Tag Archives: PML

Probable Maximum Loss Scope of Work for CMBS Lenders

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The commercial mortgaged-backed security (CMBS) industry has been reborn in 2010.  CMBS underwriters call their new underwriting paradigm CMBS 2.0.   Providers of third party reports such as Phase I Environmental Site Assessments, Property Condition Assessments and Probable Maximum Loss reports ask: What does CMBS 2.0 mean to our trade?   

The Phase I Environmental Site Assessment and the Property Condition Assessment are rather standardized and in my opinion are being provided to CMBS lenders with great reliability.   The Probable Maximum Loss report needs standardizing.   In 2007, ASTM published two new standards for Probable Maximum Loss Reports:  ASTM E2026-07 Standard Guide for Seismic Risk Assessment of Buildings, and ASTM E2557 Standard Practice for Probable Maximum Loss (PML) Evaluations for Earthquake Due-Diligence Assessments.

These new ASTM Standards improve the process, but are too flexible.  For example, the standards do NOT specify how an engineer should calculate a PML and some engineers perform calculations that are out of the mainstream or worse, do no math at all-they just call it based on their judgment.  Of course my colleagues may be very good engineers, but what the industry needs is an objective measurement of seismic risk.   The process should be transparent and peer reviewable.  

Objective reliable Probable Maximum Loss Reports are easily achievable; we just need some help from our clients.  Yes, the clients must do their part.   If clients require the following we will be more than half the way there:

  1. Only order reports from firms with registered engineers on staff;
  2. Require the engineer to show his/her math;
  3. Require that the engineer call the Scenario Expected Limit as the PML, but also report the Scenario Upper Limit.

I have participated in writing the Probable Maximum Loss Scope of Work for several lenders and my rational for my recommendations is presented more thoroughly in my RMA Journal article titled Managing Seismic.

Happy Holidays,
Joe Derhake, PE

Comments on ASTM E2026— Standard Guide for Estimation of Building Damageability in Earthquakes

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Engineers perform Probable Maximum Loss Reports (or Seismic Damageability Reports) for real estate investors, lenders, and insurance companies. The consumers of Probable Maximum Loss Reports have many different needs and there is considerable variance in methodology between providers-sometimes for client driven reasons and sometimes because of the engineer. 

ASTM E2026 Standard Guide for Estimation of Building Damageability in Earthquakes ,  is a standard that tries to meet the needs of all stakeholders. The result is that the standard is often not very prescriptive. The very flexible ASTM for PMLs allows for a plethora of different types of PML Reports and is silent on the issue of the formula for calculating the PML.  

The most significant element of the ASTM E2026 Standard is a defined set of vocabulary.   Significant elements are as follows:

First, the term Probable Maximum Loss is defined as “a term used historically to characterize building damageability in earthquakes. It has had a number of significantly different explicit and implicit definitions. It is recommended that the term not be used in the future, and that the terms probable loss (PL) and scenario loss (SL), whose definitions are precise, be used to characterize the earthquake damageability of buildings and groups of buildings.”

Second, instead of simply stating the “Probable Maximum Loss Number” for a report, the ASTM Standard recommends providing multiple numbers.  An engineer’s prediction is really not a single number (or damage ration); rather, we develop a curve of probabilities. Providing lenders a probability curve does not really work for the financial industry. Instead we have historically expressed to lenders a number associated with a given scenario. The ASTM E2026 Standard defines two important numbers on the curve:

Scenario Expected Loss (SEL)- the expected value loss in the specified ground motion of the scenario selected. Since the damage probability distribution usually is skewed, rather than symmetrical, it should not be inferred that the probability of exceeding the SEL is 50%; it can be higher or lower than this amount.

Scenario Upper Loss (SUL)-the scenario loss that has a 10% percent probability of exceedance due to the specified ground motion of the scenario considered.

The ASTM E2026 Standard also provides different levels of investigation.   The four levels of inspection defined are:

Level 0 PML –  Screening Level of Assessment

Level 1 PML –  Drawing review and Site Visit

Level 2 PML – Structural Calculations

Level 3 PML – Full Engineering Review

The ASTM E2026 Standard goes a long way to improving the consistency of the practice of Probable Maximum Loss Reports (a.k.a. Seismic Damageability Assessments), but the ASTM’s committee need to accommodate all stakeholders produced, in my opinion, an overly flexible standard.   I recommend that a lender seeking to use the PML product as a consistent underwriting tool should also consider applying the following four recommendations:

  • 1) Use Theil Zsutty as a method of calculation for the PML;
  • 2) Show the math on the calculations;
  • 3) Work should be done under the responsible charge of a registered engineer;
  • 4) Follow ASTM E2026-2007 and ASTM E2557-2007;
  • 5) Do a Level 1 Inspection-in other words, require a site visit.

Probable Maximum Loss Reports

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If the big one comes, how much damage will your loan portfolio sustain?  A building with significant damage runs a high risk of falling into foreclosure.  If a lender is active in a seismically active state such as California, they may want to get a handle on their seismic risk by ordering Probable Maximum Loss Reports.  

The Probable Maximum Loss Report predicts the amount of damage a building will sustain when the 475-year earthquake comes.  Just like we can estimate how large a 100-year flood will be, we can estimate the magnitude of a 100-year earthquake—and a 475-year earthquake.   We choose this non-round number because the 475-year event has a 10% chance of occurring in the next 50 years.

A PML Report expresses the seismic damage as a percentage intended to represent the expect damage to the building divided by the replacement cost of a building.   For example, if a building that costs $10 million to build and has a 10% PML, then when the 475-year event occurs we are predicting that the building will experience $1 million in damage.  

