Asaying in the field of journalism is that “only bad news is good

news” or that “bad news sells” in the media marketplace. In a

similar fashion the recent growth of environmental and tort (i.e.,

wrongful harm) laws in the United States has resulted in the apparent

popular merchandising of a number of “deleterious condition models”

and negative valuation methods for the assessment and appraisal of real

estate related risks.

“Deleterious condition models” purport to evaluate hundreds of harmful

environmental factors negatively impacting real estate from:

■ natural causes (flood zones, landslides, soil liquefaction);

■ man-made substances and emissions (toxic sites, asbestos, lead-based

paint, electromagnetic fields, radon);

■ building environments (sick building syndrome, construction defects);

■ public works projects (permanent and temporary takings);

■ market stigma from social conditions (crime scenes, the place of

residence of sexual offenders).

A s s e s s i n g

H a r m f u l F a c t o r s

An Alternative Model for the Valuation of Affected Properties

By Wayne C. Lusvardi

The Growth of Negative

Valuation Models

“An easily understood,

workable falsehood is more

useful (marketable) than a

complex incomprehensible truth.”

— Murphy’s Laws

20 MARCH/APRIL 1999 • RIGHT OF WAY

There is a veritable growth industryin negative real estate valuations. Suchnegative valuations attempt to recoverclean-up costs and punitive damages in toxic tort lawsuits against large corpo-rations, obtain damages from publicagencies in airport or freeway noise classaction suits, compensate for constructiondefects from new home builders, pay forthe replacement of homes proximate toso-called hazardous waste sites, and toobtain lower assessed valuations forproperty tax purposes as a result of anyof the above. To apply the above proverbto the current practice of real estate appraisal, “bad values sell” in our newliability culture.

These new risk assessment modelsand negative valuation methods for theappraisal of real estate contain a numberof overlooked problems such as:

1. Potentially harmful conditions areeverywhere and in everything. By logicalextension, if everything is harmful,nothing is. Within the framework ofharmful evaluation models and negativevaluation methods truly there is littlethat could not be called a deleterious orharmful condition.

2. Harmful condition valuation modelsemploy only single entry accounting of debit items such as remediation costsand accompanying “market resistance”or “stigma.” The problem with this ap-proach is that external conditions impact-ing real estate have inseparable positiveand negative aspects and are lopsidedly

in favor of the positive. Benefits are oftenlarge, imminent, and likely to recurwhile costs are often small, speculative,remote in time and typically projectedby extrapolation.

3. The cost to remediate a harmfulcondition does not reflect “market value”between a “willing informed emitter”and a “willing informed recipient” eitherof whom hypothetically can alter theircircumstances by a price mechanism asspecified in the legal definition of marketvalue. The concept of markets impliesthe ability to alter one’s circumstancesby education, avoidance, prevention, ormitigation. As such a deduction for thecosts to remediate harmful conditions orstigma does not reflect market value inthe legal and accepted definition of theterm.

4. Under new Federal evidentiary law,purported harmful conditions must firstbe proven by the scientific method tocause material damage before being adju-dicated for compensation in a court of law(Daubert v. Merrell Dow Pharmaceuticals,1993). Most so-called harmful conditions,substances, or emissions impacting real estate have not been proven to be harmfulto human health or safety.

5. A determination of the “relevantparcel” (i.e., larger parcel) for evaluationis often omitted in negative valuationmodels. The impacted parcel is assumedto be harmed without considering thepositive impacts on benefited parcels.Moreover, an impacted parcel and a

mitigated or benefited parcel form aneconomic “complement” not an eco-nomic “substitute” that reflects marketvalue.

6. Harmful condition assessmentmodels don’t consider that the marketuses insurance to mitigate the occurrenceof many risks (Freeman; Britt).

7. Harmful condition models evaluatetemporary episodic risk to the neglect oflong-term market trends. Short-termlosses may be recovered in the long runby natural market cycles.

8. Harmful condition models andnegative valuation methods are decep-tively simple and thus are seeminglymore appealing than complex but morerealistic valuation models.

This article provides an alternativemodel for the valuation of potentiallyharmful environmental conditions. Thismodel is intuitively simple, market-based, considers both what is harmfuland beneficial, employs double entry netimpact accounting, comports with accepted science, and fits with traditionalreal estate investment risk analysis. In theinterest of brevity, a full theoretical explanation of the alternative trade-offmodel described below has not been attempted.

