is put on the major factor which influences this value in the case of contaminated properties and therefore stigma is taken into consideration.

In order to offer a clear view towards achieving the final goal, the paper is structured in six chapters, each having its own specific role and contribution. Chapter 1 acts as an introduction to the research. The rationale behind choosing this topic is explained, starting from the inception until the final phase. It emphasises the rising awareness on the rapidly changing urban population and the limited urban space, followed by the increased interests in redeveloping brownfield land in Romania. The aim of research is presented here and the objectives are outlined. Very importantly, the research methodology is described, comprising three main parts: a literature review, a questionnaire and a hypothetical case study.

Chapter two plays the role of the literature review. It starts with defining contaminated land, commonly known as brownfield and offers varied definitions adopted in different countries. Further on, emphasis is put on how the valuation process is tackled internationally in terms of stigma quantification. It offers a perspective on 2

Valuation of Investment Interests in Contaminated Properties in Romania

Introduction

what stigma is and how different researchers have developed techniques for taking account of it. These approaches on valuation have been critically examined and combination of them formed the basis of the models in the next chapter. The last subchapter familiarises the reader within the Romanian brownfield context, discussing what has been done so far in terms of research on valuation of contaminated properties. It also describes the current status of contaminated land and the national inventory initiative and critically analyses the National Strategy for the Management of Contaminated Sites.

In chapter three two valuation models are being produced, which incorporate stigma in different ways. The first model values the property as contaminated and is based on the yield adjustment to reflect stigma, following the ideas of previous researchers. There is an element of novelty here, as the model tends to offer a more generalised applicability, as it is relative to five levels of contamination. The second model is however based on a risk assessment of the contamination, which takes account of more inputs related to stigma. It values the property as uncontaminated and reduces the final estimated value with a stigma percentage.

Chapter four consists in designing a questionnaire and then analyses its results.

It has to main roles. The first one is to offer the necessary inputs for the models based on the experience of respondents, also acting as generalised data on stigma for interested individuals. The second role is to provide an overview on the commonly practices used in valuation by property professionals in Romania as this is a hardly known aspect. The survey was sent to a surprisingly large number of individuals, all members of the National Association of Romanian Valuers; the response rate was extremely low, with only 81 responses out of 1880 sent invitations. However, the responses seemed sufficient to provide the necessary inputs.

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Valuation of Investment Interests in Contaminated Properties in Romania

Introduction

In chapter five it was decided to combine the information from the present Romanian property market and some information from a real life project of decontamination in order to produce a hypothetical case study; in the absence of a full project data this approach has been the only option. The case study is described along with the assumptions considered, each backed up by reasonable arguments to reflect the present and forecast Romanian property market. A valuation is carried out from the perspective of the freeholder by applying the two conceptual models. Further on, an investment opportunity is appraised to produce the rates of return, in other words the aim of this Dissertation. A simple sensitivity testing is also carried out to analyse the results relative to changes in the inputs.

The last chapter is dedicated to making a summary of the paper and most importantly drawing conclusions on the findings.

1.2 Rationale The rationale will present how the idea was born, what changes it encountered and how it developed to its final state.

It is well known that world population is growing at an alarming rate. It is estimated that by 2050 there will be 9.2 billion people living on this planet (Unitated Nations Populations Fund , 2010). A main concern is that the urban population is expected to almost double by this time, from 3.4 billion in 2009 to 6.3 billion (Unitated Nations, 2010), making urban areas more crowded and with limited space for development. One of the solutions to minimize the so much debated impact of building on greenfield land is to redevelop previously developed land, also known as brownfield.

Redeveloping brownfield however, comes at a cost; there are benefits and challenges as well. Therefore the following question arises: is it worthwhile to redevelop 4

Valuation of Investment Interests in Contaminated Properties in Romania

Introduction

this type of land? The initial thoughts for the topic of this Dissertation paper were to produce a comparison between the return rates of brownfield redevelopment projects in the UK and USA. A deeper research revealed that even if the financial data was limited, studies have already been conducted, especially in the USA. Consequently, the need was to assess a country which has relatively very little to offer, in terms of research on brownfield redevelopment.

The research is focused on Romania’s brownfield redevelopment potential, for a couple of significant reasons. Firstly, as an ex-industrialised country, it has encountered tremendous changes in its economy after the fall of the communist regime in December, 1989. Many of the nation’s industries could not keep up with the competition on the private market and many of them closed down, became privatised or have simply been abandoned (Cobarzan, 2007). This created not only unemployment and urban decline, but also land dereliction. Therefore, the availability of brownfield land positioned Romania on the top of all EU countries, with an astonishing estimated 900,000 hectares (Oliver et al., 2000).

The other significant reason was the nation’s expenditure on remediation of brownfield. If in 2000 Romania was at the bottom of the EU countries list, it reached the mid in 2007, overtaking countries like Austria and Finland on annual expenditure on remediation of contaminated sites (European Environmental Agency, 2007). Detailed figures speak for this in subchapter 2.4 – The Romanian Context. Therefore, this clearly suggests an increasing interest in redevelopment of brownfield and an in the same time increasing development and investments opportunities.

However, the far most important reason is the large gap in the knowledge of redeveloping brownfield in Romania. At the moment there is slow progress on

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Valuation of Investment Interests in Contaminated Properties in Romania

Introduction

producing effective legislation or development framework, while the know-how and knowledge is being developed in a slow pace; more importantly, it is the European legislation and international literature, guidance and practices which appear to offer significant information about this; in addition to all of these there is the lack of experience in this field. With not much research being done so far, there is definitely a lot of work to be carried out.

Finally, availability of sources of finance from the European Union for the countries with the lowest GDPs such as Romania provides an additional incentive and increases the investments interest and opportunities. There are two programmes currently running in Romania for 2007-2013: the Environmental Sectoral Operational Programme (ESOP) and the Regional Operational Programme (ROP), both funded by the European Regional Development Fund (ERDF), (Simule et al., 2010).

In conclusion there seems to be interest in brownfield redevelopment; however, unless financial viability exists with acceptable rates of return, the investors/developers will decide whether or not to take the risks associated with contamination. In order to be financial viable, a project must be carefully assessed and the start for this is a valuation of the contaminated property. Prior to decision making and investor must therefore analyse if the project could offer the desired target rate of return. However, it is a challenge to produce this type of valuation and to carry out accurate risk assessments. Hence, the significance of the study for a field which is yet in its beginnings is indisputable from the perspective of both developers and investors and Romanian government.

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Valuation of Investment Interests in Contaminated Properties in Romania

Introduction

1.3 Aim and objectives The research seeks to investigate the potential rates of return for brownfield redevelopment projects in Romania. As there are a couple of relevant aspects to be taken into consideration, the aim will be achieved following a number of interlinked and well delimited stages, each with specific objectives. In the order of discussion in this research, the objectives are:

Doing a research and literature review on how brownfield projects are tackled in terms of valuation techniques for investment opportunities in order to create a generalised view on this matter.

Producing two conceptual models for valuation of contaminated sites, based on the international approaches analysed in the literature review; one is based on the all risks yield adjustment while the other is based on a risk assessment approach; more importantly, both incorporate the quantification of stigma attached to contamination. The purpose of the models is to be applied in a case study from Romania, compare them and analyse each one’s appropriateness.

Quantifying the stigma by means of a questionnaire survey based on the experience, opinions and knowledge of the Romanian property market of a large group of property valuers.

Create a case study in order to apply the conceptual models and incorporate the results of the survey, in order investigate the rate of return produced.

1.4 Research Methodology The methodology used in this research was based on three parts comprising the literature review, a questionnaire and a hypothetical case study.

The literature review was primarily focused on brownfield regeneration textbooks, property valuation, finance and investment textbooks, journal articles and conference papers whose authors have been involved in the research of this field. Much

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Introduction

of the literature came from the UK and the argument for this is given by the European context of both Romania and UK. Another argument is the quality and amount of information available in UK in comparison with other European countries. References within the research have also been made for studies produced in the USA. The aim of the literature review was to set a background of what has been done so far both nationally and internationally in terms of valuation of brownfield, which was the way to do it and what methods have been used for investment valuation of brownfield, while also providing a critical analysis of the National Strategy for the Management of Contaminated Sites in Romania (NSMCS). Having assessed valuable information about the international approaches on valuation of brownfield two valuation models will be produced, based on two different approaches on stigma quantification, in order to examine whether the methods produce similar results or not.

The questionnaire, which represents the second part of the methodology, was sent to a large group of real estate professionals, all members of the National Association of Romanian Valuers. The purpose of it was to investigate the figures which reflect stigma in property valuations in accordance with the Romanian property market and also taking into account their opinions and experience. This will prove to be a valuable input for the case study analysis, the last part of the methodology. This consists in creating and analysing a hypothetical case study. It will be hypothetical since the information (especially financial) of related projects in Romania is unavailable. However, the case study will combine data from a real life project whose name could not be revealed due to confidentiality reasons and information from the current Romanian property market.

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Valuation of Investment Interests in Contaminated Properties in Romania

Background Knowledge on Valuation of Contaminated Properties

2 Background Knowledge on Valuation of Contaminated Properties 2.1 Introduction to Brownfield Contaminated properties are generally known under the term of brownfield or previously developed land (PDL) and may include either the land element or the land and building elements. No matter that, the reuse of land produces significant benefits (social, economic, environmental) and is considered one of the most efficient tools of regeneration; brownfield redevelopment not only increases the land supply by returning previously developed land into beneficial use, but it reduces the impact on cities’ green belts and prevents urban blight. It creates sustainable environments, adds value to communities, not to mention the creation of jobs and business and investment opportunities.

The definition of brownfield varies from country to country: in USA for instance brownfield is linked to contamination, while in the UK it is regarded as “land that has been previously subject to physical development (other than agriculture) and where its reuse may be complicated by one or more factors, which may include contamination�

(English Partnerships, 2006). It therefore may include structures or buildings on the property, or simply the land element. In a study regarding the scale and nature of brownfields in Europe produced for CABERNET, Oliver et al. (2000) defines brownfields as sites affected by the former uses of the site and surrounding land, which may have a real or perceived contamination problem and are mainly located developed urban areas.

From the mentioned definitions it is clear that brownfields are associated with contamination, whether it exists or it is only a potential one. However, they are very unclear in terms of presenting the risks associated with contamination. In England, the Part 2A of the Environmental Protection Act 1990 refers to contaminated land as 10

Valuation of Investment Interests in Contaminated Properties in Romania

Background Knowledge on Valuation of Contaminated Properties

causing “a significant harm”, without specifying what exactly “significant” is. On the other hand, the National Strategy for the Management of Contaminated Sites states that brownfields are “sites on which human activities determined the presence of pollutant substances whose concentrations may present an immediate or long term risk for the human health and environment, (Ministry of Environment and Forests, 2010).

Even if many definitions are open to interpretations, for the context of this Dissertation, a contaminated property will be referred to as previously developed land, which may cause harm to human health and the environment.