Most lenders treat the PML as a sort of pass/fail.   Any building with a PML lower than 20% is seen as an acceptable risk and buildings with PMLs over 20% have seismic risks that require mitigation.   Typical mitigation takes the form of either earthquake insurance (expensive) or seismic retrofit (usually expensive).   

The PML has long been a somewhat controversial product for mortgage bankers and borrowers, as too often they have seen two engineers return two significantly different PML numbers for the same property.   Historic use of the inconsistently defined term PML has left much confusion over what has been the measure of risk in the past and what is the comparable measure under ASTM terminology.  This is because the methods employed to calculate the PMLs by engineers have varied widely. Recently, ASTM has updated their original PML Standard with ASTM 2026-07 and published a new standard aimed directly at lenders, ASTM 2557-07 and these new standards have gone a long way toward creating consistently.

The ASTM Standards is more of a toolbox than a strict scope of work.   ASTM 2026-07 is a very flexible standard; this standard is a tool box that literally offers 768 different ways to do a PML.   For a banker, PMLs that are calculated differently, and cannot be compared to each other, create unwanted inconsistency in their underwriting process. 

To fix the 768-types-of-PMLs problem, a banker must specify which method they need.  Here is how to order a PML: ASTM 2557 recommends that the PML is reported as the Scenario Expected Limit, Design Basis Earthquake (DBE), 475-Year-Event and I recommend adding: Level 1 Building Damageability Assessment, Level 1 Building Stability Assessment, Level 1 Site Stability Assessment, and Calculated by the Thiel Zsutty Method.    Wow…that is a mouthful.

Insist that your engineers follow these tips and you will find that your PMLs are more transparent, understandable, and consistent with other finance industry PMLs. 

 

1.       Report one number, define the PML as the SELDBE.   Offering PMLs as both the Scenario Expected Limit (SEL) and the Scenario Upper Limit (SUL) is too confusing.  Accept the recommendation of ASTM E2557 and require your engineer to report the PML as the SEL only. 

 

2.       Require that the engineers use the Thiel Zsutty Method to calculate the PML.  This is the most commonly used method and is more transparent than other calculations (the importance of transparency is discussed below).  While the ASTM Standards do not specify a method of calculating the PML, if you allow one engineer on your panel to use Thiel Zsutty and another to use their own proprietary methods, then you will receive inconsistent results.

 

3.       Show the math.   Simply giving a high PML result without demonstrating how it was derived makes conducting a peer review futile.  How can anyone discuss or refute a computation that is absent?  Peer reviewable work is a fundamental hallmark of the engineering profession, and requiring engineers to show their work should be standard.

 

4.       Explain the “b” value.  The most controversial variable in the Thiel Zsutty Method is clearly the Building Vulnerablity Parameter, or the “b” value.   The engineer should explain how the “b” value was chosen.  The determination of a building’s damageability factor, b, starts with a table look-up and then must be carefully adjusted to specific earthquake damageability characteristics of the building that the engineer encounters in the field.  Absent this discussion, the report suffers from the fatal flaw of being inscrutable.

 

5.       Require the work to be done and signed by a registered engineer.  Structural assessment of buildings is at the heart of engineering work.  Only registered engineers possess the requisite certification, knowledge and skill for performing PMLs. 

Bankers have long been frustrated by the lack of consistency and transparency in PMLs.   If bankers instruct the engineers very precisely, the PML products delivered by the engineering community will feel less like supposition and more like science.

 

By:          Joseph P. Derhake, PE

Partner Engineering and Science

Phone: 800-419-4923

 

 

 

Property Condition Assessment

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When investing in commercial buildings, real estate investors are need a high quality commercial building inspection, often called a Property Condition Assessments.  

When asked to do a Commercial Building Inspection, I start by trying to understand the client’s goals.  Are they ordering the report for a lender?   Do they want a 100% detailed inspection or a walk through?   Has the seller made any significant disclosures?  Are there other stakeholders such as equity sources or partner who need to understand the condition of the building?  Once I understand the goals I propose the appropriate level of diligences, which can range from a walk-through inspection by a senior building inspector to a team of engineers and specialist digging into every aspect of the building.

Either way, the Property Condition Assessment Report which includes a discussion of the following building systems:

–          Structure;

–          Building Envelope;

–     Roof;

–         HVAC Equipment

–          Mechanical, Electrical, and Plumbing;

–         Paving, Drainage, Landscaping;

–          Fire Suppression and Security Systems;

–          Elevators;

–          ADA Compliance.

A PCA report typically includes two important tables: an Immediate Repairs Table; and a Replacement Reserves Table.   The Immediate Repairs Table is a schedule of all failing or worn out systems requiring attention in the next 90 days.   The Replacement Reserve table will typically estimate the building’s capital replacement schedule for the next twelve years.  

When I dispatch a team of engineers and building systems specialists, I call the report a Property Condition Evaluation.  These reports typically range between $5,000 and $25,000 and are appropriate for large complex assets.   The most common specialist to add is that of a structural engineer.  The structural engineer will produce a structural report or a Probable Maximum Loss Report, when in seismic zone 3 or 4.  

Other specialists that add great value are an HVAC specialist, an elevator specialist and a roof specialist.  The specialist typically produces reports that are ultimately included in the appendix of the master PCE report. 

The specialist does thing that are beyond the scope of our building inspectors.  For example, the HVAC specialist will turn on the air conditioning system in the dead of winter.  The specialist opens up the systems being inspected and collects parametric data.  The result of the more detailed inspection is a very detailed report with specialty reports in the appendices.  Partner Engineering’s project manager and field inspector is almost always a registered engineer or very senior building inspector. 

Our Property Condition Evaluations save the client significant money in most engagements.  Often clients are able to negotiate price reduction or other consideration that is 10 times our fee.  Our work typically pays for itself!