The Risk Trade-Off Model The Risk Trade-Off Model elaborated

upon more fully in the body of this articleis based on the outline shown in Figure 1, below:

ASSESSING HARMFUL FACTORS

Class Risk Reward Degree of Risk Perception Risk RateRisk Probability

I High High Reasonable Varies Phobia 10%

II High Low Intolerable Varies Stigma >10%

III Low High Acceptable Varies Phobia 5% - 10%

IV Low Low Negligible Varies Phobia 5%

Figure IT h e R i s k T r a d e o f f M a t r i x

MARCH/APRIL 1999 • RIGHT OF WAY 21

Risk/Reward Tradeoff. Living in atechnological society presents a numberof inescapable tradeoffs between risksand rewards, losses and gains, costs andbenefits, opportunity and danger. Wedrive automobiles to work for the rapidform of transportation it provides, with-out giving much thought to the smalldaily potential risks of loss of life involved. We make certain that our children have whooping cough vaccina-tions, despite the miniscule risk of deathinvolved. We increasingly rely on wire-less (cellular) communications and don’tconsider electromagnetic waves fromsuch devices a health hazard becausethey emit considerably less energy than alight bulb.

Some people live or farm in floodplains and are willing to pay for floodhazard insurance for the trade off oflower land costs or availability of waterfor farming, full well knowing thatwhen the 100-year flood cycle comestheir property may suffer damage. Anymodel for evaluating risks relating to realestate must take into account this trade-off or exchange dimension of costs andbenefits. This tradeoff equation has traditionally been measured in real estateby a risk versus reward investment analy-sis. The underlying assumption of thetradeoff concept is that risks and rewardsare inseparable and that markets maxi-mize rewards and minimize risks (seeFigure 2, page 25).

Levels of Risk Tradeoff. Like climb-ing a ladder where there is a tradeoff between height and safety, there are levels of risk tradeoff from familiar risks,to low, prospective, and substantial risks.Varying levels of risk require a differentrisk policy. High risks with low accom-panying rewards are usually consideredas “intolerable risks.” Low risks associatedwith high rewards usually are thought tobe “acceptable risks.”

Where high risks are matched withhigh rewards the public typically de-mands that the risks be kept “as low asreasonably possible.” Low risks that areaccompanied by low rewards often areconsidered to be “negligible risks” thatrequires only benign neglect (see

NEW FILM

22 MARCH/APRIL 1999 • RIGHT OF WAY

ASSESSING HARMFUL FACTORS

Figure 2). Intolerable and reasonablerisks typically are mitigated with insur-ance. Acceptable and negligible risks arenot frequently insured because they rep-resent low or non-risks.

Intuitive Risk. What the public typi-cally understands about risk is oftensummarized into shorthand proverbs,recipe knowledge, or rules of thumbthat guide everyday market decisionmaking without any formal education orscientific knowledge. A risk evaluationmodel must be translated into the lan-guage of these intuitive guidelines andinformal systems of knowledge.

For example, “acceptable risks” areusually described in terms of theproverb “waste not/want not.” In otherwords, some rewards are worth pursuingdespite the high risks. “Intolerable risks”are usually described in terms of “bettersafe than sorry.” “Reasonable risks” arefrequently described by the public asrisks where if “nothing is ventured,nothing is gained.” “Negligible risks” areoften described as taken “with a grain ofsalt;” meaning they are considered assmall as a grain of salt (see Figure 2).

Risk Perception/Regulation. Anotherfactor in the tradeoff model is percep-tion or misperception of risk. Accurateperception of the probability of futurerisk is typically termed “stigma.” Theopposite of stigma is “phobia” wherethere is an irrational misperception ofharm without any rational basis. Fairmarket value real estate valuations canconsider stigma but cannot considerphobia. This is because the concept ofphobia assumes irrational perception,panic, or fear of risk rather than rationaland knowledgeable perception. Contraryto current popular thinking in the fieldof real estate appraisal, most environ-mental conditions evoke phobia notstigma (Lewis).

Risk perception in a technological society is dependent on the reasonable-ness of the regulation of risks.Regulation where there is no real riskcan create its own stigma. Where somerisks such as flood hazard zones arehighly regulated, any negative marketreaction to properties located in such

zones beyond that already reflected inland sales prices would be phobic because regulation and mandatory floodinsurance minimizes the risk of loss.

