For CRE investors acquiring properties on the west coast, a seismic risk assessment is standard practice. In seismic zones three or four, the question is not whether a significant seismic event will occur, but when it will occur—so a clear understanding of your potential losses in such an event becomes a critical part of due diligence. However, due to industry wide inconsistencies in assessing and calculating earthquake risk, understanding your potential losses can be a tricky and sometimes costly undertaking.
Traditional Seismic Risk Assessment Models
Earthquake risk for real estate due diligence is usually expressed as Probable Maximum Loss (PML). PML assessments provide a statistical estimate of building damage based on user-defined risk tolerances. Most PML assessments are performed in accordance with two ASTM standards: E2557 and E2026. These standards define common terminology used in assessments, and identify levels of assessment to allow clients and consultants to effectively communicate objectives and scopes of work. They are not, however, specific regarding methods of calculation. The ASTM standards (authored by committee) are written loosely and incorporate at least six approved methodologies along with acceptance of “proprietary methods both disclosed and undisclosed.” While this ensures an open playing field for vendors of loss models, it allows for subjectivity and variance in calculations, reporting, and results.
Many of the loss models incorporated in the ASTM standards are based on arguably outdated statistical performance data of large populations of building types. They are not always finely tuned to consider building specifics or recent earthquake performance data or research. In fact, the most commonly used loss models are based on data collected in the 1980s.
For institutions that hold large pools of loans or securities, building-specific risk management is less important due to the size of their portfolios and the law of averages. On the other hand, investors who operate on a smaller scale carry concentrated risk, so building-specific results are critical for decision making. Unfortunately, the most definitive way to evaluate building-specific risk involves expensive and time-consuming analysis that rarely fits into a due diligence timeframe.
Next Generation Loss Methodology
The alternative approach for impartial, repeatable and building-specific risk analysis uses “Next Generation” loss methodologies developed under the FEMA-P58 project. The P58 project was developed by the Applied Technology Council (ATC) and funded by the National Science Foundation. It included a decade of earthquake performance research and contributions of over 100 engineers and scientists. The project was completed in 2012, but a complex user interface resulted in slow adoption of this method until 2018, when updated tools significantly streamline its use. Recent software improvements now allow application of this Next Generation loss model in a reasonable time frame at reasonable costs for the practicing engineer.
The P58 loss model is the state of the art method used in performance-based building design, and for truly building-specific loss estimation for PML studies. P58 is tailored to assess the damageability of individual structural and nonstructural components of the building such as windows, cladding, cooling towers, plumbing, interior finishes, elevators, and even building replacement and repair costs specific to the region or market.
The U.S. Resiliency Council Transaction Rating
Attempting to solve the PML inconsistency problem and further industry adoption of modern methods, a not-for-profit organization called the U.S. Resiliency Council (USRC) was formed in 2016 (among other things) with the goal of establishing consistency and transparency in seismic risk assessment rating systems and the PML process. The USRC provides two types of ratings, Verified and Transaction. The latter is intended as a major enhancement to the current PML process.
A USRC Transaction Rating is a peer review process that provides their 3rd party certification to a completed PML report. This provides a higher level of confidence that the report not only adheres to ASTM standards, but uses modern methodology such as P58 or ASCE-41 to reach defendable and repeatable conclusions. Their expedited review time and modest certification cost easily fit into conventional due diligence time frames and budgets. Some assets have long histories of varied PML reports that provide conflicting results. Within the same ASTM level of investigation, the report with the USRC rating should rise to the surface as the most compelling estimate of damageability.
A founding member of USRC, Partner Engineering and Science (“Partner”) executed the first seismic risk analyses in June 2018 using the new USRC Transaction Rating. Their client, a private equity firm based in Los Angeles, was refinancing three large commercial buildings via an insurance entity with a conservative seismic risk policy. The buildings, located in San Pedro, a coastal city on the Port of Los Angeles, had prior seismic studies with varying risk outcomes due to application of different earthquake damage loss models, some based on earthquake performance data more than 30 years old. The buildings had recently undergone seismic upgrades to achieve damageability ratings that would meet specific lender risk targets and eliminate the need for costly earthquake insurance. As is often the case, various engineering consultants were involved with the retrofit and the prior studies.
Partner’s clients required an independent and unbiased third-party seismic assessment to verify the post-retrofit damage scores. Partner assessed the buildings using modern, building specific, FEMA P58 methodology and certified the damage loss scores through the USRC transaction rating process. This provided the high level of confidence that the client and end user needed to support a successful outcome with no disputes. The turnaround time for the USRC review and rating was within two business days.
The USRC Transaction rating is a forward-thinking approach to seismic risk analysis, particularly for equity investors. It incorporates the most modern methods in practice today to give you a truly building-specific understanding of your risk. Furthermore, it can better prepare you for disposition: if you hold a high-value asset, it will most likely be evaluated using this more modern loss method when you sell or refinance.