There are numerous successfully completed brownfield redevelopment projects and examples come from various countries: Greenwich Peninsula in London (UK), the Turning Torso in Malmo (Sweden), the Volt/Phoenix project in Tilburg (The Netherlands) (World Bank, 2010) or SEMA Business Park in Bucharest, Romania. These involved the conversion of previous use into more income generating uses. Yet having plenty of benefits, brownfield redevelopment comes with associated risks: high remediation costs, limited use of land, environmental permits and approvals, limited finance, stigma etc. There is a variety of challenges which can be added to the list; however, the latter is the subject of the next subchapter, a relevant aspect in valuating contaminated properties.

2.2 The stigma In order to assess the financial viability of contaminated properties investments, a series of factors have to be taken into account. It could be argued that the assessment is more like a careful consideration and analysis of risks. These are then incorporated into the investment valuation to examine whether the project is likely to be worthwhile or not. The far most challenging issue when conducting an investment valuation for a contaminated property is quantifying the stigma.

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Background Knowledge on Valuation of Contaminated Properties

As this a relatively new term for many, it has not quite been mentioned in valuations. Moreover, the Red Book or the International Valuation Standards (IVS) do not mention about stigma and this is because it is not an official recognized name (Royal Institute of Chartered Surveyors (2011), International Valuation Standards Committee (2003)). However, it does exist and it is a risk which must be taken into account in valuations.

What exactly is stigma? A few authors have considered its existence and some of the first mentions belong to Patchin (1988) in the United States and Syms (1996) in the United Kingdom; on the other hand, no such studies have been carried out so far in Romania. In his research Patchin (1991) referred to stigma as “a variety of intangible factors, from possible public liability and fear of additional health hazards to the simple factor of the unknown”. He totally acknowledged the loss of market value of contaminated properties and moreover he used real life examples to emphasize this.

Syms (1996) went for a more detailed approach defining stigma as “that part of any diminution in value attributable to the existence of land contamination, whether treated or not, which exceeds the costs attributable to a) the remediation of the subject property, b) the prevention of future contamination, c) any known penalties or civil liabilities, d) insurance and e) future monitoring”. It can be clearly inferred the different approaches the two authors had: Patchin kind of lined up the factors which cause stigma, while Syms referred to it as that extra loss in value caused by a variety of factors, other than the ones related. No matter the approach, both definitions led to the same meaning of stigma: loss in value beyond the costs of remediation, insurance, monitoring, liability etc, leading to ‘stigmatised’ properties.

Having understood the concept of stigma, the next part will examine what approaches researchers have used in order to incorporate stigma into valuations.

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Background Knowledge on Valuation of Contaminated Properties

2.3 Approaches to Valuation A number of methods have been produced by researchers, each of them having different views on what they considered to be common practice models. Some of the earliest studies on valuation of contaminated properties which also incorporate stigma were carried out in the United States and since then, they evolved into various forms around the globe. The issue with stigma is that it is hardly quantifiable and many suggested different approaches of how to estimate its effects as accurate as possible.

Fortunately for this paper, there is no widely recognized technique and studies about this topic are still in progress. The following paragraphs will therefore examine some of these approaches.

The Sales Comparison Approach Patchin (1994) proposed the far most simplistic method for valuing contaminated properties: the Sales Comparison Approach (SCA). Easy to guess, the principle of it was to find market data on contaminated properties and compare it with the subject property. However, the comparables (or ‘case studies’) were not in terms of physical characteristics of the property, but in terms of contamination problems. As he acknowledged the limited market data available, he suggested that appraisers should create their own databases of contaminated properties, containing the unimpaired property values and impaired values after the discovery of contamination to determine the stigma value loss, as percentage of the unimpaired value. He also advised on how this data should be gathered and analysed to provide a reasonable degree of comparability. The percentage range of stigma value loss would then be applied to the subject property to produce the impaired property value. Because the valuation of contaminated properties was at that time in its beginnings, the method could be considered a starting point for a ‘rule of thumb’ valuation; however, the degree of subjectivity within it may lead to unrealistic results. In terms of contamination, two or 13

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Background Knowledge on Valuation of Contaminated Properties

more properties may be similar, but they are very unlikely to be similar in terms of severity and harm they may pose, while the perception of public might also be different.

A comparable method for contaminated properties cannot really be used since properties have their own characteristics. What Patchin could have been done though was to test the method on a large number of properties and analyse how accurate the results would have been.

The traditional method The traditional method has been discussed in many instances by researchers such as Richards (1996a, 1996b), Patchin (1988) or Kennedy (1996). The principle of this method lies in the form of a simple investment valuation, adjusting the yield so that it reflects the stigma effect. The mentioned authors have all used this principle, naming their methods slightly different, even if the basics of them were the same.

Patchin (1988) used three scenarios to emphasize how the method works. He used the income capitalization approach, in which he argued that the capitalization rate was dependent on the equity yield rate, mortgage terms available and anticipated future depreciation or depreciation. Based on these components he calculated the capitalization rate using “the Ellwood method” and used it to produce the estimated value as if the property was not contaminated. He then increased the capitalization rate to reflect stigma and calculated the value as if ‘after remediation’ and in the end subtracted the ‘after’ value from the value ‘before contamination’ to emphasize the loss in value (or damages as he names them). Although the scenarios were developed to highlight the method, no references were made whatsoever on the justification of increasing the capitalization rate; arguments for this should have been included to understand how the increased yields have been obtained. It is therefore probable, that Patchin only wanted to outline the technique, leaving the appraisers to decide on the

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Background Knowledge on Valuation of Contaminated Properties

extent of the increase. Consequently, without such arguments, this approach is highly subjective.

Using the yield alteration technique, Kennedy (1996) produced the ‘short-cut’ DCF (discounted cash flow), also naming it the “traditional all risks yield technique”.

Surprisingly, Kennedy stated that he adapted it after a previous study of Patchin in 1992, unfortunately without referencing it; efforts have been carried out to find Patchin’s initial work on this method, but with no success, so Kennedy’s approach will be discussed in this paragraph. He started from considering the uncontaminated full open market rental value for comparable properties, which he then reduced due to “market evidence” and “use restrictions”. Further on he adjusted the initial yield, obtained from similar uncontaminated properties, with an environmental risk and uncertainty ‘premia’, in other words stigma. The full rental value was then capitalized in perpetuity, also deferring the total for the duration of the remediation period. The cost of clean-up and monitoring were then subtracted to reflect the contaminated net present value. A suggestive example outlines the method in Table 2.1.

Unimpaired FRV Reduction due to market evidence Reduction due to use restriction Impaired FRV Initial yield (unimpaired ARY) Environmental risk premia Environmental uncertainty premia Contaminated ARY Years Purchase @ ARY PV 12 months @ ARY less Remediation Cost Monitoring Cost Contaminated NPV

£120.000 £8.000 £10.000 £102.000 7,50% 1,00% 2,50% 11,00% 9,09 0,901 £835.381 £732.000 £18.000 £85.381

Table 2.1: Example of ‚Short-cut’ DCF, adapted after Kennedy (1996)

The ‘short-cut’ DCF is a simplified version of an investment valuation, which offers a quick view on the potential of the property; however, it has to be emphasized

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Background Knowledge on Valuation of Contaminated Properties

that it does not take account of any temporal distribution of costs and simply subtracts them from the contaminated value, most likely undervaluing the property. Another point here is that Kennedy does not offer any arguments on deciding the quantum of all risks yield adjustment. Similar to Patchin (1988), no framework was given for how the stigma ‘value’ was decided, proving again high subjectivity. One thing is for sure though: stigma was taken into consideration and the technique proved that.

Similar to Patchin and Kennedy, Richards (1996) used the ARY adjustment, only this time, in a traditional term and reversion investment valuation. Part of the survey and interviews he carried out, he created a scenario whose aim was to devise the best practice approach at that time. Based on the 12 valuation scenario responses (30 percent response rate) he found out that most of the respondents allowed for an additional 0.5 percent reflecting the stigma and 1 percent reflecting the uncertainty attributable to the contamination. An example of Richards’s technique is set out below.

Unimpaired yield Clean-up stigma Uncertainty of contamination Security of term income

10% 0,50% 1,00% -1,00%

Term income YP 2 yrs @10,5%

£80.000 1,724

Reversionary income YP perp@11,5% PV 3 yrs @11,5% Total Income

£85.000 8,696 0,721

Clean-up costs Finance costs Land quality statement Total costs PV 2yrs @11,5% Impaired Value

£220.000 £10.000 £2.500 £232.500 0,804

£137.920

£532.934 £670.854

£186.930 £483.924

Table 2.2: Term and reversion ARY approach, adapted after Richards (1996, p13)

As this was just a scenario with specific characteristics of the property, the adjustments in yields again only emphasized the principle of incorporating stigma into

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valuations. That is why as part of the first model produced in chapter 4, a more generalised approach is to be adopted (further details are found in chapter 4 for the ARY adjusted model). On the other hand, an interesting point was emphasized in this approach: the respondents reduced the yield for the ‘term element’ with 1 percent to reflect the additional security of the term income, compared with the reversionary income.

Looking back through the techniques, each of it brings something new into valuation, some new consideration or something that sometimes might be forgotten by even the most experienced valuers. However, the main issue is that none of the techniques have been tested and basically they represent nothing but theoretical concepts of ‘how to do it’. The next approach though, tries to overcome this issue by not only testing the method, but by tackling a totally different perspective of how stigma could be quantified.

‘Risk Assessment’ Approach This approach has been developed by Syms (1996) and it is part of his unpublished PhD thesis ‘Redevelopment and Value of Contaminated Land’. Similar to the Sales Comparison Approach it starts by valuing the property as if it was uncontaminated; Syms considers in his approach only the value of the land, subtracting the value of the buildings from the total property value (land plus buildings). The next step involves estimating the remediation costs which will further be deducted from the unimpaired land value; many authors refer to these as the ‘cost to correct’. Finally, the ‘Risk Assessment’ approach is being applied on the remaining value. As its name suggest, the approach is based on assessing the risks associated with contamination; in order to quantify these risks, Syms carried out a survey between 1994 and 1996 on 130 surveyors and other professionals. He gathered valuable data, among which is the core of this

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approach: four variables regarding the perceived impact on the land value (as percentage). The average of these values (say 20%) is then applied to the unimpaired land value and the result is therefore the impaired value of the land. Moreover, he tested his results on a number of ten contaminated properties and in most circumstances the estimated stigma loss values were close to the real stigma loss values extracted from the sale transactions data. That proved the efficiency of his method.

The most significant aspect of this approach if by far the risks assessment; in comparison with the previous presented approaches it seems that the degree of subjectivity is much lower which makes the approach better by actually reflecting the risks based on the judgement of the respondents and not on ‘arbitrary adjustments’.

