Foreclosed Residential Projects
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. The resulting scenario is forcing the insurance industry to develop risk management solutions to help the owners — often banks and lending institutions — avoid liability.
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, with less than 10 percent of the total number of homes scheduled to be built having 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.
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 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 foreign to them.
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 than 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, 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’s Treasure
While the housing crisis 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.”
Flores said mortgage availability to potential home buyers, as well as proximity to jobs, schools and shopping must be considered. Another 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,” he said.
One of the keys to securing 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.
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.”