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Risky proposition: When lenders become developers

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Every time you pick up a newspaper or turn on the TV, you hear about the mortgage crisis and about foreclosed homes that are going back to the bank. The resulting credit crunch and talk of recession has soured the buying public's appetite for purchasing homes, and many developers find themselves unable to sell their homes and condos. It all ends up going back to the bank.

Over the past several years many of the condominiums have been developed by limited liability corporations, formed by investor groups that are now facing the prospect of having buildings full of completed, or nearly completed, units with few prospective buyers. Absorption rates are such that it will take years to sell off units, and with extraordinary ongoing debt service costs on the construction loan, some developers are simply opting to walk away from these condo projects and let the bank sort them out.

When this happens, lenders unwillingly find themselves in the development business and facing some very hard and complicated choices, none of them particularly desirable. They can "fire sale" the project to another developer for pennies on the dollar and take a significant loss on the project, or they can sell off the units to individual homebuyers at a significant discount in the same market that drove the original developer to abandon the project in the first place. Whoever the "takeover developer" is -- whether it is the lender taking the place of the original developer or a second developer that takes over the project and sells the units to individuals -- the entity that ends up selling to the public takes on some complicated technical issues and risks.

These risks include:

¥ The original Department of Real Estate approval required for the sale of units to the public does not automatically pass on to the takeover developer.

¥ Building permits may have expired or unresolved construction issues may remain with the approving agency.

¥ Construction may not be complete, and if not appropriately handled, manufacturer and installer warranties may be voided.

¥ There may be Fair Housing Act compliance issues and other accessibility deficiencies.

¥ Disgruntled subcontractors who were not paid for their services may have sabotaged functional aspects of the project.

¥ There may be built-in construction defects if the failing developer was not paying proper attention.

¥ Warranty packages may not have been properly assembled by the original developer and may not be available to transfer to the unit buyers.

¥ There may be incomplete or uncommissioned construction that may not be visible to an outsider, but will need to be uncovered and completed.

¥ The insurance coverage that protects the developer from claims arising out of construction defects does not pass on to the takeover developer.

¥ The takeover developer may lose the right to repair afforded by Senate Bill 800 (Right to Repair Law), if certain documentation and buyer notifications are not handled properly.

When the units are sold to the general public, the takeover developer assumes the same risks that the original developer would have, but without the benefit of the history, detailed project knowledge and insurance coverage of the original developer. Fortunately, there are ways to mitigate these risks through appropriate due-diligence, investigation and proactive planning.

At least one general liability carrier is filling this market niche with a policy designed specifically for the completed operations risks of the takeover developer. To qualify for this coverage, however, the carrier requires some extensive property condition inspections, including intrusive investigation and water testing of critical elements. This is a good idea for anyone taking over someone else's project, especially when there may be a chance of sabotage by disgruntled subcontractors. A consultant knowledgeable in the Department of Real Estate process and who has experience working with the building department can help to navigate through the change of ownership issues prior to sale to the public, as well as the issues resulting from a developer who may not have followed the required changes stated by the building inspector before they left the project.

The mortgage crisis and resulting anemic residential market have put lenders into risky and often uncharted waters, especially when it comes to large multifamily projects that may go back to the bank either pre-completion, pre-sale or in a partially sold condition. It seems as though almost every developer in town is talking about forming a "vulture fund" to pick up these failing projects. This is certainly not a recommended hobby for the uninitiated; however, understanding the risks and how to mitigate them is necessary and may lead to some great opportunities for the savvy takeover developer.


Bumgardner is a principal with Gafcon Inc., a San Diego-based construction management firm providing professional construction consulting, construction program management and construction-related claims support.

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