Testing the validity of his data brings in even more certainty. There are some interesting points in this approach which are worth mentioning. The first one is the fact that Syms applies the approach only for the value of the land unlike the other methods and this means that any buildings or structures are valued separately; it seems rationale, since it is reasonable to say that stigma is only associated with contamination and not with the buildings. The second point is that Syms considered this approach as valuation for asset purposes of industrial properties and not for investment purposes. Therefore, taking into account the two points, in the case of investment valuations the buildings can only be valued by capitalizing the income; if market evidence suggests that the income is affected by the perceived stigma due to contamination, then the property values will have to be stigmatised as well; Syms however does not offer any recommendations on this matter as it is not the purpose of his study to do so. His approach is considered extremely beneficial in valuations, as it can reflect the local market conditions of a specific location and moreover the efficiency of it is reflected in the results of his testing.

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Background Knowledge on Valuation of Contaminated Properties

Therefore, a part of his approach has been incorporated in one of the models in chapter three for valuing contaminated properties for investment purposes.

The Full DCF Approach The more developed and accurate version of the ‘short-cut’ DCF discussed earlier in this subchapter is the full DCF technique, as named by Kennedy (1996). As with any other discounted cash flow, the accuracy here is due to the temporal distribution of the remediation costs. Kennedy used the same yield adjustment principle by allowing a ‘premia’ for stigma, only this time he included an explicit growth assumption in his method; the net present value (NPV) of the costs was calculated at an equated yield rate, which included the annual revenue growth. Further on, the full rental value was capitalized at the all risks yield and the result was deferred for the remediation period at the equated yield in order to obtain the reversionary income’s NPV. The two net present values were then added to obtain the total NPV. Consequently Kenney simply and successfully pointed out that the full DCF is more accurate in comparison with the shortcut DCF and produces a better NPV. Indeed the outcome of this comparison is predictable for any sensible mind and the method proves its relevance when comparing the attractiveness of different property investments. Consequently, undervaluing the property is avoided, more accurate assumptions can be done and also the internal rate of return can be calculated, as a major comparable indictor of the investments.

Some researchers produced even more complex techniques, using for instance variable discount rates for different period of times. Chalmers and Roehr (1993, p.35) referred to these rates as “yield premiums resulting from risk” and emphasized that stigma can exist at any time after the discovery of contamination. Figure 1 below is outlines their proposal.

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Background Knowledge on Valuation of Contaminated Properties

8%

Stigma Premium for Yield

7% 6%

4%

5%

3%

4%

Contaminated Stigma Premiums

1%

3% 2%

3%

3%

3%

Before Remediation

During Remediation

After remediation

Uncontaminated Discount Rate

1% 0%

Figure 2.1: Variable Stigma Premiums chart, adapted after Chalmers and Roher (1993, p.35)

The variable stigma premiums are used to reflect the risks associated with a certain period of time and lead to more accurate calculations in accordance with the risk

assessments carried out. It can be clearly noticed that the premium decreases during time to reflect the diminution of risks.

As discussed above, there have been plenty of researchers to address the stigma in valuation. The techniques presented are just the basics for a thorough analysis undertaken by involved parties prior to any decision making. These types of analysis are detailed property investment appraisals, such as those presented by Issac and O’Leary

(2010) who take account of more variables which influence the potential of the investments; in addition, properties may be acquired for simple investment purposes or for redevelopment, which involves even more variables. Therefore the valuation of the contaminated land represents only a part of other specialized aspects of property investment appraisal. The previous researches however, provided significant information on how the judgements on valuing contaminated properties may be done and constitute a solid base for creating the two models in chapter 4.

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Background Knowledge on Valuation of Contaminated Properties

2.4 The Romanian Context Approaches to valuation The main independent professional body in Romania which regulates property professionals is the National Association of Romanian Valuers (ANEVAR), member of IVSC and TEGOVA. It mainly operates under the International Valuation Standards, while also having its own internal regulations, methodologies and recommendations for its members. Regarding contaminated properties, ANEVAR does not make any recommendations on the methods and techniques to be used and only states that valuations must be produced in compliance with the IVS. Furthermore, no studies regarding valuation of contaminated properties have been published in Romania yet.

However, some studies related to contaminated properties such as finance for brownfield redevelopment have been carried out (see Cobarzan (2007)). It is therefore clear that research on this field is limited and mostly inexistent and that international approaches to valuation of brownfield play a significant role in valuing contaminated property.

Current state of contaminated land In 2000, the European brownfield regeneration network CABERNET has put Romania on the top of the European countries with the largest amount of brownfield land with an astonishing 900,000 hectares (Oliver et al., 2000). This was further supported by a recent statement of Laszlo Borbely, the Minister of Environment and Forests who confirmed this figure and also emphasized the increasing awareness for brownfield redevelopment (Mediafax, 2011). Such an astonishing availability is mainly the consequence of the collapsing industrial legacy after the fall of the ex-political regime in Romania. On the other hand, this figure is in contradiction with Baceanu (2005), advisor for the National Environmental Protection Agency, who stated that Romania has an estimated 98,381.94 hectares of brownfield land; this situation was 21

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Background Knowledge on Valuation of Contaminated Properties

most likely created given the different definitions adopted by the two authors. The CABERNET report refers to contaminated land simply as polluted land, while the Ministry of Environment and Forests uses a more elaborate definition, presented in the beginning of this chapter (Oliver et al. (2005), Ministry of Environment and Forests (2010)). Given these two situations, the exact extent of brownfield land in Romania seems unclear for the moment.

Similar to the National Land Use Database for PDL in the UK, the Ministry of Environment and Forest is committed to produce the National Inventory for Contaminated Sites (Ministry of Environment and Forests, 2010). However, according with short term action plan of the National Strategy the inventory should have been ready and moreover, promoted by the end of December 2010. Being contacted by email, Brandusa Petroaica, director at the NEPA confirmed that the inventory is in its final stage, awaiting validation; she also stated that the delays are being incurred due to the financial and juridical implications caused by classifying a site as contaminated. It seems again very unclear when exactly the inventory will be available and the answer probably lies within the top people of the government. Consequently, an exact and official figure will be obtained when the inventory will be published.

In terms of expenditure on remediation of contaminated land, Romania is at the mid list among the European Union countries, with an annual expenditure of 0.5‰ of its GDP (European Environmental Agency, 2007); the situation in 2007 got better compared with 2000, when an average of €0.07 per capita was spent on sites remediation, meaning 0.05‰ of the GDP (European Environment Agency, 2005); these figures are extremely low, compared with the highest values of €20 and €25 per capita in the United Kingdom and Netherlands respectively. However, the point here was to suggest the increasing interest in developing brownfields. In addition, this is confirmed by the 22

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development of the NICS and the National Strategy for the Management of Contaminated Sites.

The Strategy In 2010 the Ministry of Environment and Forests published for public debate the first version of the National Strategy for the Management of Contaminated Sites (Ministry of Environment and Forests, 2010); since then no other version has been published. The scope of the strategy is divided into short, medium and long term actions. Setting the public policies with regards on the management of brownfield by 2013 is the short term action, while the medium and long term includes remediation of priority sites and finalising the rest of the sites by 2050. It is therefore undoubtedly that that the government has taken responsibility and is committed to solve these environmental issues.

The necessity of the strategy is mainly justified by two major arguments. The first one is that similar to other European countries, Romania has long history of industrialization which created a significant amount of contaminated land; the other argument is the influence of the European policy through its environmental concerned directives, which forced the EU member states to identify contaminated sites, to produce reports regarding their state and to remediate these sites. There is probably another unofficial argument which is related to the increased interest of investors in purchasing and redeveloping these contaminated sites, and which faced the lack of an appropriate regulatory framework. However, many of them looked at these sites as investment opportunities and the success of them can be found in many examples. To conclude, there was both a demand and ‘enforcement’ for the development of the strategy.

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The strategy offers a broad description of how to manage contaminated sites without going into details, comprising more or less general information. It presents the potential of brownfield redevelopment, however not specifying any clear figures on this matter. It also draws attention on the impact and risks of contaminated sites and the importance of protecting the human health and the environment. The most interesting part however is concerned with the development of the NICS, proving how exactly brownfield is tackled, from classifying a land as contaminated, prioritisation and investigation to action plans and remediation. It also put emphasis on the financing mechanisms especially on non-reimbursable EU structural funds and governmental funds. Since this is the first version of the strategy it is believed that the newer versions will comprise more figures and technical data and will not just be descriptive. Moreover, the strategy should offer more guidance and be more orientated towards operational activities. In other words, it is very simple to write novels about brownfield without actually making things move.

The discussion of the NSMCS was carried out to emphasize the increasing interest in brownfield for both public and private sector; in response to the growing interest the government produced a strategy and is committed to further develop it for the success of curing the industrial ‘contaminated legacy’. Details of the strategy have not been discussed in scrutiny as they are not aim of this Dissertation paper.

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Theoretical Valuation Models

3 Theoretical Valuation Models 3.1 Introduction In this chapter, two valuation models will be produced. The idea of using two models came after the review of the literature where different practices for valuing contaminated properties have been discussed. There was no commonly agreed best practice model and of course, some might argue that the best practice model varies from country to country or from the perspective of each individual valuer; this could not be truer, that is why the idea of producing a new model to compare it with the previous approaches seemed like a rational thing to do. Not only that it sounds interesting and challenging but it will give a better understanding of brownfield valuation by analysing their contrast and similarities.

The two models will use both use the full DCF approach, however the stigma will be quantified in different ways. The first model is the ‘comparable’ and will incorporate stigma as an additional premium to the all risks yield, considering the property as impaired, similar to the approaches discussed in the previous chapter; this approach is commonly used in valuations and therefore the emphasis will be put on the second model. This will have a different approach and will reduce the estimated value with a percentage resulted from a risk assessment of the contaminated property. So basically, the appreciation of its performance will be done in comparison with the first model.

In order to create the models, a simple generalised scenario will further be described. A site was formerly used an industrial activity and currently hosts a number of buildings, accommodating commercial spaces (shops). The NEPA has just registered the site as contaminated in its national inventory for contaminated sites, after launching a programme which enforced landowners to carry out site investigations for their land if 26

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that was linked with previous industrial activities. The freeholder is interested in remediating the land and appointed a professional valuer to carry out an investment appraisal.

3.2 ARY Adjustment Model This model has been adapted after Kennedy’s (1996) work. The valuation starts by choosing an initial yield from comparable unimpaired properties, to which a stigma premium will be added. The element of novelty is the stigma premium which varies depending on the level of contamination. The premium is obtained from either a personal database produced by the valuer or from a local public database; many valuers might not have the necessary experience in valuing contaminated properties, therefore such a database would be welcomed. The database will differentiate between levels of contamination and the appropriate stigma premium must be selected. Therefore the only thing a valuer should assess is the degree of contamination in order to choose the right stigma premium; simplistically, the database will look like this:

Contamination Level ARY Adjustment or Stigma Premium

Very High

High

Medium

Low

Very Low

3.0%

2.0%

1.0%

0.5%

0.2%

Of course, adjustments to the premium could be made to reflect particularities such as location (for instance a prime location might reduce the stigma premium to reflect the increased interest of the investor and therefore producing a higher bid value). For the purpose of the model only a simple contamination scale was used, from very low level of contamination to very high level. However, the database could incorporate any other scale for contamination, appropriate for more detailed valuations.

