CPRC 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. problem. 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 PAID 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— For CPRC Briefs and a complete publica- such as peer review, construction documenta- tions list, see www.ucop.edu/cprc or call tion, and third-party inspection—are effective (510) 643-9328. This Brief may be copied and should be incorporated into programs to without permission.
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