• Credit: Brian Stauffer

Throughout the recent economic downturn, residential construction has been a bright spot, a boom that overshot all predictions. As low interest rates fueled the speculative housing market, condominium projects have dominated the construction scene in thriving metropolitan areas. While the NAHB has no statistics on the proliferation of apartment-to-condo conversions, its numbers show that 120,000 new for-sale condos or cooperatives were built in 2004 alone.

The dark side to all this activity is that after every construction boom comes a rush of claims, with condos as the top target. Although California's court system is particularly notorious for its runaway construction-defect litigation, statistics show that condos are a problem everywhere. Chevy Chase, Md.–based Victor O. Schinnerer & Co., a leading insurer of design and engineering firms, reports that in the past five years, the multifamily billings of its clients represented less than 4.5 percent of their total revenues, yet lawsuits from those projects accounted for 20 percent of all claims. And as housing prices seem to defy gravity, the stakes are higher than ever. The average condo claim paid by the insurance company was about $190,000, with the top 10 percent averaging more than $820,000. Small architecture firms aren't immune, either. Of the top 25 paid claims, seven were on behalf of small firms, averaging $670,000 apiece.

The problem is the nature of the product itself. Many condo associations don't have enough money set aside for maintenance. In California, condominium owners have a full 10 years from the date of completion to bring a lawsuit—plenty of time for deferred maintenance to take its toll. So defect litigation firms go knocking on doors, putting together a laundry list of things owners don't like about their units. Maybe it's noise, leaking windows, or the way the fireplace vents. Often, the complaints are justified. Because real estate is so expensive, developers are spending more to buy land or old buildings to convert and less on quality materials and labor. It's common for developers to form a limited liability partnership, slap up the projects as cheaply as they can, and sell them for a lot of money.

Sometimes, the developers have disappeared by the time they're called on the carpet. “A lot of people have a very strong emotional attachment to their condo,” says Judy Mendoza, senior risk management consultant for Victor O. Schinnerer & Co., San Francisco. “In many cases it's their first home. They've spent a lot of money and it's not as perfect as they think it's going to be.”

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Indeed, it's both architects and homeowners who are caught in this dysfunctional system. David Baker, FAIA, San Francisco, says the cost of insurance to deal with litigation adds $30,000 to $50,000 to the price of a unit. He carries a $100,000 deductible policy on condo projects, which represent a quarter of his work. “We've had 99 percent of our projects come through without a lawsuit,” he says, “but it only takes one to make some part of your life unhappy.” The single lawsuit Baker did face involved water leaks resulting from a poorly installed roof and windows that were value engineered to meet budget on an affordable-housing project. The subcontractor failed to test the windows, as Baker's firm requested, and the problems went undetected. “The vested interest of litigation attorneys is to increase the conflict,” he says, pointing out that although the roof cost only $30,000 to replace, the legal fees amounted to $100,000.

Baker minimizes his exposure by working only with repeat clients, ideally those who are large and professional enough to have a prevention strategy. Some of his developer clients set up separate maintenance companies with mandatory service agreements; others issue manuals that put upkeep requirements in writing. Baker has also had success getting developers to write contracts that indemnify him from liability.

Lately, Torti Gallas & Partners, Silver Spring, Md., has also begun including a provision that indemnifies the firm for the amount of deductible on its liability insurance. “We ask the owner to hold us harmless for the first $100,000 of any claim resulting from a condo, the idea being that owners today are benefiting from the low interest rate as a method of inflating prices for condos,” says Tom Gallas, CPA and executive vice president. “If we're doing a project and the fee is $1 million, and the deductible is $100,000, that's probably our profit on the project. By getting them to indemnify us, they'd cover the first $100,000 on any claim prior to our insurance company stepping in.” He says the firm toyed with the idea of adding a $100,000 line item in its fees to address risk, but clients resisted, saying they shouldn't have to pay for legal fees that never materialize. Alternatively, Torti Gallas sometimes limits its liability to no more than the project fee. “Developers often can identify with this approach because in essence it's what they do—match risk with return,” Gallas says.

The success of architect-developer agreements varies by state and the nature of the working relationship. In its literature, Victor O. Schinnerer notes that indemnification clauses have teeth in states in which architects can be sued only by the party with whom they have a written contract. But in others, such as California, architects are fair game in claims from intended beneficiaries, so disclaimers in the developer contract provide no protection against litigation brought by homeowners. Condo developers are often set up to go out of business once a project is complete, too, leaving the design professional as the only source of restitution for design and performance deficiencies.

Even so, architects are carefully vetting developer agreements in hopes of deflecting litigation. Whether or not the language holds up in court, a carefully worded contract can establish expectations up front and nip trouble in the bud. Fletcher Farr Ayotte, in Portland, Ore., inspects the developer's sales contract with the homeowner. “We're looking for things like a certification of satisfaction—something the buyer signs that says they're satisfied with the condition of the unit and that all the work has been done,” says CFO Paul Strassmaier. The firm also asks the developer to make clear to buyers that the sales agreement does not include the architect. And, most critical of all, its own contracts specify that the developer must establish a maintenance fund for the project. After all, it's not unusual for new buildings to have problems. What's important is whether developers fix defects promptly and at no cost to buyers.