(Note: in the absence of market data with regards on these stigma premiums in Romania, question number 5 of the survey was specially designed to fill this gap and the resulting stigma premiums were used in the case study analysis presented in chapter 5).

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Once the stigma premium has been agreed, an impaired value of the property can be obtained by capitalizing the annual income (the rental value of the buildings); the model is illustrated in Table 3.1 and a very high level of contamination has been considered with premiums arbitrarily chosen.

ARY Adjustment Model Contamination Level ARY Adjustment or Stigma Premium

Very High

High

Medium

Low

Very Low

3,0%

2,0%

1,0%

0,5%

0,2%

Unimpaired Yield Stigma Adjusted Yield All risks yield (ARY) Total Remediation costs

8,00% 3,00% 11,00% £500.000

Quarterly Cash Flow ( 1 year remediation) Quarter 1 Remediation Costs -£50.000 PV @ 11% 0,9742 Costs Cash Flow -£48.712 Impaired Value 1 DCF -£48.712

Rental Value YP in perp. @ 11% PV in 1 year @ 11% NPV

2 -£200.000 0,9492 -£189.832

3 -£150.000 0,9247 -£138.707

-£189.832

-£138.707 NPV

£70.000,00 9,09 0,9009 £573.301

4 -£100.000 0,9009 -£90.090 £573.301 £483.210 £105.959

Table 3.1: ARY Adjustment Model

The valuer must assess the rental value to be used in the model (in this case the net FRV for similar properties is £70,000 per annum). Kennedy (1996) suggested that sometimes there is the case when “market evidence” shows that contaminated properties are rented for smaller annual rents than similar uncontaminated properties.

Indeed, if market evidence exists then valuers must reduce the FRV, otherwise the contaminated property might be overvalued.

The income is deferred for the remediation period to reflect the loss in value due the non-income period. Further on, the costs are discounted to present and then subtracted from the impaired value obtained after capitalization. The result will be the net present value of the contaminated property.

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Theoretical Valuation Models

3.3 Risk Assessment Model This model represents a totally new approach on investment appraisal techniques. However, it was produced after the initial idea of Syms (1996, 1997), who used his risk assessment approach to value assets of manufacturing companies. The idea of developing this model came as a challenge to apply this approach to investment properties. The principle of it is extremely simple consisting in applying an end reduction due to stigma to the impaired value of the property, the end reduction being quantified by means of a risks assessment approach.

The risk assessment comprises the quantifying stigma depending on the available market data and experience and opinions of property professionals with regards on four aspects: type of industry activity previously occurred on the property (named r1 in the model), impact of stigma before and after remediation (r2 and r3) and acceptability of treatment option used for remediation (r4). A very important aspect is that r2 and r3 will be assessed depending on the level of contamination, from very low to very high contamination, similar to the scale used in the previous model. These reductions will produce a total stigma impact (r) which will be applied to the final estimated value (see table below).

Contamination Stigma based on industrial activity - r1 Perceived Stigma Before Remediation - r2 Perceived Stigma After Remediation - r3 Perceived Stigma on treatment method - r4 Total Stigma Reduction ( r ) where 1 1 1, 2, 3 1 4

r1% r2% r3% r4% r%

41.53% 46.60% 25,80% 5.00% 33.25%

Table 3.2 : Risk assessment approach to quantifying stigma

The argument for this method of quantification is the following: many argue the subjectivity of choosing the appropriate stigma reductions. Some say it should be x% after remediation, while others say it should be considered y% before remediation; in the same time, specific industries affect the stigma more or less, for instance a site

29

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Theoretical Valuation Models

which had been previously used for chemical works will definitely have a greater stigma impact than one which has been used as a timber manufacturing factory. To try to overcome this aspect, the average of these values has been proposed. In addition to this a further reduction is applied for the perceived acceptability of the treatment option. It is common sense to believe that not all the treatment options known to present totally remove the contamination and therefore stigma is attached to the final value.

Having established how stigma is quantified the remaining thing is to value the property. This is done using the traditional income method by capitalizing the full rental value and deferring the income over the period of remediation. Using a discounted cash flow for the costs (remediation costs and any other costs) these are then deducted from the capital value. The remaining value will represent the net present value of the property which has taken account of the all the quantifiable costs, except for stigma.

The final calculation is to apply the total stigma reduction and produce the impaired property value. The exemplification of the model is set out in the Table 3.3.

Risk Assessment Model Contamination Level Stigma r1 Perceived Stigma Before Remediation r2 Perceived Stigma After Remediation r3 Perceived Stigma on treatment method r4 Total Stigma Reduction ( r ) Yield Total Remediation costs Stigma Reduction

8.00% £500,000 34.02%

Quarterly Cash Flow ( 1 year remediation period) Quarter 1 Remediation Costs -£50,000 PV @ ARY 0.9742 Costs Cash Flow -£48,712 Unimpaired Value Over All Cash Flow -£48,712

44.80% 46.60% 25.80% 5.00% 33.25% Full Rental Value YP in perp @ 8% PV of 1 year @ 8% Unimpaired Value

2 -£200,000 0.9492 -£189,832

3 -£150,000 0.9247 -£138,707

-£189,832 -£138,707 NPV 1 (before stigma) NPV 2 (after stigma)

£70,000 12.50 0.9259 £810,185

4 -£100,000 0.9009 -£90,090 £810,185 £720,095 £342,844 £226,200

Table 3.3: The Risk Assessment Model

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There is now probably the question of where did the values used for stigma quantification appeared from. Well, in a country where brownfield regeneration is highly developed these values should be somehow gathered into a database, should the method had been accepted as part of the general practices of valuation; it is not the case here, however there are at least two remaining options. Similar to the suggestion in the first model, valuers could create their own such databases if they accepted the method.

For the case of Romania though, where redevelopment of brownfield is yet at the beginning there is absolutely no data available on the market with regards on how much would the valuers reduce the estimated values due to stigma. Therefore, the only thing that could provide information on this is to question the professionals involved in the property market. Since it was the case of stigma premiums in the first model as well, it was decided to produce as survey which addressed these issues. It is the purpose of the next chapter to do that, in order to obtain some useful values which shall be used in the analysis of the case study.

It is worth emphasising that the values in both models were chosen arbitrarily and only used for demonstration purposes. Therefore any interpretation of the results for comparative purposes between the two models would be meaningless at this stage since it is the purpose of the case study to do that. Yet, a major aspect can be clearly noticed after the first broad look on the two models. The ARY adjustment model uses a much generalised approach to quantify stigma without analysing any particularities of the property. On the other hand, the risk assessment model takes account of the contamination levels, its characteristics and treatment options. The influence and the advantages and disadvantages of each of the model will be further discussed in chapter five.

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Valuation of Investment Interests in Contaminated Properties in Romania

Questionnaire Survey

4 Questionnaire Survey 4.1 Introduction As discussed in the previous chapters, the most challenging part of an investment valuation is quantifying the risks associated with stigma. That is why the questionnaire survey has been specially designed to provide valuable information about it, for two purposes. The first and most important is to investigate and critically analyse how the Romanian property professionals quantify stigma in their valuations, given the national characteristics of the property market. The second purpose is to use the survey’s results, as input for the case study which will be presented in the following chapter. In needs to be emphasized that the survey was based on the both the opinion and experience of the respondents with regards on the Romanian property market, whether they have ever valued a contaminated property or not.

In order to analyse stigma in relation with the Romanian property market, the survey has been sent to 1880 professional property valuers, all chartered or corporate members of the National Association of Romanian Valuers (ANEVAR). For flexibility and easiness in use, an internet hosted survey service was preferred; each individual was sent a personalised email invitation comprising a short introduction and survey description along with the link to access the 12 question. However, an increased reluctance to responding to the survey has been noticed; some participants questioned the veracity of the survey while others even confirmed they have never heard about stigma, asking whether the term exists in the literature or it has been ‘invented’ by the author of this research.

The participants have been allowed two weeks for their responses with a reminder sent after the first week. A total of 81 respondents fully submitted the 33

Valuation of Investment Interests in Contaminated Properties in Romania

Questionnaire Survey

questionnaire, representing a response rate of 4.3%, much below the expected rate of 20%. Even so, the results were interesting and offered a valuable foundation for understanding the concept of stigma in Romania. It is recommended to read the survey questions in Appendix 1 before proceeding to the next subchapter.

4.2 Results and analysis This subchapter should be read in conjunction with Appendix 2 which presents the full results of the survey. The first questions of it were designed to provide information about the valuers experience in valuation of contaminated properties. A suggestive summary is presented in the table below.

Respondents who: Valued at least of contaminated property Valued more than 50 properties Often valued residential properties Often valued industrial properties Refused a valuation at least one time

69.1% 13.6% 59% 50% 21%

Table 4.1: Overview on experience of valuers

42% of the respondents have claimed to have valued between one and five contaminated properties, while 30.9% have never valued a contaminated property at all; however 13.6% of the respondents valued more than fifty properties, which suggests that they have quite some experience and moreover 72% of them valuing industrial contaminated properties very often. Surprisingly though is the fact that from those who valued at least one contaminated property, 59% claimed to have valued residential properties often which is more by 9% than the respondents who claimed to have valued industrial properties often; in other words the majority seemed to have valued more residential proprieties than industrial properties. This is rather unusual since contamination is mostly found within the industrial properties.

In question number 4 the valuers were asked to select the technique they use to quantify stigma. The largest proportion of respondents (38.6%) quantify stigma by using 34

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Questionnaire Survey

an end deduction of the final estimated value of the brownfield, followed by a 22.8

percent which use the increase of ARY technique. The results are presented below.

Stigma Quantification By reducing the final estimated value

13.1%

38.6%

15.1%

By increasing the All Risks Yield By using variable rates

10.4%

22.8%

I do not quantify the stigma effect

Figure 4.1: Proportion of techniques used for stigma quantification (results for question 4)

The variable rates have been previously explained (see figure 1) and are used by 10.4% of the respondents. 13.1% of the responses referred to other methods and

unfortunately, some of them them were not at all with regards on the posed question but in relation with costs of remediation; remediation; this raised the question of whether some of the respondents were familiar with the concept of stigma or not. not. However one respondent was quantifying the stigma by by adjusting the physical depreciation percentage of the building; questions about this reasoning arise, since stigma can affect both the land and buildings on it, while physical depreciation cannot be quantified for the land element of

the property.

Question no.5, “Depending “Depending on the contamination level, what percentage you add to the All Risks Yield, in order to reflect the stigma effect?” was probably the most

‘problematic’ to the respondents. The purpose of it was to analyse the valuers’ opinion with regards on the stigma premium of the ARY. Initially, this was an open question and the respondents were free to introduce the values they use in their valuations. The online survey service allowed for permanent monitoring and updates and the first

investigation on the progress of the survey revealed that some responses included 35

Valuation of Investment Interests in Contaminated Properties in Romania

Questionnaire Survey

stigma premiums as high as 30%. Immediate measures have been taken by using closed

answers and limiting the premium to 5%. The input table can be found in Appendix 2 while the weighted average result is presented in the figure below.

