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Environmental Risk Management and Best Practices for Lenders
and Appraisers
2014 Appraisal Institute Annual MeetingAugust 5, 2014
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Current Trends in Lending/Financing of Commercial Real Estate
• Pressure from regulators
• New ASTM Standard for Phase I’s
• New Transaction Screen Assessment (TSA) Standard
• SBA Lending
• Lenders updating environmental/appraisal policies
• More levels/forms of due diligence than ever before on
more loans
• Seems to be a big push in the CRE market again…
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How Environmental Issues Often Seem
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Environmental & Appraisals
Types of Contamination Building Contamination
E.g., asbestos, lead paint, radon, formaldehyde Encapsulate, Enclosure, Removal
Soil & Groundwater Contamination E.g., hydrocarbons, solvents
Phase I (initial review) through III (remediation)
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Appraiser Poll
Question:
Are environmental issues typically not looked at because of ignorance or apathy?
Response:
We don’t know and we don’t care…
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Comments from LinkedIn by Appraisers
I agree that hardly anyone outside the appraisal world reads USPAP. That includes AMC's and Lender's that often make requests to appraisers which are not compliant with USPAP. This leads to both appraiser and lender frustration.
If USPAP is the governing document for appraisers, you would think at a minimum that underwriters would be required to understand the document.
I dread taking the refresher every 2 years. It's definitely the most boring CE class. It usually turns into 8 hours of complaining about the profession.
What is USPAP? Does any lender really care about USPAP anymore? Basically, lender guidelines appear to always over rule USPAP.
Professor Warren, your last comment it sooooo true. We all need to wake up to what is really happening vs debating appraisal methods among ourselves, as if the typical big boy lenders really care about appraisal methods or quality.
That being said, it seems a bit ridiculous that we create and enforce rules that many lenders could care less about.
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Comments from LinkedIn by Environmental Consultants
• You will always have a problem until lenders start rejecting sub-standard Phase I ESA's. When lenders are accepting Phase I's that have zero historical research and records reviews that cost $1200 and were done in five days, it will not matter who does the site visit.
• Unfortunately, a significant part of the industry has a product mentality rather than one of service. The result is a business solely driven by price, thus tempting the industry shortcomings.Professor Warren, your last comment it sooooo true. We all need to wake up to what is really happening vs debating appraisal methods among ourselves, as if the typical big boy lenders really care about appraisal methods or quality.
That being said, it seems a bit ridiculous that we create and enforce rules that many lenders could care less about.
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Appraisal Institute Survey - 2013
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CRE Appraiser Concerns
Fee pressure & expanding scope of work Formulary approach (forms, checklists, ratios, indices)
gaining more prominence Greater liability Increasing barriers to direct communication with lenders
resulting in appraisal report acceptance and/or perceived report quality issues
Over regulation of appraisal profession
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Concerns of Appraiser Clients
Long turnaround times Cost of appraisals Misunderstandings concerning the scope of work in
engagement letters Compliance with standards/regulation Sufficiently supported value conclusions Quality work product Shortage of qualified appraisers Concise valuations (do not want lengthy reports)
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Hottest Topics for Staff Appraisers
Inadequate market analyses Appraisal compliance with bank regulations Not recognizing or appreciating clients’ needs Insufficient details on market conditions and trends
affecting real property Going concern valuations (different methodologies
causing confusion)
Reluctance to interact with client out of fear of violating appraiser/client “firewall”
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Appraiser Challenges
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Take Aways
Communication Breakdowns Tough and uncertain regulatory environment Unsatisfied clients and frustrated service providers Clear need (and opportunity) to bridge the gap
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Challenges that Appraisers Face
• Challenges– Pressure on bank appraisal/environmental
departments– Cost to cure calculations– Not all appraisers are competent to assess
environmental impacts (might have to call one in)– Bidding process – appraisers would need to know this
upfront because the as-is impaired is a different kind of assignment
– Potential project delay/cost increase
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Lenders’ Reaction to Environmental Issues…
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Issues Important to Lenders
• Collateral Devaluation• Direct Liability - Loan origination to
foreclosure• Reputational Risk (Brand and Image)• Operational & Enterprise Risk• Credit & Trust Risk
• …but at the end of the day, the primary issue for lenders is Business Risk
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Key Changes to Phase I’s - 2013
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Who Qualifies as an Environmental Professional?
