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       R E S E A R C H   S E R V I N G    C A L I F O R N I A

                                                          CPRC Brief
                                                                                      Vol. 14, No. 7 October 2002

                                 The Impact of Construction-Defect Litigation
                                              on Condominium Development
                                         Cynthia Kroll, Larry A. Rosenthal, Robert Edelstein, John Quigley,
                                                                             David Howe, and Nan Zhou

This Brief summarizes study findings about the            construction-defect lawsuits have stopped the pro-
impact of construction-defect litigation on condo-        duction of attached projects and have led to
minium development in California.The purpose of           skyrocketing construction-insurance premiums.
the study was to inform the policy debate—                Builders’ general experience is that insurance and
principally between builders and insurers on one          litigation costs are significantly higher in California
side, and attorneys for homeowner plaintiffs on           than other states.
the other—over whether defect litigation is re-
                                                          Homeowners associations and trial lawyers, on the
ducing the amount of affordable, for-sale attached
                                                          other hand, argue that unfettered construction-
housing built in California. If so, litigation reform
                                                          defect litigation is necessary to protect the rights of
might improve opportunities to build such lower-
                                                          homeowners. Some see the shortage of affordable
cost housing.
                                                          housing as being caused by many complicated fac-
To contribute to an understanding of current con-         tors in the real estate market—not lawsuits. Con-
cerns about defect litigation and construction levels,    struction-defect litigation, they argue, is caused by
the study documented trends in building activity;         poor-quality construction and builders’ refusal to fix
examined litigation and the California legal envi-        their costly mistakes. They argue that insurance is a
ronment in context; and investigated legislative,         small percentage of the sales prices of single-family
builder, and insurance company responses to the           homes or condominiums.
                                                          Earlier studies have not resolved the welter of issues
Specifically, our findings indicate the following:        raised by these different points of view, and neither
                                                          does the present research.The authors sought to add
   Construction of multifamily housing and con-           an analytical perspective to the conflicting claims re-
   dominiums slowed in the 1990s                          garding existing conditions and litigation policies.
   Builders and insurers have grown increasingly          This perspective is based on an examination of
   concerned over litigation                              changing construction levels of condominiums and
   Aspects of California’s legal environment may          multifamily housing; interviews concerning the
   facilitate more defect litigation than occurs in       availability of insurance for residential builders; a
   other states                                           survey of legal conditions in comparison with those
                                                          in other states’ housing markets; and a review of
   Legislative reform and recent court decisions          innovations by builders and insurers that
   may dampen litigation activity                         have expanded building opportunities in
   Builders and insurers are finding new ways of          California.                                         5

   doing business                                         Research Approach
                                                                                                              FIAT LUX
According to builders and insurers, “frivolous”           Ideally, an analysis of the defect-litigation

