SRA Standards Curb Due Diligence Uncertainty

For properties located in earthquake zones three and four, lenders typically require an SRA. The purpose of the SRA is to examine the potential susceptibility of a commercial project to earthquake damage. For those properties that have a significant likelihood of sustaining earthquake damage of over 20% of the building's replacement cost, most lenders require earthquake insurance to be in place for the full replacement cost of the building. SRAs express this potential earthquake damage in terms of a property's Probable Maximum Loss or PML. In the industry, SRAs are often referred to as PML studies.

For properties with a PML of less than 20%, earthquake insurance is typically not required. Consequently, the results of an SRA determine if earthquake insurance is required by the lender for a building. For those properties with PML's of over 20%, property owners typically perform a cost benefit analysis of purchasing insurance or retrofitting the building to reduce the PML to below 20%. Regardless of the route the property owner chooses to mitigate earthquake damage, insurance or retrofitting, the financial performance of the property will be negatively impacted by a PML of over 20%. Consequently, much is riding on the SRA's results.

However, unlike other due diligence reports such as All Appropriate Inquiry, Phase I Site Assessments and others, a standard for the performance of SRAs has not been widely adopted. Unfortunately, the lack of widely adopted SRA standards has caused a wide variation in earthquake PML results. This problem has been attributed to the following factors:

• Lack of a universal definition of PML
• Widely disparate qualifications of SRA providers
• Lack of consistency in the level of investigation (rigor of the SRA investigation)
• Lack of consistency in the seismic risk measures that are reported in SRAs (which can vary from one to dozens of risk measures depending on the provider and report scope)

These shortcomings have added significant time and roadblocks for lender evaluation of SRAs. This is especially problematic when complex loan portfolios are being evaluated and due diligence professionals must reconcile SRAs produced by different providers that used inconsistent PML definitions and levels of inquiry.

In order to remedy these shortcomings, for the past three years, the Seismic Working Group of the Mortgage Bankers Association (MBA) the has been working with ASTM International (ASTM) to revise its seismic standards (E2026-99). ASTM is one of the largest voluntary standards development organizations in the world and develops technical standards for materials, products, systems, and services.

The Seismic Working Group is comprised of due diligence providers, commercial/multifamily originators, mortgage securitizers, portfolio lenders, and rating agencies. The composition of this group allowed for consensus to be reached for SRAs that balanced the interests of due diligence providers, rating agencies, and both long-term and short-term commercial mortgage lenders.

The culmination of this three-year effort was the promulgation in June of the significantly revised E2026-99, which is now E2026-07 Standard Guide for Seismic Risk Assessment of Buildings and a new standard, E2557-07 Standard Practice for Probable Maximum Loss (PML) Evaluations for Earthquake Due Diligence Assessments. E2557-07 addresses the shortcomings of some SRAs through the following requirements:

• Provides a consistent definition for PML
• Qualification requirements for SRA providers are established
• Levels of SRA investigation are defined
• A convention is created for consistently reporting specific seismic risk measures

In addition, the Seismic Working Group is also preparing a Seismic Handbook which is intended to demystify how seismic risk assessments are performed and provide guidance for implementing the E2026-07 and E2557-07 standards. This handbook is due out this summer.

As the ASTM standards become widely adopted, greatly enhanced consistency in SRAs will emerge. This will enormously facilitate the evaluation process of the SRAs and reduce a major uncertainly in the due diligence process.

George Green is senior director of commercial/multifamily at the Mortgage Bankers Association. The views expressed in this article are the author's own.