Professional/Educational Qualifications
RelevantExperience
Professional engineer or professional geologist license/registration
3 years
Federal or state license/certification to perform environmental inquiries
3 years
B.A./B.S. degree or higher in any science or engineering field
5 years
No B.A./B.S. degree 10 yearsPage 22
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New: HREC Split
Redefined Historical Recognized Environmental Condition• Past releases addressed to unrestricted residential use• Must consider current regulatory framework (rules change)• HRECs are not RECs
Created new Controlled Recognized Environmental Condition term• Past releases addressed to non-residential standard, subject to some
type of control• CRECs are RECs and must be included in the conclusions section of
the report
de minimis” CAN be used to describe an HREC
de minimis” CAN NOT be used to describe a CREC
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Agency File/Records Reviews
• Clients thought it was already being done
• Consistency needed
• New language:• Should be conducted for property and adjoining
properties• If not conducted, explain why• Alternate sources ok
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E1527 has been silent on vapor
EPA recommended the task group not ignore the vapor pathway
2013 revision acknowledges the vapor pathway in “migration” definition
Clarifies “Indoor Air” non-scope
Vapor
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Vapor Intrusion
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Task group split about 50/50
Ultimately agreed that:
Recommendations are not required by the standard.
User should consider whether recommendations are desired.
Recommendations are an additional service
REALLY??
Recommendations
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Regulators Are Now Talking About Environmental
http://www.occ.gov/publications/publications-by-type/comptrollers-
handbook/cre.pdf
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NCUA Environmental Guidance
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FDIC Highlights
• FDIC emphasizes process and consistency.• Training• Policies and Procedures should be established;• Environmental Risk Analysis should be conducted;• Document due diligence;• Track changes to policy and consistent application of
policy.• Monitoring• Lenders must avoid “participating in management” of
the business and thereby assuming liability under CERCLA.
• Most attorneys recommend a Phase I ESA in the event of foreclosure.
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OCC Updates
• Develop policies and procedures that reflect potential environmental risks associated with lending
• Provide for receipt and evaluation of environmental reports prior to making final commitment.
• Ensure that persons responsible for evaluating environmental risk possess relevant knowledge, skill and competence.
• A bank’s policy should reflect the EPA’s AAI rule.
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OCC Updates
• The policy should include:• Analysis of current laws and due diligence
requirements;• A level of due diligence internally required on
all real estate transactions• Risk thresholds based on property type, use and loan
amount for determining when and what type of due diligence is used;
• Varying due diligence methods depending on the type of loan, the loan amount and the risk category, including questionnaire or screening, site visit, government records review, historical records review, etc.
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OCC Updates
• The policy should include:• The potential for impacts from asbestos and lead
based paint;• Appraisal requirements for disclosing and taking
into consideration any environmental risk factors;• Criteria for evaluating environmental risk
factors and costs in the loan approval process;
• Criteria for evaluating environmental risk factors and costs in the loan approval process;
• Environmental documentation for commitment letters, reps and warranty, etc.
• A means of evaluating potential environmental liabilities for foreclosures.
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Small Business Administration Update
• SBA updated its Environmental Policy• Effective August 1, 2008 and updated six times
since (most recently in January 2014).• Especially important for institutions with
preferred status who do SBA underwriting. • 7A and 504 lenders must adhere to this
policy.• Has become default policy for many lenders.