                           C ALIFORNIA P OLICY RESEARCH C ENTER
                                                                    U N I V E R S I T Y   O F   C A L I F O R N I A
issue would compare California with other states           In the present study, such interviews also identified
and regions over a 20- to 30-year period, to account       critical years in California, starting in the early to
for economic business cycles. This ideal method            mid-1990s, when litigation concerns and demands
would track (a) new home construction by con-              for reform among builders appeared to gain mo-
dominium status and number of units per building;          mentum and when the availability of liability insur-
(b) construction-defect litigation by number and           ance became much more restricted.
type of lawsuits and sizes of settlements and en-
forced judgments; (c) shares of litigation recoveries      Residential Construction Trends
dedicated toward homeowner compensation, defect            Analysis of construction data indicates that total
repair, and legal expenses; (d) insurance costs and        residential building dropped sharply in California
availability; and (e) background economic and dem-         and nationally during the first half of the 1990s.The
ographic data by geographic area.                          construction industry’s recovery in California was
Unfortunately, the cost and inaccessibility of much        weaker than that of the nation’s builders overall. Im-
of this data make such a study prohibitively expen-        portantly, this differential included both single-fam-
sive. Basic economic and demographic factors are           ily and multifamily buildings and was not limited to
most easily tracked, yet even these data are affected      condominium units.
by changing geographic definitions over time. De-          Throughout the country for much of the 1990s,
tailed data on building permits (but not housing           multifamily permits made up a lower share of total
starts) are also available at the state and metropolitan   residential permits than in previous decades. Cali-
levels, but published series do not identify whether       fornia’s multifamily share of total permits in the
units are built as condominiums.                           mid-1980s was at a higher level than the multi-
Housing surveys provide much more restricted data          family share nationally; by the mid-1990s, Cali-
on condominium stock and construction, and re-             fornia’s multifamily permit share had dropped more
port data by aggregated time periods (e.g., five-year      sharply than nationwide. Economic and geographic
time increments) rather than annually and for few          factors explained part, but not all, of this differential.
geographic areas. (The present research was con-           Since the mid-1990s, California’s multifamily con-
ducted prior to the release of data from the 2000          struction activity has partially recovered. While its
census, which may become an alternative source for         level is now similar to that of the United States as a
analyzing changes in condominium construction in           whole, California’s recovery appears weaker com-
the 1990s.)                                                pared to pre-1990 levels.
No available data sources report the amount of con-        A variety of sources indicate a similar drop in the
struction-defect litigation or insurance availability,     construction of condominiums in the 1990s. The
the size of settlements, or changes in insurance costs     extent to which this has occurred varied widely
and accessibility. Court-docket systems are designed       among places in California and also among other
for judicial management rather than systematic data        U.S. metropolitan statistical areas (MSAs).
analysis. Insurance-market information is the basis
for actuarial analyses that form the private, propri-      In California, the share of new homes built as con-
etary knowledge base for firms in the insurance            dominium units declined in the 1990s in the major-
business.                                                  ity of MSAs for which data are available, and all of
                                                           these MSAs experienced a sharp drop in the total
For these reasons, the best sources of information on      numbers of new condominiums built. Some other
litigation activity and insurance costs are interviews     MSAs had similar experiences. Our statistical anal-
with builders, insurers, and attorneys.While limited       ysis could not demonstrate what share of the decline
interviews do not generate reliable statistical mea-       in California was due to background economic
sures of important policy factors such as insurance        conditions rather than litigation or other uniden-
costs or litigation frequency or cost, key-informant       tified factors.
interviews can illuminate concerns and strategies of
builders, insurers, and related services such as prop-     Changes in the price and characteristics of condo-
erty management and trade associations in address-         miniums in California also indicate that shifts oc-
ing defect-litigation risk.                                curred in the state’s condominium market in the
                                                           1990−2000 period. Condominium prices have risen
relative to single-family home prices within the           were left during the 1990s without any significant
state, and the relative price differential between         legislation moderating substantive liability standards.
California and other U.S. condominiums was less
affected by the recession of the early 1990s than the      Legislative and Judicial Reform
relative price differential for single-family homes.       The state legislature has attempted to encourage
                                                           means other than litigation to resolve construction-
California’s Legal Environment                             defect disputes. In 1995, for example, a new law
Interviews with builders and insurers confirm that,        modified court procedure in such cases by requiring
throughout most of the 1990s, construction-defect          more meaningful exchanges of information be-
litigation became more prevalent in California than        tween plaintiffs and defendants as well as dispute
it did elsewhere, and affected condominium projects        resolution to encourage pretrial settlement. Inter-
more than single-family homes or apartments.The            views with litigants revealed that this procedure—
comparative incidence or cost of litigation within         known as the “Calderon process,” for the bill’s
California, in the aggregate, remains to be measured.      author—is easily circumvented, and thus less suc-
However, a review of Internet information sources          cessful than originally intended.
on construction defects revealed a more intense
market for litigation services in California than else-    However, recent amendments taking effect in 2002
where, even accounting for population size and re-         may improve the Calderon process by lengthening
cent growth.                                               the dispute-resolution period and expanding the
                                                           participation of subcontractors and insurers. Ad-
Builders and insurers regularly argue that Califor-        ditionally, the California Supreme Court in De-
nia’s legal environment is particularly conducive to       cember 2000 rejected a lawsuit, applying the
defect litigation. However, a detailed comparison of       economic-loss doctrine in a case where no personal
the legal environments in California and 20 other          injury or damage to property had occurred.
places (19 states and the District of Columbia) re-
veals great similarity on the procedural side. Califor-    New Business Methods
nia’s statutes of limitations and repose—four years        The building industry has adapted to daunting legal
and 10 years, respectively—governing the period of         challenges and insurance limitations, but these adap-
years when post-construction lawsuits may be filed,        tations carry their own costs. Key business adjust-
are at the median for the 21 places. States commonly       ments by builders and insurers, designed to address
allow legal action for latent defects to be taken up to    heightened litigation risk, include: (a) peer review of
10 years following a building’s completion.                project design; (b) third-party construction inspec-
In the area of substantive liability standards, Califor-   tions, often documented via videotape; (c) post-sale
nia appears more unusual. Of the 21 places studied,        building maintenance programs; (d) segmented and
it is one of only five that apply the plaintiff-friendly   wrapped insurance policies; and (e) pooled insur-
doctrine of strict products liability to claims of de-     ance coverage provided through trade organiza-
fective residential construction.                          tions, particularly among subcontractors.