ARY Stigma Premiums relative to the level of contamiantion Very Low Level

0.9%

Low Level

1.6%

Medium Level

2.7% ARY Premium

High Level

3.4%

Very High Level

4.1% 0%

1%

2%

3%

4%

5%

Figure 4.2: ARY Stigma premium relative to the level of contamination (results for question 5)

Depending on the level of contamination on a scale from ‘very high’ to ‘very low’, the variety responses have been weighted against the responses quotas. As

expected, the results indicate the increase of stigma with the level of contamination, reflecting the higher associated risks. This question has been designed in need of the input for the ARY Adjustment Model in the previous chapter. At a first glance, these premiums seem to be very high in contrast with the expectations of much lower values.

Further on, the participants were asked about how they incorporate the remediation costs into valuations. The majority (51.2%) claimed they apply an end deduction of the estimated value while 31.7% increase the ARY to reflect these costs. In terms of how they estimate the remediation costs, a surprising percentage of 56% used detailed visual inspections from the list of six possible answers, with three maximum choices. 55% claimed to have used detailed environmental cost reports while almost

44% have used information available from comparable proprieties (the full response for questions and 6 and 12 can be found in Appendix 2).

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Questions 7 to 10 were adapted after the research on risk assessment carried out by Syms (1996). They have been designed to produce four independent variables regarding the impact of stigma. Question 7 and 8 investigated the percentage reduction in value before and after contamination; it was decided to go for the same simple

approach on the scale of contamination, considering that valuers use their own knowledge and experience or ask for advice of environmental specialists in order to appreciate in which category the contaminated property fits; in other words any other scale could have been used, as long as the property has been classified properly. This was an open question and the input values were in the range of 0% and 100%; given the large number of different values for each level of contamination, the weighted average

was calculated and the results are illustrated in Figure 4.3.

Expected Stigma Impact on Value Before and After Remediation Very Low Level

4.6% 7.6%

Low Level

7.6%

13.4%

10.8%

Medium Level

18.6%

High Level

After

23.4%

25.8%

Very High Level 0%

10%

20%

Before

36.8%

30%

46.6%

40%

50%

Figure 4.3: The expected stigma impact on value before & after remediation (questions 7 and 8)

As expected, the stigma reductions after remediation were clearly lower than before remediation, suggesting an ‘improvement’ of the values. However it can be observed that even if the remediation happened, the risks have not completely disappeared and there still was a stigma effect which reflected these residual risks.

In the next question, a list of industrial activities in Romania has been produced and the participants were asked to indicate the percentage of stigma stigma reduction for

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Questionnaire Survey

them. Similar to other questions, the weighted stigma reduction average for each industry has been calculated and then ranked in order of severity (see Table 4.2).

Perceived Stigma Effect by Industry Rank Industrial Activity 1 Radioactive materials processing 2 Asbestos manufacture 3 Chemical industries 4 Oil refining 5 Waste disposal industries 6 Explosive industry 7 Mining and extractive industry 8 Dyestuff manufacturing 9 Paint manufacture 10 Petrochemical industry 11 Steel manufacture 12 Building materials industries 13 Glass manufacture 14 Pharmaceutical industry 15 Gas industries 16 Metal smelting industry 17 Paper manufacture 18 Semiconductors industry 19 Shipyard industry 20 Timber industy 21 Car manufacture 22 Electricity generating industry 23 Textile industry

Stigma Effect 62,66% 49,22% 44,80% 43,83% 41,36% 39,57% 38,14% 38,05% 37,17% 36,30% 27,62% 25,75% 24,75% 23,68% 22,96% 22,32% 21,31% 19,95% 18,43% 17,83% 17,46% 16,37% 16,15%

Table 4.2: Perceived Stigma Effect by Industry (results for question 9)

Question 10 also investigated the stigma impact, only this time in relation with the methods of treatment adopted. According with the results the most accepted method is the full excavation and backfilling with clean material with a perceived stigma effect of 4.1% (see Table 4.3). At the other pole soil washing treatment was perceived as the least favourable for the value, accounting for a reduction of 6.6%. No matter the treatment method, the perceived impact lies within an average of 5% reduction in value; however, these similar results could be the cause of a limited knowledge on behalf of the respondents with regards on the treatment methods. Nevertheless, the values might reflect reality as brownfield redevelopment is in its beginnings and practitioners lack of experience.

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Perceived Stigma Effect by Remediation Options Weighted average 0% 1-2% Full excavation and backfilling with clean material 4,1% 35,4% 16,7% Partial excavation of hot spots and backfilling with clean material 5,0% 22,0% 18,7% Soil washing treatments 6,6% 13,2% 18,7% Bioremediation and chemical methods 4,7% 30,9% 19,1% Other methods (please specify) 5,9% 29,5% 13,6%

3-5%

6-10%

11-15%

>15%

17,7%

17,7%

9,4%

3,1%

20,9%

25,3%

7,7%

25,3%

17,6%

5,5%

5,5% 19,8 %

16,0%

18,1%

7,4%

13,6%

17,0%

12,5%

8,5% 13,6 %

Table 4.3: Perceived Stigma Effect depending on treatment methods (results for question 10)

4.3 Conclusions of the survey The survey was designed to provide valuable inputs for testing the models presented in the previous chapter. In addition, it reflected an overview of the practice of contaminated property valuation in the Romanian property market. The survey was sent by email to almost 1900 property valuers and was based on their opinion and experience, no matter if they have valued a contaminated property or not.

A number of 81 responses have been received, 69% of which have valued at least one contaminated property. For such a large population a much higher response rate was expected and this denotes two main things: a low interest on the topic together with a low acquaintance of a relatively new term in Romania, the stigma. It is undoubtedly that stigma is not very familiar yet within the property professionals and this is supported also by a series of ‘unrealistic’ data (e.g. 30% stigma premium); however, these anomalies have not been considered as valid data and have not been used to produce the presented survey results.

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51% of the respondents claimed they apply an end deduction of the estimated value when incorporating costs of remediation, while 31.7% increase the ARY to reflect these costs; the most common methods for estimating the costs of remediation were detailed visual inspections, detailed environmental cost reports and evidence from comparable properties.

The questions designed for the risk assessment model provided valuable and rationale results. The stigma effect after remediation had clearly a lower impact then before remediation, on all levels of contamination. The most severe stigma impact has been observed on in the asbestos, chemical and radioactive material processing industries. A question mark is though posed for question no. 10, where more differentiate stigma impacts were expected for the treatment options.

Overall, the survey provided the necessary information to be used in the case study and moreover it gave a clear understanding of the practice of valuing contaminated properties in Romania.

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Valuation of Investment Interests in Contaminated Properties in Romania

Hypothetical Case Study

5 Hypothetical Case Study 5.1 Introduction Similar to many researchers who tested their investment valuation techniques it was ideal to test the two models on a real life investment project; unfortunately, due to unavailability of data and no success in persuading a developer to reveal information a different approach has been adopted. In order to attempt to keep a balance (proportion) between the variables, it was decided to combine the information from the present Romanian property market with some information from a real life project of decontamination to produce a hypothetical case study.

The purpose of the case study is to test the models relative to the data obtained from the survey and to investigate whether the investment is worthwhile or not. It comprises two different parts: a valuation done from the perspective of a landowner and an appraisal of an investment scenario produced from the perspective of an investor.

5.2 Project Description and Assumptions The property is located in a prime location of Bucharest and has an area of 8,200m2, currently accommodating a six-story office building. It has just been classified as contaminated by The National Environmental Protection Agency and the office activity will soon close down for ground remediation works. NEPA listed the property with the highest priority for remediation due to nature of contaminants and enforcement of new legislation; the investigation carried out by specialists revealed oil residues in the ground, which migrated from the a neighbour site known to have hosted an oil storage plant 50 years ago. The level of contamination is considered very high.

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Valuation of Investment Interests in Contaminated Properties in Romania

Hypothetical Case Study

It was estimated by environmental consultants that remediation will take 3 years, using soil washing treatment. The total costs of remediation (including finance) will be ÂŁ 1,950,000 with the following breakdown: 6% in the first year, 62% for the second year and 32% for the last year.

The gross floor space of the office building is 5,880 m2 with a gross to net ratio of 86% and plot to footprint ratio of 12%. The freeholder had a 10 years lease with fiveyear rent reviews at a market rent of ÂŁ150 per m2, which ended because of contamination. Market evidence suggests a yield of 7% for similar uncontaminated properties. Stigma is attached due to contamination and the survey among property professionals suggested an upward adjustment of the yield with a premium of 4.1%, resulting in a total all risks yield of 11.1% (see valuation in Table 5.2). The freeholder commissioned a valuation in order to sell the property. An investment fund is interested in purchasing the property for a considerable profit, seeking to achieve a targeted rate of return of 11.1%.

5.3 ARY Adjustment and Risk Assessment Models at work The models which have been described in chapter three are now being applied in the case study to value the property. The base of the case study was considered at an agreed stigma premium for both the freeholder and the investor, which should be considered as a very important aspect. This basically reflects the sale price agreement between the seller and the buyer. However, a simple sensitivity analysis will be carried out to investigate how slight in the premium will affect the IRR of the investment.

In the ARY Adjustment Model (see Table 5.1), market evidence suggested that properties which have been contaminated and remediated suffered a 5% reduction in the rental value. The valuation in this model is carried out considering that the property

43

Valuation of Investment Interests in Contaminated Properties in Romania

Hypothetical Case Study

is contaminated and therefore takes account of the reduced rent (in the risk assessment model the valuation is done as if the property is not contaminated). The main input of the ARY adjustment model is the stigma premium, as resulted from the survey. As the contamination is considered to be very high, the premium is 4.1%, leading to an ARY of 11.1%. The annual income was multiplied by the years purchase in perpetuity at the ARY rate and deferred three years for the period of contamination when the property does not produce any income. The DCF for costs was then produced and its negative net present value was added to the net present value of the property to produce the stigmatised estimated property value, which is approximately £3.1 million.