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SBA Environmental Due Diligence Policy
2 levels of Environmental Due Diligence for SBA
1. Phase I – for high risk properties• If property type/use matches the list of NAICS codes for
Environmentally Sensitive Conditions
2. Records Search with Risk Assessment – low risk properties• Includes a search of the government databases (compliant
with AAI);
• A search of historical use records, and;
• A risk assessment by an environmental professional determining whether the site is “High”, “Elevated” or “Low” risk
• New Gas Station/Dry Cleaner Requirements
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Sample SBA Policy Matrix
Minimum Due Diligence Requirements
Real Estate Loan Type
<$150K $150K < $5MM
Low Risk Loans Questionnaire RSRA/TSA
High Risk* Loans – NAICS Codes
Phase I Phase I
Gas Station Phase I + Evidence of UST Compliance
Phase I + Evidence of UST Compliance
Dry Cleaners Phase I Phase I
Dry Cleaner (older than 5 years old)
Phase I and Phase II Phase I and Phase II
Special Use Facilities (i.e. Daycare)
More specific requirements (i.e. Lead Paint Testing, Lead in
Drinking Water, etc)
More specific requirements (i.e. Lead Paint Testing, Lead in
Drinking Water, etc)
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Dry Cleaners
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The Trouble with Dry Cleaners
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Size has Mattered (but that doesn’t have to be the case)
Regional & National Lenders• Resources in place to understand environmental issues on the
property
• Screen all loans by an EP
• Have staff/internal resources to manage environmental risk
Credit Unions/Regional & Community Banks• No on-staff environmental expertise (typically)
• Not as sophisticated with regard to environmental issues or due diligence options available
• Often rely only on environmental questionnaires and/or proceed without accurate knowledge of environmental condition of property
• Rely on external guidance to dictate their practices
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Environmental Due Diligence Options
• Environmental questionnaire (EQ)• Desktop due diligence (various levels)• Transaction Screen Assessment (TSA)• Phase I Environmental Site Assessments• Phase II, III, Remediation, etc.• Storm water Issues• Sustainability/Green Issues• Environmental Insurance • Others
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Policy Matrix
Page 43
Minimum Due Diligence Requirements
Real Estate Loan Type
<$250K $250K < $1M >$1M
Low Risk Loan - new
Questionnaire/Desktop Desktop/Transaction Screen
Phase I
High Risk* Loans - new
Phase I/Transaction Screen
Phase I/Transaction Screen
Phase I
Renewals -Low Risk
Questionnaire/Desktop Questionnaire/Desktop Questionnaire/Desktop
Renewals -High Risk
Questionnaire/Desktop Questionnaire/Desktop Desktop/Transaction Screen
Multi-Family Questionnaire/Desktop Desktop/Transaction Screen
Desktop/Transaction Screen
Outdated Phase I Questionnaire/Desktop Questionnaire/Desktop Desktop/Phase I update
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Common Commercial Issues
• USTs• Fuel Oil Tanks• Spills• Storage/disposal of
Hazardous Waste• Vapor Intrusion• Mold
• Gas Stations• Dry Cleaners• Lead, asbestos• Radon• Storm water Runoff• Superfund
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What the Seller Sees
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What the Buyer/Lender Should See
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Best Practices/Takeaways
Create and follow environmental policies and procedures; Use commitment fees from borrowers to cover the costs of the
due diligence; At a minimum, obtain an environmental questionnaire and some
form of government environmental records for each commercial transaction;
Different types of properties require different levels of due diligence;
Start the process as early as possible to allow enough time for evaluation and follow-up work that may be required.
Work with a company or expert that has experience in this area and consider outsourcing the review process similar to other functions that are not “core-competencies” of the bank .
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Summary
• Lenders have unique processes and reasons for conducting due diligence.
• Market pressures have reinforced long-term trend to increased due diligence.
• Regulators enforcing risk management due to a perceived over-concentration of risk regarding commercial real state.
• Risk Management (Credit, Collateral, Environmental, etc.) is as critical as ever to lenders.
• Environmental and appraisals are both pieces of the puzzle that are being revised under the current environment.
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How Much and How Long??
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Upcoming EBA Meetings
January 2015 – Charleston, SC
June 2015 – Denver, CO
January 2016 – Long Beach, CA
June 2016 – Fort Worth, TX
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August 5, 2014 58
Convergence of Appraisal and Environmental Services within Financial Institutions
Eric Schwartz, MAI, SRAChief Appraiser
Appraisal Review DepartmentAmegy Bank of Texas
August 2014
Disclaimer: The opinions expressed are solely those of the author and are not necessarily the opinions of the management or employees of Amegy Bank.
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Vendor Pool Qualifications – Who is “qualified”?