Three of these five places had other factors that          These steps aim to enhance insurance availability
could mitigate the effects of strict liability. For ex-    and improve building quality and maintenance.
ample, New Jersey has an aggressive home warranty          While such efforts add to total project cost, the in-
program, whereas Pennsylvania has applied the eco-         dustry’s adaptations to litigation realities suggest it
nomic-loss doctrine, narrowing the scope of recov-         believes these changes will reduce legal expenses in
erable damages and reducing overall litigation risk        the long run.
to builders. Although Washington, D.C. has neither         Changes in building practices and insurance prod-
the economic-loss doctrine nor a warranty pro-             ucts allowed California builders to respond to
gram, it has lost rather than gained population in re-     market demand, boosted by a rapidly expanding
cent years—and may have little new construction            economy and growing population, at the end of the
raising the potential for litigation.The neighboring       1990s. In addition, builders and insurers new to Cal-
states that include the greater District of Columbia       ifornia entered some of the state’s more lucrative
MSA have not applied strict liability to construc-         condominium markets, but have focused on luxury
tion-defect cases. In contrast, California and Nevada      condominiums, not affordable units.
                                                           1504                                                 Nonprofit Org.
                                                                                                                U.S. Postage
Policy Implications and Recommendations                    UNIVERSITY OF CALIFORNIA
                                                           California Policy Research Center                    University of
Much of the policy development concerning these            1950 Addison Street, Suite 202                         California
issues has been hampered by poor information and           Berkeley, California 94720-7410
few means for tracking the effects of programs.This
Brief also leaves some key questions unanswered.
The research has demonstrated that multifamily
building levels remain low in California after a slug-
gish recovery, that litigation levels are high, and that
builders have had difficulty obtaining insurance for
residential projects that involve homeowners associ-
ations, especially when attached units are involved.
The research has not demonstrated the presence,
nor proved the absence, of a direct link between liti-
gation and the shortage of affordable housing, nor
has it identified specific policies and programs that
could alleviate the situation.
The lack of good measures makes it premature to                reduce litigation cost.We also recommend eval-
make specific policy recommendations. However,                 uation of recent dispute-process reforms in Cali-
some general points are evident, and new policy ap-            fornia and evaluation of warranty programs
proaches would benefit from better data on defect              elsewhere.
litigation and housing-market conditions, as well as           Survey construction-risk insurers nationwide to
more information on other states’ experience with              identify the extent of California’s troubled mar-
some of the more promising means for addressing
                                                               ket conditions.
the problem.Thus we recommend:
                                                           Resolving the affordable-housing problem in Cali-
   Continuing policy efforts to move construc-             fornia will require more than reforms in the area of
   tion-defect disputes out of the courtroom to the        construction-defect litigation. From a policy stand-
   bargaining table.                                       point, such reforms must be part of a broader
   Policymakers seeking further reform need to             strategy that enhances subsidies, loosens overly re-
   consider all parties with systematic stakes in          strictive land controls, and overcomes unreasonable
   maintaining construction-defect litigation, such        community opposition to new low- and moderate-
   as developers and homeowners associations, in-          income housing stock.
   surers, and trial lawyers.                              Robert Edelstein is professor at UC Berkeley’s Haas
   Better data and analysis would make it much             School of Business and co-chair of the Fisher Center for
   easier to determine the effectiveness of existing       Real Estate and Urban Economics. John Quigley is pro-
   and future reforms. Analysis of the 2000 census         fessor at the Haas School of Business and the Department
   will help measure how condominium construc-             of Economics. He also holds an appointment at the
                                                           Goldman School of Public Policy and directs the Berkeley
   tion and costs differ in California markets from
                                                           Program on Housing and Urban Policy. Cynthia Kroll is
   other parts of the United States. Further econo-
                                                           regional economist at the Fisher Center, and Larry A.
   metric analysis of annual building-permit data at
                                                           Rosenthal is executive director of the Berkeley Program on
   the metropolitan and state level could also ex-         Housing and Urban Policy and a lecturer at the Goldman
   plain how specific legal conditions affect multi-       School of Public Policy. David Howe and Nan Zhou were
   family construction.                                    graduate students in economics and information and sys-
   Monitoring of court cases over the next few             tems management, respectively, during the course of the
   years would help to determine whether the               study.
   anticipatory strategies of builders and insurers—
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