ARY Adjustment Model Contamination Level Very High ARY Adjustment 4.1% Unimpaired Yield Stigma Adjusted Yield All risks yield (ARY) Total Remediation costs

High 3.4%

Medium 2.7%

7.00% 4.10% 11.10% £1,950,000

Quarterly Cash Flow ( 3 years remediation) Remediation Quarter Income Costs 1 £0.00 £29,250 2 £0.00 £29,250 3 £0.00 £29,250 4 £0.00 £29,250 5 £0.00 £302,250 6 £0.00 £302,250 7 £0.00 £302,250 8 £0.00 £302,250 9 £0.00 £156,000 10 £0.00 £156,000 11 £0.00 £156,000 12 £0.00 £156,000

Low 1.6%

Rental Value YP in perp. @ 11.1% PV of 3 yrs @11.1% Impaired Value 1

Net Cash Flow -£29,250 -£29,250 -£29,250 -£29,250 -£302,250 -£302,250 -£302,250 -£302,250 -£156,000 -£156,000 -£156,000 -£156,000

PV of 1£ @11.1% 1.0000 0.9740 0.9487 0.9241 0.9001 0.8767 0.8539 0.8318 0.8102 0.7891 0.7686 0.7487 NPV (of costs) NPV (property) Total NPV

Very Low 0.9% £720,338 9.01 0.7292 £4,732,285

DCF -£29,250 -£28,490 -£27,750 -£27,030 -£272,052 -£264,986 -£258,104 -£251,401 -£126,385 -£123,103 -£119,906 -£116,791 -£1,645,249 £4,732,285 £3,087,035

Table 5.1: Valuation of the contamianted propery using the ARY adjustment model

In the risk assessment model the main inputs were the four perceived stigma reductions resulted from the survey (see detailed responses in Appendix2). The first

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Valuation of Investment Interests in Contaminated Properties in Romania

Hypothetical Case Study

reduction r1 was due to the industrial nature of contaminant, oil residues, which was extracted from Table 4.2. In contrast with the ARY adjustment model the property was valued as uncontaminated, at the market yield percentage of 7%. The discounted costs of remediation were subtracted from the unimpaired value to produce a total net present value before stigma. This was reduced with 35.28% following the risk assessment and produced a value of almost £4.6 million (see Table 5.3).

Risk Assessment Model Industry Stigma r1 Perceived Stigma Before Remediation r2 Perceived Stigma After Remediation r3 Perceived Stigma on treatment method r4 Total Stigma Reduction ( r ) Market Yield Total Remediation costs Stigma Reduction

7.00% £1,950,000 35.28%

43.83% 25.80% 46.60% 6.60% 35.28% Full Rental Value YP in perp. @ 7% PV of 3 years @ 7% Unimpaired Value

Quarterly Cash Flow ( 3 years remediation period) Remediation PV of 1£ Quarter Income Net Cash Flow Costs @11% 1 £0.00 £29,250 -£29,250 1.0000 2 £0.00 £29,250 -£29,250 0.9832 3 £0.00 £29,250 -£29,250 0.9667 4 £0.00 £29,250 -£29,250 0.9505 5 £0.00 £302,250 -£302,250 0.9346 6 £0.00 £302,250 -£302,250 0.9189 7 £0.00 £302,250 -£302,250 0.9035 8 £0.00 £302,250 -£302,250 0.8883 9 £0.00 £156,000 -£156,000 0.8734 10 £0.00 £156,000 -£156,000 0.8588 11 £0.00 £156,000 -£156,000 0.8444 12 £0.00 £156,000 -£156,000 0.8302 NPV (of costs) NPV (property) Total NPV (before stigma) Stigma Reduction Total NPV

£758,250 14.29 0.8163 £8,842,255

DCF -£29,250 -£28,759 -£28,277 -£27,803 -£282,477 -£277,739 -£273,080 -£268,500 -£136,256 -£133,971 -£131,724 -£129,515 -£1,747,352 £8,842,255 £7,094,903 35.28% £ 4,591,764

Table 5.2: Valuation of the contamianted propery using the Risk Assessment Model

The very noticeable aspect of the results is by far the immense difference in net present values of the two models; one of the objectives of the survey was to compare the results and it seems that the risk assessment model has clearly produced a better 45

Valuation of Investment Interests in Contaminated Properties in Romania

Hypothetical Case Study

net present value. Of course, this is great news for the freeholder. However, it is known that the inputs of the models were based on the experience of the property professionals who completed the survey. One of the argument for the big difference could be that some of the valuers might have overestimated the stigma premiums while underestimating the stigma reductions or vice versa. This is either due to lack of experience or simply an imbalance in appreciating the effect stigma premium and stigma reduction. Another argument, however not as strong as the above is that inputs represent weighted average of all the data gathered in the survey. The expectation was a balance between the two inputs in the models to finally produce close matching results. Therefore, this clearly leads to the fact that prior to valuation of contaminated properties considerable and sensible judgements have to be done for quantifying the stigma.

On top of all these aspects there is the novelty in using and appreciating stigma as part of valuations. It seems that many valuers are not familiar with this term which is considered an element of novelty. As mentioned previously in the paper, there were cases when respondents estimated stigma premiums for the yield as high as 30%. This clearly suggests that there is yet no full appreciation and understanding of what stigma is and how it affects the value.

The next part of the case study is the appraisal of the investment from the perspective of the investment fund. The fund plans to purchase the property in its current state, remediate it and dispose it after five years, therefore the total holding period will be eight years. At that time the exit yield is expected to be 9%; the argument is that the current market yield is 7% and it is believed to go up with 1.5% in 8 years due the competition on the market with much newer buildings, which will make this building less attractive, similar to performance of other buildings in the past; On top of this 1.5% 46

Valuation of Investment Interests in Contaminated Properties in Romania

Hypothetical Case Study

an extra 0.5% is added due to the residual stigma attached as a consequence of past contamination considering the property will have a very low level of contamination.

The performance indicator on the potential of the property is the internal rate of return, calculated after producing the discounted cash flows in Appendices 3 and 4. The inputs of the DCFs can be found below, in Table 5.3.

Remediation costs Gross internal area Gross to net ratio Net internal area Projected lease: Market rent Expected return rate FRV

£1,950,000 2 5,885 m 86% 2 5,055 m 5 years 2 £150 per m 11.1% 758,250

Exit costs Rent review Current market yield Exit yield YP @ exit yield Holding period Rent growth Annual Lease Rent

3.00% 5 years 7.00% 9.00% 11.11 5 years 2.50% £720,338

Table 5.3: Inputs used in the case study

The net present values of the models are the starting point of the investment appraisal. Considering the ARY Adjustment model the investment seems to be viable as it produces a positive net present value and the internal rate of return of 15.69% is over the expected target of 11.1%. On the other hand, the IRR of the investment based on the risk assessment model is 10.85% which is below the target rate of return and theoretically make the investment unviable according with the investor’s expectations.

However, as the net present value is positive and the IRR is very close to the target rate the fund could practically consider this investment.

5.4 Sensitivity Testing on the Investment Opportunity To precisely illustrate how variations affect the investment potential, a simple sensitivity testing has been carried out, considering the suggestions of Isaac and O’Leary (2011, p:238).The target indicator is the IRR and the variables assumed are the exit yield and stigma premium for the ARY Model and the stigma reductions for the Risk Assessment Model.

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Valuation of Investment Interests in Contaminated Properties in Romania

Hypothetical Case Study

The two variables have been chosen because they have the biggest impact on the internal rate of return. That is because stigma premium or reduction affects the purchase price of the property, a major outflow in the appraisal. In the same time the exit yield is extremely important as it reflects the property’s sale price after the holding period. A high exit yield leads to a lower capital value of the property and vice-versa. The resulting IRRs are presented in the tables below, surrounding the base IRR produced by the two models.

Exit Yield

Sensitivity testing for ARY Adjustment Model Stigma premium for valuation IRR 5% 4.10% 3.00% 2.50% 2.00% 7.50% 19.70% 17.84% 15.48% 14.36% 13.22% 8.00% 18.91% 17.06% 14.72% 13.61% 12.47% 8.50% 18.19% 16.35% 14.01% 12.91% 11.78% 9.00% 17.52% 15.69% 13.36% 12.27% 11.14% 9.50% 16.90% 15.07% 12.76% 11.66% 10.54% 10.00% 16.31% 14.50% 12.19% 11.10% 9.98%

1.50% 12.05% 11.31% 10.62% 9.98% 9.39% 8.84%

1.00% 10.84% 10.10% 9.42% 8.79% 8.20% 7.65%

Table 5.4: IRR variation, relative to the exit yield and stigma premium

The variation in stigma premium has been considered only for the valuation of the contaminated property, in other words it reflects the freeholder sale price or the fund’s purchase price, while the investor’s rate of return of 11.10% has obviously been kept constant. At a first glance, the investment appears to be viable in many instances of the two variables. However, it was mentioned in the survey chapter that the values seem quite high. It can be clearly observed that the higher stigma is attached to the property, the lower the freeholder’s sale price and the higher investor’s internal rate of return. However, when stigma is reduced and the exit yields increase, the project becomes less viable. The hatched values of the IRRs do not met investor’s expectation and therefore would make the project unattractive.

For the second sensitivity testing the variation of stigma reduction has been considered. It was predictable however that the IRR would be lower in this case, due to the higher bid obtained necessary to purchase the property. Evidently, the higher the 48

Valuation of Investment Interests in Contaminated Properties in Romania

Hypothetical Case Study

purchase price, the lower the IRR. The resulted investment IRR is 10.85% at an exit yield of 9% and does not meet the target rate; however if the stigma reduction is kept constant at 35.28% and the exit yield moves in with 50 base points then the IRR will be 11.49% and the target will be met. Consequently, the results suggests that the by using the risk assessment model the investment is less viable and the IRR is lower compared with the ARY adjustment model.

Sensitivity testing for Risk Assessment Model Stigma reduction in valuation IRR 50% 40.00% 35.28% 30.00% 7.50% 16.13% 13.87% 12.93% 11.95% 8.00% 15.37% 13.12% 12.18% 11.20% 8.50% 14.66% 12.42% 11.49% 10.52% 9.00% 14.01% 11.78% 10.85% 9.50% 13.40% 11.18% 10.25% 10.00% 12.83% 10.62% 9.69% Exit Yield

25.00% 11.08% 10.35%

Table 5.5: IRR variation, relative to the exit yield and stigma reduction

A linear interpolation is further conducted between the variables of the two tables, in order to match the resulted base IRR in Table 5.4 with the corresponding variables in the Table 5.5. Keeping the exit yield at 9%, for the IRR of 15.69% in the Risk Adjustment Model, the premium of 4.1% corresponds to 56.50% stigma reduction (compared with 35.28% the actual value); similarly, at an IRR of 10.85%, the stigma reduction of 35.28% corresponds to a stigma premium of 1.88% (compared with 4.1% the actual value). The interpolation was done in order to see what values of stigma premiums or stigma reductions were needed so that the NPVs of the models would be equal.

Actual Value

4.10%

ARY Model Stigma Premium 4.10% IRR=10.85% 1.88%

Risk A. Model Stigma Reduction 56.50% IRR=15.69% 35.28%

Actual Value 35.2%

Figure 5.1: Correspondance of variable in the two sensitivity tests

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Valuation of Investment Interests in Contaminated Properties in Romania

Hypothetical Case Study

From the two sensitivity tests it resulted that variations in exit yields and stigma premium and reductions can produce appropriate IRRs to meet the investor’s rate. However, the more stigma decreases and exit yield increases the investment becomes less financially viable, producing lower IRRs. The stigma premium seems to ‘grow’ at a much faster rate than the stigma reduction, meaning that it reduces the value of the property at a much faster pace than the corresponding stigma reduction.

In terms of viability of the hypothetical case study the investment is considered a success for both of the models. It was intended to simulate the case study as a real life investment based on accurate market data. Even if it proves to be a success, there are probably other variables which have been overlooked. However, the case study offered a better view on how stigma contamination is tackled and presented the contrast between the two models.