Professional Credentials Geographic competency Property competency
August 5, 2014 59
Management of Environmental Services
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Database Management
In-house Pros-
Easily tailored to individual requirements Use of existing resources Customizable Integration into other databases
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Management of Environmental Services
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Database Management
In-house (continued) Cons:
Reallocation of limited resources Functional requirements may not be understood by staff ASTM standards may seem “foreign” to
appraisers/reviewers
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Management of Environmental Services
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On-line database management tools
Real Estate Management Information Service – (eg. RIMS) Web based project management system
Procurement and tracking Vendor management Performance
Pros: Reasonably low cost Automated credential monitoring Secure report upload/download/storage
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Management of Environmental Services
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Features to look for:
Online service request Ease of interface for vendor and management Automated task and project tracking Vendor Performance reports Contact database management system 24/7 accessibility
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Management of Environmental Services
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Synergies of task types
Appraisals and environmental reports must be tied to the same project. Requires a hierarchical management system similar to: Project
Task• External • Internal
Reporting• External• Internal
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Management of Environmental Services
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Environmental due diligence
• Least stringent to most stringent Environmental Questionnaire Desktop Due Diligence/Screening ASTM Transaction Screen AAI/ASTM Phase I ESA Phase I “Plus”
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Management of Environmental Services
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Bank personnel and appraisers should possess some level of competency with:
ASTM E-1527-13: Standard Practice for Environmental Site Assessments: Phase I Environmental Site Assessment Process (known as ESA)
ASTM E-1528-14: Standard Practice for Environmental Site Assessments: Transaction Screen Process
• Reference: www.astm.org
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Management of Environmental Services
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• Process Management Within the appraisal/real estate unit?
Maintain database of appropriate service providers Understand qualifications of service providers Internal reviews of Desktop Reports, Transaction Screens,
and Phase I Recommendations may need to be outsourced to qualified
environmental experts/attorneys
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Management of Environmental Services
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The appraiser’s role
Eyes, ears and nose of the lender Recognize your limitations You are likely not an environmental professional, but… Tell us what you see/smell and hear (the contact say) Why?.....................
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Tell the client what you observed. If you don’t tell the client early the assignment process, you might get a reaction like the following from the Chief Appraiser.
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Some banks ask you to note if you observed any of the following:
Storage tanks Collection Sites Drums/containers and/or pesticides/chemicals Asbestos Miscellaneous
Soil contamination Water leaks Water damage Mold
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Scope of Work - The appraiser is to contact the Client in cases of extraordinary assignment or limitations (e.g., restricted subject access, lack of lease information for known key tenants, discovery of significant environmental impairment, etc.) to consider possible adjustments to the scope of work. In such cases, while the bank account officer’s input may be useful, adjustments to the scope of work for any appraisal assignment must approved by the Client.
Environmental Issues - It is recognized that appraisers are not qualified to detect hazardous waste and toxic materials. Moreover, it is recognized that any comments made that may suggest the possibility of the presence of such substance is not confirmation of the presence of hazardous waste and/or toxic materials. Such determination would require investigation by a qualified expert in the field of environmental assessment. The appraiser observation is important in revealing the possibility of “red flag” environmental situations or conditions. For this reason, the appraiser is required to complete the Environmental Site Inspection form.
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• Appraisal Institute Guide Note 6: Consideration of Hazardous Substances in the Appraisal Process
• Guide notes are not part of the standards of professional practice but instead provide guidance on how the standards may apply to specific issues.
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Highlights of Guide Note 6 Explains the differences between the
existence of hazardous substance(s) and environmental contamination;
Consideration of the Competency Rule and Scope of Work Rule
Extraordinary assumptions and hypothetical conditions
Definitions Basis of proper valuation
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Guide Note 6-Consideration of environmental conditions along with social, economic and governmental conditions is fundamental to the appraisal of real property. (Introduction to Guide Note 6).
Need for special consideration to the impact of hazardous substance on the valuation of real property.
Hazardous substances are considered environmental contamination when their concentrations exceed appropriate regulatory standards. (see definitions in GN6)
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Guide Note 6- Competency
• Competency rule in USPAP Properly identify the problem to be addressed
and have the knowledge and experience necessary to complete the assignment; or
Disclose the appraiser’s lack of knowledge or experience to the client before accepting the assignment….take all steps necessary…and describe the steps take; or
Withdraw from the assignment
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Guide Note 6- Competency (continued)
• If the assignment calls for the appraiser to take into account the effects on value of hazardous substances, most appraisers rely on other professionals for assistance.
• If the appraiser lacks the knowledge and expertise they have to disclose that lack of knowledge and experience prior to the acceptance of the assignment.
