Foreclosed Residential Projects

When It’s Broken, How Do We Fix It?

Halloween has come and gone, but modern-day ghost towns continue to haunt the U.S. landscape. After nearly a decade of exponential growth, developers and homebuilders have seen the market for their product — single-family and multi-family homes — disappear with the pop of the housing bubble. And the resulting scenario is forcing the insurance industry to develop customized risk management solutions to help the owners — often the banks and lending institutions — avoid liability.

Undeveloped Projects

In July of this year, new home construction fell to its lowest level in more than 17 years and was down almost 40 percent from the previous year. As new home sales dried up, many construction projects came to a screeching halt, and new projects were delayed or cancelled. Development projects that were once grand visions of large, new residential communities lay empty, creating modern ghost towns where less then 10 percent of the total number of homes scheduled to be built have been completed.

As the saying goes, “If it ain’t broke, don’t fix it.” But what happens when it is broken? The question then becomes, how do we fix it?

The residential housing industry in the United States, while not necessarily broken, has been stretched to its breaking point. The ensuing credit crunch has compounded many builders’ ability to borrow money or restructure their debt. With no other alternative open to them, they are either filing for bankruptcy or allowing their projects to be foreclosed upon by banks or lending institutions.

It has been estimated by some experts that there are billions of dollars worth of partially completed projects on the books of banks and lending institutions across the United States. One such project that was recently reported in the news as being financially troubled involved a development of more than 800 homes, where the developer had already invested $100 million into the project before defaulting and requiring the lender to start foreclosure proceedings.

Lender’s Liability

A lender’s exposure to general liability claims arising out of a foreclosed residential project varies depending on what the lender decides to do with the project. Once lenders foreclose and all construction operations cease, premises liability coverage is needed to cover the existing hazard, and issues such as nuisance, protective safeguards (watchmen, fencing and lighting), and removal of hazardous materials need to be addressed. Banks and lending institutions are well-acquainted with managing their risks associated with the ownership of vacant properties.

However, banks and lending institutions never envisioned they would end up in the possession of so many partially completed residential projects. In the current poor real estate climate, builders are not lining up to purchase these foreclosed projects, allowing lenders to remove the projects from their balance sheets. That is forcing lenders to explore alternative solutions to get the projects off of their books and to try and recover as much of their original loans as possible.

Some of the options lenders are considering are contracting with another general contractor to finish the project and try to sell the units or sell the entire project. Another option is for lenders to form a joint venture with new builders to complete the projects, agreeing to share any profits derived from the sales of the finished units. Some lenders may consider retaining the original general contractor and subcontractors to complete the project, although the original builder has filed for bankruptcy.

Each of those scenarios requires a customized risk management solution for all of the parties involved to avoid liability arising out of the remaining construction activities and the completed project. Banks and lending institutions are not in the business of constructing and selling homes, so the concept of construction defect liability and the long tail associated with it may be a foreign concept to them. However, it is a concept that banks and lending institutions need to come to grips with in a hurry.

Once a lender determines it is in its best interest to complete the project or finds a buyer willing to purchase the project in its current state, a risk management solution must be fashioned for all of the parties that will be involved when construction activities are resumed and that will address all the exposures and potential liability that may arise out of the project.

“We identified early on the need for a liability insurance solution for foreclosed residential projects,” said Treacy Duerfeldt, strategic development specialist for the Western States Contractors’ Alliance (WSCA). “Working with our member service provider, Flying Eagle Insurance Services (FEIS), we fashioned a risk management solution that coupled a commercial general liability policy with a residential warranty program provided by another WSCA member service provider, Professional Warranty Service Corp.

“Banks and other financial institutions are realizing that they are subject to the same construction defect litigation exposures as the original contractor or builder from whom they took over the project,” Duerfeldt explained. “They are now in the chain of commerce bringing the project to the public, and they have a completed operations exposure. Our solution works equally well for builders or developers who purchase these projects.”

One Man’s Trash is Another Man’s Treasure

While the housing crisis at times appears to be a catastrophe of record proportion, to some investors it presents a unique opportunity to make substantial profits. After all, this is not the first time that the housing market has collapsed to the point where some developers and builders were swept away by economic conditions beyond their control. It happened in the early 1990s, and while that drop was not as dramatic as the current one, it was preceded by many years of profitable growth for those in the housing industry who were able to take advantage of the opportunity.

“There are no bank loans available for these types of projects at this time. If you purchase a foreclosed project from a lender, it is probably going to be a cash deal,” said Augustine “Teen” Flores, president of FeeBuilders, a real estate development firm in Santa Ana, Calif. “Each project requires a tremendous amount of due diligence in order to accurately price out a profitable solution to a foreclosed project. Many factors go into determining which projects have the greatest potential for success.”

For instance, Flores said mortgage availability to potential home buyers, as well as proximity to jobs, schools and shopping must be considered. Another important consideration is the speed in which the project can be completed and the cost necessary to complete it.

“It is a very high standard to demonstrate to investors that you can succeed where the other guy failed,” Flores said.

One of the key issues faced by the lender or the purchasing party of a foreclosed project in trying to secure liability coverage is demonstrating to an insurance carrier the insurability of the project. Were corners cut in the last days of the project as the original builder was facing financial hardship? Did the project encounter any damage as it sat idle? What was the condition of the building materials that were exposed to the elements for months and months? Those are all questions that an insurance carrier will need to evaluate prior to determining whether to accept the liability risks of the new builder.

Leslie Thomas, vice president of La Jolla Pacific in Irvine, Calif., says her company provides its clients and their insurance carriers with a detailed evaluation of the project from a litigation/forensic standpoint, including video documentation and digital photographic documentation of the current building/ structure condition.

“Once the decision has been made to proceed with the project, we can provide a broad range of services during the completion of the project and the turnover to homeowners,” she said.

If the insurance carrier determines the project is insurable after reviewing all of the information available on the foreclosed project, a liability policy can be issued covering all the parties against losses arising out of the remaining construction operations and their statutory liability for construction defects.

Foreclosed projects also present an increased need for a high level of post-construction services. While the new builder may believe the potential for profit looks good on paper, angry homeowners can have an adverse effect on the bottom line of any residential project.

“The importance of post-construction services cannot be overlooked by lenders or builders who are completing a foreclosed project,” said Dorna Brown, president of Development Solutions & Service in Agoura Hills, Calif. “The best way to reduce liability exposure during the completed operations period of the project is to provide the new homeowners with complete information regarding the warranties and maintenance of their new home, and to address any service issues promptly. This will boost customer satisfaction and help protect the builders and lenders profits.”

The Emergency Economic Stabilization Act of 2008 is intended to relieve the credit crunch in the United States, and many experts believe that as the number of foreclosures stabilizes, residential construction should begin to recover. Whether that occurs by mid-2009 or later is for the experts to debate.

Yet one thing that is certain is that these foreclosed residential projects will need to be completed at some point, and when they do, insuring them will require the assistance of a knowledgeable insurance professional who can identify the unique risk characteristics of the project, work with the insurance carrier to fashion a proper insurance solution, and coordinate all the information to and from the various parties necessary to fashion a proper risk management solution for the client.

Topics USA Contractors Construction Risk Management