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Valuation of Investment Interests in Contaminated Properties in Romania

Summary, Conclusions and Recommendations

6 Summary, Conclusions and Recommendations

The aim of research was to investigate the potential rate of return on properties affected by contamination.

Chapter one introduced the reader into the topic, by drawing attention on the on the rapidly changing urban population and limited urban space, followed by an analysis of the increased interests in redeveloping brownfield land. Further on, the rationale presented reasonable arguments to produce a research on this topic. The first significant argument was the ex industrialised profile of the country which led to a legacy of contaminated properties due to which Romania occupies the top list of all EU countries, with an astonishing estimated 900,000 hectares. The increasing national expenditure on remediation also suggested an increasing interest in contaminated properties and represented a second major argument. The gap in knowledge of valuation such properties and lack of experience added to the list of arguments for carrying out the research. Finally, the availability of EU funds for remediation which acts as an incentive proves the growing interest of investments in contaminated properties.

It was therefore clearly suggested why a research on valuation of investments interests should be produced.

The literature review in chapter 2 has concentrated on defining contamination and stigma, analysing the existing research and fitting all this within the Romanian property sector. The review revealed that many approaches to valuing contaminated properties have been carried out internationally; however, no such studies have been produced in Romania; one argument for that is suggested in the low response rate of the survey which reflects the very low interest in such studies. Approaches such as the

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Valuation of Investment Interests in Contaminated Properties in Romania

Summary, Conclusions and Recommendations

Sales Comparison or yield adjustment carried out by most of the researchers proved to present a very high degree of subjectivity. That is because the researchers did not offer any explication whatsoever on the adjustment values, but only outlined the techniques used. On the other hand, a further investigation revealed that one researcher, who adopted a different approach, has actually used his model inputs based on the results of a survey he created, therefore providing more credibility upon his approach. Moreover he tested the model on a number of projects, and the results were very satisfactory proving the efficiency in estimating the values as accurate as possible.

The critical analysis of the valuation approaches has made a good idea of what was to be done in chapter 3; the review of the approaches revealed that there was no commonly agreed practice model. As the risk assessment model developed by Syms was not created for investment purposes, it was decided to adapt it and test it as a new approach for valuing investment interests in contaminated properties. In order to appreciate the performance of the model, a basic yield adjustment model was used for comparison. Very importantly was the fact that the models were to be ‘fed’ with stigma inputs from the results of a survey. Even if it was the purpose of the case study to compare the models, a significant conclusion has been drawn: the ARY adjustment model uses a much generalised approach to quantify stigma without analysing any particularities of the property. On the other hand, the risk assessment model takes account of the contamination levels, its characteristics and treatment options.

Chapter four comprised the description and results of the survey. A total of 81 respondents fully submitted the questionnaire, representing a response rate of 4.3%, much below the expected rate of 20%. The most commonly method of incorporating stigma into valuations was by applying and end deduction for the estimated value and was used by 38.8% of the respondents. In this case it would seem reasonable to assume 53

Valuation of Investment Interests in Contaminated Properties in Romania

Summary, Conclusions and Recommendations

that the risk assessment model would be compatible with most of the respondents expected valuation techniques, as it is based on a final stigma reduction. Answers to question number five revealed that stigma premiums seem to grow almost linearly with the level of contamination, from 0.9% for a very low level to 4.1% to a very high level.

The survey also produced a list of current industrial activities which were ranked relative to the stigma impact perceived by the respondents; the most severe ones were the asbestos, chemical and radioactive material processing industries with stigma reductions of up to 63%. Very strange results were obtained when the respondents have been asked to appreciate the stigma impact in relation with methods of remediation. It seems that the treatment options have been perceived to have similar stigma reductions of 4%-6% in contrast with much varied reduction expectations.

The last chapter has put the two models in practice. It is indubitably inferred that the performance of the two models is very much attributed to the methodology adopted around it, which is surveying and testing. Of course, it was ideal to test the models on five or ten real life projects but unfortunately this was not possible.

Moreover the data resulted from the survey appears to not be viable in some instances (such as the high stigma premiums). Applying the results of the survey, the values of the contaminated property were ÂŁ3.1 million using the ARY Adjustment Model and ÂŁ4.6 million using the Risk Assessment Model. Therefore, the new approach based on risk assessment seems have produced a higher property value. Further on, the investment opportunity was appraised. Since the property was cheaper in the first model, the obtained IRR was 15.7%, over the target, while the other model produced an IRR of 10.85%.

Overall, the investigation proved that investing in contaminated property is worthwhile if a sensible valuation of the property is carried out. Using the first model 54

Valuation of Investment Interests in Contaminated Properties in Romania

Summary, Conclusions and Recommendations

the target rate of return was met, while in the case of the second model an additional 25 base points were needed for meeting the target rate.

As a recommendation mostly for the private sector, this study could represent a starting point for further research with regards on stigma perception in Romania; estimating stigma is definitely a great challenge and surely this research could be extended to a much more advanced level to produce useful findings for valuing contaminated proprieties in Romania. Furthermore, the interest in contaminated properties could be increased if the Romanian Government set up dwellings targets to be built on previously developed land; this constitutes the recommendation for the public sector, as the discussed literature review revealed that there is plenty of brownfield to be redeveloped and this could be a major advantage, especially with the help of non-reimbursable funds from the EU.

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Chalmers, J.A. & Roehr, S.A., 1993. Issues in the Valuation of Contaminated Property. Appraisal Journal, 61(1), pp.28-44.

Cobarzan, B., 2007. Financial Tools for Brownfield Redevelopment. Case Study on Romania. Dissertation Thesis. Michigan State University.

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Evans, P., 2008. The environmental and economic impacts of brownfield regeneration. Working Draft. NorhtEast MidWest Institution.

Hollander, J.B., Kirkwood, N.G. & Gold, J.L., 2010. Principles of brownfield regeneration. Washington: Island Press.

Valuation of Investment Interests in Contaminated Properties in Romania

Hollander, J.B., Kirkwood, N.G. & Gold, J.L., 2010. Principles of Brownfield Regeneration. Washington DC: Island Press.

Homes and Communities Agency, 2009. Previously Developed Land that may be available for development. Results from 2009 NULD-PDL in England. Birchwood: Homes and Communities Agency.

International Valuation Standards Committee, 2003. International Valuation Guidance Note No. 7 - Consideration of Hazardous and Toxic Substances In Valuations. 6th ed. IVSC. Isaac, D. & O'Leary, J., 2011. Property Investment. 2nd ed. London: Palgrave Macmillan.

Isaac, D., O'Leary, J. & Daley, M., 2010. Propery Development. Appraisal and Finance. London: MacMillan Press.

Laider, D.W., CIRIA, Wilbourn, P. & Bryce, A.J., 2002. Brownfields : managing the development of previously developed land : a client's guide. London: Construction Industry Research and Information Association.

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Mallett, H. & Beale, L., 2008. Guidance for the Safe Development of Housing on Land Affected by Contamination. National House-Building Council and Environment Agency.

McCabe, S., 2010. Corporate Strategy In Construction: understanding today's theory and practice. Oxford: Wiley Blackwell.

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Ministry of Environment and Forests, 2010. The National Strategy for Management of Contaminated Sites. [Online] Bucharest Available at: http://www.mmediu.ro/legislatie/proiecte_acte/2011-0609_proiecte_acte_primaversiunesngsc.pdf [Accessed June 2011].

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Patchin, P.J., 1991. Contaminated Properties - Stigma Revisited. Appraisal Journal, 59(2), pp.167-72.

Patchin, P.J., 1994. Contaminated Properties and the Sales Comparison Approach. Appraisal Journal, 62(3), pp.402-10.

Richards, T., 1996a. The valuation and appraisal of contaminated land and property. The Cutting Edge 1996. RICS Research.

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Royal Institute of Chartered Surveyors, 2010. Contamination, the environment and sustainability. Implications for chartered surveyors and their clients. 3rd ed.

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Valuation of Investment Interests in Contaminated Properties in Romania

Survey Questions – Appendix 1

SURVEY QUESTIONS - APPENDIX 1 The stigma effect in valuation of contaminated properties

Welcome!

The issue regarding the quantification of stigma in the valuation of properties affected by contamination has been in debate for a long time, especially in the English and American literature. In Romania the stigma is a relatively new term.

The stigma effect represents the reduction of the estimated value of a contaminated property, caused by an aggregate of intangible factors, such as fear of unknown, liability, perception and reaction of the property market etc.

The context of the questionnaire survey is referring to the following aspects:

Valuation of investment properties located in Romania Contaminated or potentially contaminated properties The estimation of the investment value (calculation of worth) when it is equal to the market value (the investor’s interests does affect the values in a positive or negative way)

The scope of the survey is to investigate your opinions, based on the experience you have and the property market, no matter if you have valued a contaminated property or not.

1. How many properties affected by contamination have you valued? [ ] None

[ ] 1-5

[ ] 6-10

[ ] 11-20

[ ] 21-50

[ ] Over 50

2. What types of properties have you valued?

Often

Rare

Never

Residential Commercial Industrial

3. Have you ever refused to produce a valuation of a contaminated property? [ ] Yes

[ ] No

Valuation of Investment Interests in Contaminated Properties in Romania

Survey Questions – Appendix 1

4. How do you quantify the stigma effect in your valuation for contaminated properties?

Note: Capitalization/discount rate along with the associated risks reflects the ARY – all risk yield.

Example: ARY = C/D rate % (capitalization/discount rate) + S% (rate caused by stigma) Reduction of the final value refers to a fixed amount or percentage which reduces the value.

[ ] By reducing the final estimated value [ ] By increasing the capitalization/discounting rate (All Risks Yield) [ ] By using variable rates for different period of times [ ] I do not quantify the stigma effect [ ] Other method (please specify): 5. Depending on the contamination level, what percentage (S%) do you add to the All Risks Yield, in order to reflect the stigma effect?

Note: The All Risks Yield includes the capitalization or discounted rate along with the associated risks, to which the risk associated with the stigma effect will be added. EXEMPLE: ARY = 7% + S%; where S% is the percentage associated with stigma effect .

0%

0.5%

...%

3%

...%

4.5%

5%

Very High Level High Level Medium Level Low Level Very Low Level

6. How do you incorporate the remediation costs into valuations?

Note: The deduction from the Net Operating Income is taking place during the life of the investment and implies different calculations compared with the end reduction of the final estimated value.

[ ] End reduction of the estimated value [ ] Increase of the All Risks Yield [ ] Deduction from the Net Operating Income [ ] Other method (please specify): 7. Depending on the level of contamination BEFORE remediation, what is the percentage reduction of the estimated value caused by the stigma?

0% Very High Level High Level Medium Level Low Level Very Low Level

1%

2%

...%

50%

...%

100%

Valuation of Investment Interests in Contaminated Properties in Romania

Survey Questions – Appendix 1

8. Depending on the level of contamination AFTER remediation, what is the percentage reduction of the estimated value caused by the stigma?