Where risks have been highly regulatedby environmental protection laws andtort laws without any proven likelihoodof harm to human health or safety, thereal risk becomes the threat of a lawsuit

or the imposition of a fine, exaction, orexcise tax. As H. W. Lewis, Ph.D., pro-fessor of physics at the University ofCalifornia at Santa Barbara has stated,the reason for remediation or removal of most environmental substances orconditions is “fear of litigation,” not fearof harm. Such a condition may betermed “regulatory stigma.”

Risk Tradeoff Examples. There arefew real estate related risks that wouldfall into the category of a Phase I highrisk/high reward condition in the RiskTradeoff Model. Living in a flood plain isa high risk/high reward condition but itis mitigated by flood insurance and longcycles between major floods. Most realestate related risks fall into the Class III& IV category of negligible or acceptablerisks. The highest statistical risks involving real estate are house fires and

home accidents. House fires are some-times attributable to the physical condi-tion of real estate but are often insured(Breyer).

The popular misconception is that achip of lead-based paint, a particle of asbestos from insulation, a molecule ofradon gas from soil, one miligauss ofelectrical energy from distant powertransformers, or the mere proximity tothe underground migration of minuteconcentrations of toxic substances, represent significant risks (Bate; Breyer;Foster; Gots; Lewis; Mazur; Moore;Wildavsky). There is an overreaction toman-made carcinogens and emissions,and unconcern with immensely greaternatural carcinogens and human lifestylemistakes and misdeeds.

An example of an acceptable risk often taken by the public with real estateis installing asbestos insulation becauseof its irreplaceable life saving and fire retardant properties compared to itsminiscule hypothetical risk (Moore).However, because asbestos in buildingscan lead to lawsuits it may have a phobiceffect on real estate values. Examples ofintolerable risks are gross constructiondefects or negligence in building on unstable land (see Figure 2). Examplesof negligible risks are radon (Moore)and freeway noise.

Risk Rate. All of the above factorsmeasure risk in qualitative-categoricalterms. How should we quantitativelymeasure risk? The method that real estate economists, bankers, and appraisersuse in dealing with future contingenciesis the mechanism of financial discounting,such as annuity or compound interest.With an annuity we make small pay-ments (costs) now to reap greater sums(rewards) in the future through thepower of compound interest.

The value of something is measuredhigher in the present than in the future(a bird in the hand is worth two in thebush). Historical rates of return for bankdeposits, savings accounts, and invest-ment returns have hovered in the rangeof 5 percent to 10 percent per year. Lowinvestment risk has been associated withlow risk rates of around 5 percent. High

The implication of the Tradeoff Model is that we should avoid squandering huge sums today

to avert distant or highly speculative or improbable threats.

MARCH/APRIL 1999 • RIGHT OF WAY 23

risk has been associated with rates of 10percent or higher. Moderate risk hasbeen in the 5 percent to 10 percentrange (see Figure 2).

Applying the Model. The applicationof discount rates to measure risk mustconsider the factors of time and proba-bility. We are typically willing to paymore to avoid risks that are imminent intime than those that we must deal withthat are far away. Using a grand examplefrom physicist H.W. Lewis in his bookTechnological Risk, let’s assume that thepurported risk of carbon dioxide build-upin the air (global warming) is a realrather than a perceived threat to the entire world.

This presumed threat would harmreal estate values by raising the level ofthe oceans, increasing the risk of forestand brush fires, requiring more energyto cool buildings, result in more andlonger draughts requiring tax increasesfor huge water and flood protection projects, require a massive relocation ofpopulation near to places of work toavoid driving automobiles, etc. Lewis estimates that global warming would result in a catastrophic one-third loss ofthe world’s estimated gross domesticproduct of $30 trillion (GDP 1996). Inother words, the loss would be $10 tril-lion, but it is not expected for 200 years.

Employing a 10 percent discount rateused by the U.S. Federal Office ofManagement and Budget (OMB) to reflect the high future risk involved, theresulting present worth of the cost toavert this hypothetical world tragedy today would be a one-time lump sum ofonly about $50,000. We are willing toaccept this small speculative risk in return for the trillions of dollars thatpersonal mobility from the automobilecontributes annually to the economyand to real estate values. Albeit this per-sonal mobility comes at the cost of somelives (mitigated by insurance) and theunpaid price of irritating pollution thatwe are willing to tolerate to some degree.

