14 November 2013

The 4% difference: Why Denver builders are choosing apartments over condominiums

A recent report prepared for the Denver Region Council of Governments (DRCOG) concludes that developers may opt to build apartments instead of condominiums because they can save up to $15,000 per unit by cutting quality control, using inexperienced subcontractors, and carrying less insurance. On a $400,000 home, such steps could increase a developer's profit margin by nearly 4%.

DRCOG had commissioned the study to investigate why new condominium construction in Denver has been slow to rebound following the Great Recession. The report, released on 29 October 2013, concluded that one factor is developers’ perceived risk of increased liability for construction defects on condominium projects. Many developers believe that apartment renters are less likely to sue for shoddy workmanship than condominium owners, and some have therefore chosen to build low-quality apartments rather than spend the extra money on well-built condominiums.

Local politicians such as Lakewood Mayor Bob Murphy were quick to seize upon this report and call for new laws to protect developers from construction defect claims. In an interview with the Denver Business Journal, Murphy called the report “devastating” and said that it was “conclusive that the litigation is by far the biggest factor stalling condo development.” Although the Colorado Senate rejected such a bill last session, a number of politicians and homebuilder advocates still contend that legislation is needed to encourage developers to build more cheap condominiums. Under current law, developers who violate the building code or fail to follow industry standards can be held liable for the cost of repairing property damage caused by their mistakes. Last session’s proposed bill would have made developers immune to some such claims and would have prohibited condominium owners from seeking relief in court for construction defects in communities located near bus stops or light-rail stations. A new bill for 2014 may take the same approach.

Despite the statements of Mayor Murphy and others, however, the actual DRCOG report contains little evidence to support such a bill. The report itself, which is available from DRCOG's website, identifies multiple factors that have slowed condominium construction in addition to the perceived legal risks associated with lower quality work. These include more stringent lending requirements from banks, surplus inventory from foreclosures, and overall economic and market conditions that presently favor apartments.

With regard to construction defect issues, the report does identify three areas where developers may be able to save money by erecting apartments instead of condominiums. One is quality control: for condominium projects, prudent developers often choose to retain a third-party inspector to visit the site and verify that subcontractors are performing their work correctly. This is a wise step to ensure that any defects are identified promptly and corrected on the spot, and one which we recommend to many of our clients. Making such repairs during construction, while subcontractors are still on site and before other trades have covered up the work area, is typically far less expensive than taking a building apart and fixing mistakes years later. On an apartment project, however, a developer may choose to omit this step and delay repairs until renters complain. By eliminating this quality control expense, the report found that a developer could save an estimated $1800 per unit during construction.

A second area of the potential savings comes from the use of less-experienced subcontractors. The report found that general contractors who build condominium projects may demand a “premium” of between 4% and 6% of job costs to pay for subcontractors who have the necessary credentials and insurance to do the most challenging phases of the work. This is deemed crucial for condominium projects, because the eventual owners may seek redress in court if their homes contain construction defects. By contrast, those who rent apartments are less likely to insist on quality workmanship, so general contractors may be able to get by with a cheaper workforce. The report found that using less-qualified subcontractors can save developers an estimated $9300 per unit.

The third area of savings on apartments comes from lower insurance costs. The report assumes that condominium communities will not have the same level of on-site maintenance as apartment complexes, and that condominium owner associations “introduce an element of risk for litigation that apartment properties do not have.” As such, developers of apartment projects often pay between $3674 and $3952 less per unit for liability insurance than developers of condominium projects.

Adding these three figures produces a total savings of $14,774 to $15,052 per unit for apartments. Developers interviewed for the DRCOG report stated that they the only way they could make sufficient profits on “entry-priced” condominiums (those with a sales price under $450,000) was to use the cheaper construction methods associated with apartments. These developers are apparently reluctant to cut the same corners on condominiums, however, because of the fear that buyers may sue for the cost of repairing defects. Some have suggested that the state legislature should enact laws restricting homeowners’ rights in disputes over defective work, which could allow developers to build cheap condominiums without fear of liability for defects and property damage.

Although this is one viewpoint, one should recognize that the authors of the DRCOG report relied primarily on interviews with homebuilders, contractors, and defense lawyers; they admit that that they spoke to “very few” plaintiff attorneys (they did not contact The Witt Law Firm), and they spoke to no homeowner association representatives. As such, the authors concede that the subjective portions of their report reflect the opinions of the development industry and "should be recognized as one side of the discussion."

Meanwhile, the report’s objective data largely refute the suggestion that litigious homeowners or associations are to blame for slow condominium development. The report describes a market that has been saturated with cheap, low-quality condominiums, many of which have been the subject of multi-million dollar defect lawsuits and foreclosures in recent years. Although several national builders have now pulled out of the Colorado attached-housing market, a lingering oversupply of condominiums has been holding sales prices down. The report expects this oversupply to diminish within a few years, but it may take some additional time before the market fully normalizes and returns to the point where local, honest contractors can compete with those who have been peddling cheap, substandard work. The report likewise notes that many prospective buyers cannot currently obtain the financing or afford the down payment needed to buy a new home. While these conditions are also improving, it may take more time for the economy to rebound to the point where these individuals will start looking for attached housing instead of rental apartments.

Although high insurance rates do remain a valid concern, the report suggests that this increase is the result of 2010 legislation that the homebuilders themselves sponsored. Senate Bill 10-1394, now codified at Colo. Rev. Stat. § 13-20-808, protects builders from unfavorable insurance policy interpretations by creating a rebuttable presumption of insurance coverage for property damage from construction defects. According to the DRCOG report, however, roughly a dozen insurance carriers have left the state in recent years, and “brokers attribute their departure to the passage of the 2010 legislation.” The report notes that new insurance providers have entered the market, but these carriers tend to specialize in the “high cost/high risk” arena and charge premiums that are 25% to 45% higher. If SB 10-1394 is in fact the cause of increased insurance premiums, the homebuilders can only blame themselves for this portion of the cost; they should not point the finger at condominium owners or cite these higher premiums as an excuse to seek immunity for their own negligence.

In short, the DRCOG report identifies a variety of factors that have slowed condominium development in Denver. Construction defects have certainly been part of the problem, but nothing in the report suggests that taking away homeowner rights will reduce the subpar work that has plagued the Colorado market in recent years. Although some homebuilders may have the perception that they will be sued on any condominium project, the reality is that they can avoid defects and litigation by implementing basic quality control measures and employing qualified subcontractors. It is true that such precautions made add approximately 4% to the costs of construction, but these steps will save millions in the long run by eliminating lawsuits over construction defects and damage. In our opinion, if legislators want more new condominiums, they should look at ways to help builders stay competitive and earn a living selling quality homes. The last thing they should do is give immunity to negligent developers and encourage even more cheap, low-quality work.