0%

1%

2%

...%

50%

...%

100%

Very High Level High Level Medium Level Low Level Very Low Level

9. Given you experience and opinion, what is the percentage reduction of the estimated value caused by stigma, depending on the type of industry?

Please insert a value between 0 and 100%.

Semiconductors industry: Mining and extractive industry: Building materials industries: Oil refining: Gas industries: Explosive industry: Timber industy: Electricity generating industry: Steel manufacture: Waste disposal industries: Metal smelting industry: Glass manufacture:

Dyestuff manufacturing: Paper manufacture: Chemical industries: Petrochemical industry: Pharmaceutical industry: Car manufacture: Radioactive materials processing: Textile industry: Shipyard industry: Asbestos manufacture: Paint manufacture:

10. Which is the percentage loss caused by stigma depending on the method of treatment?

0% Complete excavation and backfilling with clean material Partial excavation of hot spots and backfilling with clean material Soil washing treatments Bioremediation and chemical methods Other methods (please specify)

12%

35%

610%

1115%

>15 %

Valuation of Investment Interests in Contaminated Properties in Romania

Survey – Appendix 1

11. Please appreciate the following factors which cause stigma, depending on the importance they have on the value of the property: Not Important

Low Importance

Medium Importance

Proximity to contaminated properties Residual risk Fear of unknown Limited use of the property Liabilities Additional remediation costs Limited financing Market perception and reaction

12. How do you estimate the remediation costs?

Please select no more than 3 answers.

[ ] Experience [ ] Comparable properties [ ] Desktop study [ ] Preliminary environmental cost reports [ ] Detailed environmental cost reports [ ] Detailed Visual inspections [ ] Other (please specify):

Thank you for your participation!

Important

Very important

Valuation of Investment Interests in Contaminated Properties in Romania

Survey Results – Appendix 2

SURVEY RESULTS - APPENDIX 2 The stigma effect in valuation of contaminated properties 1. How many properties affected by contamination have you valued?

Valuations of contaminated properties 4.9%

3.7%

4.9% 1-5 None

13.6%

42.0%

Over 50 11 11-20 6 6-10 21-50

30.9%

2. What types of properties have you valued?

Type of contaminated property valued Residential

Never

26.8%

Rare 12.5% Often

Commercial

Industrial

19.6%0.0%

50.0%

32.1%

46.4%

58.9%

50.0%

3. Have you ever refused to produce a valuation of a contaminated property?

Contamianted Property Valuation Refusal

21% Yes No

79%

Valuation of Investment Interests in Contaminated Properties in Romania

Survey Results – Appendix 2

4. How do you quantify the stigma effect effect in your valuation for contaminated properties?

Stigma Quantification By reducing the final estimated value

13.1%

By increasing the All Risks Yield

38.6%

15.1%

By using variable rates I do not quantify the stigma effect

10.4%

Other methods

22.8%

5. Depending on the contamination level, what percentage you add to the All Risks Yield, in order to reflect the stigma effect?

ARY Premium According to Level of Contamiantion Very Low Level

0.9%

Low Level

1.6%

Medium Level

2.7% ARY Premium

High Level

3.4%

Very High Level

4.1% 0%

1%

2%

3%

4%

5%

6. How do you incorporate the remediation costs into valuations?

Incorporation of Remediation Costs into Valuation End reduction of the estimated value

6.1% 11.0%

Increase of the All Risks Yield

51.2% 31.7%

Deduction from the Net Operating Income Other method:

Valuation of Investment Interests in Contaminated Properties in Romania

Survey Results – Appendix 2

7. Depending on the level of contamination BEFORE remediation, what is the percentage reduction of the estimated value caused by the stigma? See Question No.8 8. Depending on the level of contamination AFTER remediation, what is the percentage reduction of the estimated value caused by the stigma?

Expected Impact on value Before and After Remediation Very Low Level

4.6% 7.6%

Low Level

7.6%

13.4%

10.8%

Medium Level

Before

18.6%

High Level

After

23.4% 36.8% 25.8%

Very High Level

0%

10%

20%

30%

46.6%

40%

50%

9. Given your experience and opinion, what is the percentage reduction of the estimated value caused by stigma, depending on the type of industry?

Perceived Stigma Effect by Industry Rank Industry 1 Radioactive materials processing 2 Asbestos manufacture 3 Chemical industries 4 Oil refining 5 Waste disposal industries 6 Explosive industry 7 Mining and extractive industry 8 Dyestuff manufacturing 9 Paint manufacture 10 Petrochemical industry 11 Steel manufacture 12 Building materials industries 13 Glass manufacture 14 Pharmaceutical industry 15 Gas industries 16 Metal smelting industry 17 Paper manufacture 18 Semiconductors industry 19 Shipyard industry 20 Timber industy 21 Car manufacture 22 Electricity generating industry 23 Textile industry

Stigma Effect 62,66% 49,22% 44,80% 43,83% 41,36% 39,57% 38,14% 38,05% 37,17% 36,30% 27,62% 25,75% 24,75% 23,68% 22,96% 22,32% 21,31% 19,95% 18,43% 17,83% 17,46% 16,37% 16,15%

Valuation of Investment Interests in Contaminated Properties in Romania

Survey Results – Appendix 2

10. Which is the percentage loss caused by stigma depending on the method of treatment?

Perceived Stigma Effect by Remediation Options Weighted average 0% 1-2% Full excavation and backfilling with clean material 4,1% 35,4% 16,7% Partial excavation of hot spots and backfilling with clean material 5,0% 22,0% 18,7% Soil washing treatments 6,6% 13,2% 18,7% Bioremediation and chemical methods 4,7% 30,9% 19,1% Other methods (please specify) 5,9% 29,5% 13,6%

3-5%

6-10%

1115%

>15%

17,7%

17,7%

9,4%

3,1%

20,9%

25,3%

7,7%

5,5%

25,3%

17,6%

5,5%

19,8%

16,0%

18,1%

7,4%

8,5%

13,6%

17,0%

12,5%

13,6%

11. Please appreciate the following factors which cause stigma, depending on the importance they have on the value of the property: Factors which cause stigma by relevance Not Low Important Importance Proximity to contaminated properties 0% 4% Residual risk 0% 12% Fear of unknown 4% 26% Limited use of the property 0% 5% Liabilities 0% 9% Additional remediation costs 0% 2% Limited financing 0% 9% Market perception and reaction 0% 1%

Medium Importance

Important

Very important

15% 26% 39%

38% 40% 24%

44% 22% 7%

20% 26%

44% 39%

32% 27%

18% 23%

38% 37%

42% 32%

20%

36%

43%

Valuation of Investment Interests in Contaminated Properties in Romania

Survey Results – Appendix 2

12. How do you estimate the remediation costs?

Cost Remediation Estimates Other (please specify)

8.8%

Desktop study

17.5%

Preliminary ECR

26.3%

Experience

38.8%

Comparable properties

43.8%

Detailed ECR

55.0%

Detailed Visual inspections

56.3% 0%

10%

*ECR stands for Environmental Cost Reports

20%

30%

40%

50%

60%

Valuation of Investment Interests in Contaminated Properties in Romania

DCF for ARY Adjustment Model – Appendix 3

Valuation based on the ARY Adjustment Model NPV Year

Quarter

Years

Income

Expenses

1

1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1

0 0.25 0.5 0.75 1 1.25 1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75 5 5.25 5.5 5.75 6 6.25 6.5 6.75 7 7.25 7.5 7.75 8

£0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £9,751,792

£3,116,285 £29,250 £29,250 £29,250 £302,250 £302,250 £302,250 £302,250 £156,000 £156,000 £156,000 £156,000 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £292,554

2

3

4

5

6

7

8

9

Net Cash PV of Flow 1£@11.1% -£3,116,285 1.0000 -£29,250 0.9740 -£29,250 0.9487 -£29,250 0.9241 -£302,250 0.9001 -£302,250 0.8767 -£302,250 0.8539 -£302,250 0.8318 -£156,000 0.8102 -£156,000 0.7891 -£156,000 0.7686 -£156,000 0.7487 £180,084 0.7493 £180,084 0.7315 £180,084 0.7141 £180,084 0.6971 £180,084 0.6805 £180,084 0.6644 £180,084 0.6486 £180,084 0.6332 £180,084 0.6181 £180,084 0.6034 £180,084 0.5891 £180,084 0.5751 £180,084 0.5614 £180,084 0.5481 £180,084 0.5350 £180,084 0.5223 £180,084 0.5099 £180,084 0.4978 £180,084 0.4860 £180,084 0.4744 £9,459,238 0.4631 NPV IRR per quarter IRR per year

DCF -£3,116,285 -£28,490 -£27,750 -£27,030 -£272,052 -£264,986 -£258,104 -£251,401 -£126,385 -£123,103 -£119,906 -£116,791 £134,932 £131,725 £128,594 £125,538 £122,554 £119,641 £116,797 £114,021 £111,311 £108,666 £106,083 £103,562 £101,100 £98,697 £96,351 £94,061 £91,826 £89,643 £87,513 £85,433 £4,380,842 £1,816,606 3.71% 15.69%

Valuation of Investment Interests in Contaminated Properties in Romania

DCF for Risk Assessment Model – Appendix 4

Valuation based on the Risk Adjustment Model NPV Year

Quarter

1

1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1

2

3

4

5

6

7

8

9

Years 0 0.25 0.5 0.75 1 1.25 1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75 5 5.25 5.5 5.75 6 6.25 6.5 6.75 7 7.25 7.5 7.75 8

Income

Expenses

£0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £180,084 £9,751,792

£4,621,072 £29,250 £29,250 £29,250 £302,250 £302,250 £302,250 £302,250 £156,000 £156,000 £156,000 £156,000 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £0 £292,554

Net Cash PV of Flow 1£@11.1% -£4,621,072 1.0000 -£29,250 0.9740 -£29,250 0.9487 -£29,250 0.9241 -£302,250 0.9001 -£302,250 0.8767 -£302,250 0.8539 -£302,250 0.8318 -£156,000 0.8102 -£156,000 0.7891 -£156,000 0.7686 -£156,000 0.7487 £180,084 0.7493 £180,084 0.7315 £180,084 0.7141 £180,084 0.6971 £180,084 0.6805 £180,084 0.6644 £180,084 0.6486 £180,084 0.6332 £180,084 0.6181 £180,084 0.6034 £180,084 0.5891 £180,084 0.5751 £180,084 0.5614 £180,084 0.5481 £180,084 0.5350 £180,084 0.5223 £180,084 0.5099 £180,084 0.4978 £180,084 0.4860 £180,084 0.4744 £9,459,238 0.4631 NPV IRR per quarter IRR per year

DCF -£4,621,072 -£28,490 -£27,750 -£27,030 -£272,052 -£264,986 -£258,104 -£251,401 -£126,385 -£123,103 -£119,906 -£116,791 £134,932 £131,725 £128,594 £125,538 £122,554 £119,641 £116,797 £114,021 £111,311 £108,666 £106,083 £103,562 £101,100 £98,697 £96,351 £94,061 £91,826 £89,643 £87,513 £85,433 £4,380,842 £311,820 2.61% 10.85%