Using the Risk Tradeoff Model, mostrisks associated with real estate equateto a small or zero sum in present worthdollars. This is corroborated by the im-

partial scientific literature that showsthat most man-made environmentalrisks associated with real estate are soimprobable that they are effectively zero(Bate; Breyer; Foster; Gots, Lewis;Mazur; Moore; Wildavsky). Natural dis-asters or man-made failures are often in-surable and/or the long-term rewardsgreatly exceed short-term losses.

The implication of the Tradeoff Modelis that we should avoid squanderinghuge sums today to avert distant or high-ly speculative or improbable threats.However, this “good news” won’t sell engineering risk assessments, appraisalsusing exotic valuation methods, environ-mental legal services or justify regulatorybudgets. Nor will it eliminate the stigma

P/U JJan/FebPage 25

24 MARCH/APRIL 1999 • RIGHT OF WAY

attributable to the threat of lawsuit or theimposition of a fine, impact fee, or excisetax for over-regulated environmentalrisks (i.e., regulatory stigma). But it mayoffer a more realistic alternative tool forthe evaluation of the impact of environ-mental risks on real estate.

By combining all of the above-described factors into a graphicallydepicted model, the contingency tableemerges: (see Figure 2).

A Stopped Clock Is Right Twice A Day The Risk Tradeoff Model focuses on

long-term risk while many current riskassessment models concentrate on anepisodic one-time event such as the reaction immediately prior to or after alandslide, earthquake, flood, toxic tortlawsuit, crime, etc.

By focusing on a crisis event the im-pact of the harmful condition on the realestate market is distorted. This tunnel vision approach is similar to measuringthe impact of a temporary correction inthe stock market that will naturally recover.

To value the imputed temporary valuediminution on real estate from an envi-ronmental condition that the naturaltrends of the market will eventually compensate for may be misleading, unless the condition lingers after the market has recovered. Moreover, if themarket already places a discount on realestate for latent environmental conditions(i.e., flood plains), how can it be claimedthere is an additional diminution or “stigma” upon the activation of such acondition (i.e., a flood event)?

Media, environmental protection reg-ulations, and litigation often distort andmagnify the true risks of environmentalconditions while the market minimizesand mitigates such risks. Many risk assessment models used in real estateappraisals fail to consider confoundingvariables such as the effects of media, litigation, or environmental activism,and the effects of intervening marketmechanisms such as perceptual mini-mization, insurance, government benefitprograms, and other mitigation measures(see Figure 3).

NEW FILM

H.C. PeckP/UJan/Feb

Page 22

MARCH/APRIL 1999 • RIGHT OF WAY 25

Market Price Variables

Price discount Lingering Diminution

Confounding VariablesLatent Media effects

regulatory LitigationVALUE stigma Environmental activism

Intervening VariablesPerceptual Minimization Insurance

Government Benefit Programs Natural Recovery

Other Mitigation Measures

Before Episodic Event AfterMedia Event

Litigation

TIME

High Reward Low Reward

High Risk (I) (II)High Risk/High Reward High Risk/Low Reward

Rule: “Nothing Ventured/Nothing Gained” Rule: “Better Safe Than Sorry”Risk Level: As Low As Risk Level: Intolerable Risk

Reasonably Possible Risk Examples: landslide, gross Examples: flood hazard zone; construction defects

airport, dam proximity (High Regulation: stigma)(High Regulation: phobia) Risk Rate: >10%

Risk Rate: 10%

Low Risk (III) (IV)Low Risk/High Reward Low Risk/Low Reward

Rule: “Waste Not/Want Not” Rule: “Take With A Grain of Salt”Risk Level: Acceptable Risk Risk Level: Negligible Risk

Examples: electromagnetic fields, building Examples: radon, freeway noiseasbestos, lead based paint, toxic waste site (High Regulation: phobia)

(High Regulation: phobia) Risk Rate: 5% or less Risk Rate: 5% - 10%

Figure 2R e a l E s t a t e E n v i r o n m e n t R i s k / R e w a r d T r a d e o f f M a t r i x