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Guide Note 6 – Scope of Work
• How and to what extent the appraisal problem will address known or suspected hazardous materials that may impact the property.
• Assignment conditions cannot limit the scope of work such that the assignment results are not credible for the intended use.
• Cannot allow the client’s objectives or the intended use to cause assignment results to be biased.
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Guide Note 6 – Extraordinary Assumptions and Hypothetical Conditions
• Extraordinary assumptions would be employed when you are relying on the work of others.
• Hypothetical conditions are used when the appraiser estimates the value of the property known to be contaminated in an unimpaired or uncontaminated condition.
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Guide Note 6 – Basis for Property Valuation
• Impaired value – The “as is” value of the property
• Unimpaired value – The market value developed of the contaminated property employing a hypothetical condition the property is not contaminated
• Diminution of value – Effects of costs to remediate plus use costs plus risk (stigma too).
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What’s the appraiser to do?
If you see it….report it. Call the client/email the client Take photos and send them to the client Write it up in your report/Put it in the letter of transmittal Calculate diminution in value if appropriate Employ a hypothetical condition or extraordinary
assumption if appropriate Ensure your results are credible
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What steps would you take if you saw this during the property inspection?
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Appraisal Report Language
• Ace Appraisal Services is not qualified to detect the existence of potentially hazardous material or underground storage tanks (USTs) which may be present or, or near, the subject site. The existence of hazardous materials or USTs may affect the value and marketability of the subject property. For the purposes of this appraisal assignment, Ace Appraisal Services has assumed that the subject property is not affected by hazardous materials which may be present on or in proximity to the subject property.
• Unless otherwise stated in this report, any value conclusions are predicated on the assumption that the subject property is free of contamination, environmental impairment or hazardous materials. Unless otherwise stated in the appraisal report, the existence of hazardous material was not observed by the appraiser(s) and the appraiser(s) has no knowledge of the existence of such materials on or in the property. The appraiser(s), however, is/are not qualified to detect such substances. The presence of substances such as asbestos, urea-formaldehyde foam insulation or other potentially hazardous materials may affect the value of the property. No responsibility is assumed for any such conditions, or for any expertise or engineering knowledge required for discovery. The client is urged to retain an expert in this field, if desired.
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Appraisal Report Language
• Unless otherwise stated in this report, the existence of hazardous material, which may or may not be present on the property was not observed by the appraisers. Ace Appraisal Services has no knowledge of the existence of such materials on or in the property. Ace Appraisal Services, however, is not qualified to detect such substances. The presence of substances such as asbestos, urea formaldehyde foam insulation, contaminated groundwater or other potentially hazardous materials may affect the value of the property. The value estimate is predicated on the assumption that there is no such material on or in the property that would cause a loss in value. No responsibility is assumed for any such conditions, or for any expertise or engineering knowledge required to discover them. The client is urged to retain an expert in this field, if desired.
• We have inspected, as thoroughly as possible by observation, the land; however, it was impossible to personally inspect conditions beneath the soil. Therefore, no representation is made as to these matters unless specifically considered in the appraisal.
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Appraisal Report Language
Sample of Extraordinary Assumptions when appraising convenience stores, auto dealerships and similar property types.
REALLY ACE APPRAISAL SERVICES has not observed, yet is not qualified to detect, the existence of potentially hazardous material or underground storage tanks, which may be present on or near the site. The existence of hazardous materials or underground storage tanks may have an effect on the value of the property. For this appraisal, REALLY ACE APPRAISAL SERVICES has specifically assumed that the property is not affected by any hazardous materials and/or underground storage tanks that may be present on or near the property. It is an extraordinary assumption of this report that the subject property is environmentally clean
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If FNMA, SBA, HUD and the bank are concerned about environmental conditions….shouldn’t you be?
What is your client’s policy? Do they determine what level of due diligence
based on transaction amount and/or property type?
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Resources Guide Note 6 Analyzing the Effects of Environmental
Contamination on Real Property (AI Seminar) USPAP – Competency Rule; Advisory Opinion 9 SBA SOP 50 10 5(F) Subpart B, Chapter 4 for 7A
loans and Subpart C, Chapter 3 for 504 loans NAICS Codes of Environmentally sensitive
industries
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Q&A
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