Figure 3

Distorting and Mitigating Factors in Real Estate Risk Events

Risk-Reward Matrix - W. C. Lusvardi Copyright 1998

Risk-Reward Matrix - W. C. Lusvardi Copyright 1998

26 MARCH/APRIL 1999 • RIGHT OF WAY

Taking cues from the media and reg-ulation, the public perceives the presenceor absence of risk, not its magnitude(Viscusi). The overreaction to negligiblerisks retards the sort of economicprogress that has historically broughtabout both health and material well being. But real estate appraisers are heldto a higher professional standard, andshould be required to impart that thetrue net risks of most environmentalconditions on real estate are small,nonexistent, are too far away in time toamount to much in monetary terms, orare already included in market real estateprices.

To do otherwise would result in theloss of professional status for the appraisal industry. Much like the “noproject influence rule” that governsproperty appraisals for public worksprojects, appraisals of properties withperceived risks should disregard any influence on property values after thesituation becomes a media event (media

influence rule) or a litigated event (litigation influence rule).

Marketing Fashionable NonsenseSome of the recent advertised models

for the assessment and valuation of environmental risks impacting real estatehave been incorporated into professionalappraisal seminars despite their lack of peer and public agency review. Thesemodels are grossly inconsistent witheconomic theory and appraisal princi-ples, accepted impartial science, justcompensation law, and newer case lawregarding the adjudication of propertyvaluation cases involving scientific issues.

Government agencies and publicutilities need to adhere to the principle of “caveat emptor” (buyer beware) inshopping for consultants for real propertyassessments and valuations involvingenvironmental conditions. Risk assessmentand valuation models that masqueradeas appraisal theory but offer a cafeteriaapproach for the pre-concluded negative

evaluation of multiples of hundreds ofenvironmental risks are basically formarketing of professional services or legaladvocacy purposes, not for impartial realestate appraisal. ■

Sources ConsultedRoger Bate, ed., What Risk? Science, Politics, and Public Health(Oxford: Butterworth, 1997). Stephen Breyer, Breaking the Vicious Circle: Toward EffectiveRisk Regulation (Cambridge, Mass.: Harvard University Press,1993). Scott A. Britt, Why The Real Estate Market is Increasingly Relyingon Environmental Insurance (www.ecsunderwriting.com., undated). Susan L. Cutter, Living with Risk (New York: Edward Arnold,1993). Baruch Fischoff, et. al., Acceptable Risk (New York:Cambridge University Press, 1981). Kenneth R. Foster, et. al., editor, Phantom Risk: ScientificInference and the Law (Cambridge: MIT Press, 1994). Paul K. Freeman, Managing Environmental Risk throughInsurance (Kluwer Academic Pub. 1997). Ronald E. Gots, Toxic Risks: Science, Regulation, andPerception (Lewis, 1993). H. W. Lewis, Technological Risk (New York: Norton, 1990). Howard Margolis, Dealing With Risk: Why The Public and theExperts Disagree on Environmental Issues (Chicago: Universityof Chicago Press, 1996). Allan Mazur, A Hazardous Inquiry: The Rashomon Effect atLove Canal (Harvard University Press, 1998). Cassandra Chrones Moore, Haunted Housing: How Toxic ScareStories are Spooking the Public Out of House and Home(Washington, D.C.: Cato, 1997).Kenneth Sewall, Tradeoff Between Cost and Risk in HazardousWaste Management (Garland Pub., 1990). Alan Sokal and Jean Brichmont, Fashionable Nonsense:Intellectuals’ Abuse of Science (New York: Picador, 1998).W. Kip Viscusi, Fatal Tradeoffs: Public and PrivateResponsibilities for Risk (New York: Oxford University Press,1992). Aaron Wildavsky, But Is It True? A Citizen’s Guide toEnvironmental Health and Safety Issues (Cambridge: HarvardUniversity Press, 1995).

Wayne Lusvardi is Senior Real EstateRepresentative for the Metropolitan WaterDistrict of Southern California. He holds abachelor’s degree from Aurora Universityin Illinois and a certificate in real estateappraisal from the UCLA School ofBusiness, Management and Engineering.CINNABAR

FPOArtwork 95%

ASSESSING HARMFUL FACTORS

The Flamingos are coming

to Albuquerque!June 20-24