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A Glimmer Of Hope In Real Estate

A host of legal issues can arise when investors
acquire distressed residential projects

By Paul Dubrasich

Paul Dubrasich
Dubrasich

The economic recovery is coming. Honest. It may be close at hand or it may be months or even years away, depending on whom you ask. But history shows us that, just as dusk is followed by dawn, economic downturns are generally followed by economic upturns — sooner or later.

Even while the recession has devastated the home sales market and forced residential projects into receivership, foreclosure or bankruptcy, opportunities have appeared, and will continue to arise, for investors and developers seeking to acquire and revive troubled projects. The developments may be of various types, from condominiums, to urban transit-oriented mixed use, to suburban single family home projects. They may be in various stages of completion. The acquirers may be white knight investors, foreclosing lenders or even recapitalized entities related to the original troubled owner. The variations are endless. But the market will rebound, and that is what these investors are counting on.

In spite of varied avenues that may be taken to acquire distressed residential projects, certain legal issues and considerations are common to reviving them. Not all of these can be covered in a single article. The following touches on some highlights.

Completing the development

Lenders, investors or new developers can acquire residential projects at virtually any stage of development, from unbuilt finished lots to completed condominium projects. In the case of partially or mostly completed projects, a great deal of due diligence and post-acquisition legal effort may be directed toward allocating and mitigating liability for past and ongoing construction.

WHO BEARS THE RISK OF FAULTY CONSTRUCTION?

Appellate decisions such as East Hilton Drive v. Western Real Estate Exchange (1982) 136 Cal. App. 3d 630, 186 Cal. Rptr. 267 arguably stand for the proposition that a selling party who converts existing construction to condominiums should not be held liable for aspects of construction in which that selling party did not participate. While this may be true for apartments that are later converted to condominiums, it is not necessarily true for new construction.

Title 7 of the California Civil Code, enacted in 2003 by what is commonly known as “SB800,” establishes functionality standards for new residential construction that are drafted much like a statutory warranty. These functionality standards apply to contractors, material suppliers and design professionals, as well as to “builders.” “Builder,” as defined in Title 7, includes not only those who are “in the business of building, developing and constructing” residential units, but also to “original sellers” who, at the time of the original sale, are “in the business of selling” residential units to the public (emphasis added). “Original seller” is not defined, but presumably means the first person or entity to sell the home or condominium to the end user (i.e., the consumer).

If that presumption is valid, then, arguably, claims for breach of statutory functionality standards under Title 7 may be brought against the seller of a new home or condominium to an end-user/consumer whether or not the seller was engaged in the original construction.

As such, careful pre-acquisition due diligence is vital to reveal whether adequate care has been taken in the completed stages of construction. If there was a third party general contractor, acquiring parties should give consideration to whether construction should be completed by that original contractor, if still solvent, or by a new contractor. Generally, if there was a construction loan in place, both the general construction contract and the project design plans would have been assigned to the lender as additional security for the loan. The acquiring party, whether a lender or otherwise, should be certain that all design plans and rights under existing construction contracts are also properly assigned or acquired in order to complete the project in an orderly manner.

IMPROVING CONTRACTS

Whether the buildout will be completed by the original contractor or a new contractor, it is advisable for counsel to review and, if necessary, improve upon contractual protections in the new owner’s construction contracts. Counsel should verify that the new owner’s construction contracts fully and adequately spell out the proper scope of work, performance standards, and obligations for future customer service and repair, as well as warranty, indemnification and insurance requirements. Procedures for consumer alternative dispute resolution (ADR), including the contractor’s and subcontractor’s obligation to participate in non-adversarial procedures under Title 7, should be reflected in all construction and design contracts.

Adequate indemnities from the contractors and subcontractors are, of course, vital. Even so, counsel should be aware of recent changes to Section 2782 of the California Civil Code, limiting the scope of indemnities for construction deficiencies that general contractors may impose on their subcontractors. These provisions also establish strict procedures allowing subcontractors to undertake the defense of construction claims and for allocating comparative liabilities between contractors and subcontractors.

Notably, while new owners or builders should be familiar with the procedures for enforcing a construction indemnity under Section 2782, the new procedures do not prohibit a builder from obtaining equitable indemnity from a general contractor or subcontractor. This fact may open the door for a new owner, if necessary, to hire a new contractor to complete the project, but still be able to seek recovery from a prior contractor or subcontractor for construction defects even without an assignment of rights under the previous construction contract.

INSURANCE

Insurance is also a must for taking over and completing new residential projects. While a detailed discussion of owner and contractor insurance requirements is beyond the scope of this article, the new owner and its general contractor must, at a minimum, acquire and maintain adequate commercial general liability (including completed operations), workers’ compensation and auto insurance.

In the case of a partially completed project, acquiring parties should be made aware that, unless it is properly modified, even a strong CGL completed operations policy may not cover a previous builder’s or contractor’s work. Fortunately, in this market, policies are available that can be structured to cover liability for both past completed operations and the new owner’s future construction. These policies, as one would expect, tend to be more expensive than liability or wrap-up policies that cover future work only, and they typically are conditioned upon a thorough inspection of completed construction by the new carrier, but they are highly recommended to clients taking over partially completed residential projects.

California Department of Real Estate jurisdiction

Under the California Subdivided Lands Act (Business and Professions Code Section 11000 et seq.), no person may sell or lease, or offer for sale or lease, interests in a “subdivision” — defined in the act as land or lands, wherever situated in California, divided or proposed to be divided for the purpose of sale or lease or financing, whether immediate or in the future, into five or more lots or parcels — without first obtaining a public report from the California Department of Real Estate (DRE).

A copy of the public report must be given to the prospective buyer by the owner, subdivider or agent prior to the execution of a binding contract for the purchase of the subdivision interest. The DRE issues different types of public reports, including preliminary, conditional and final public reports, each of which allows a subdivider to move progressively further in the marketing and sales process, from taking reservations, to entering into conditional sales contracts, to closing sale escrows.

AMENDING THE CURRENT PUBLIC REPORT

Even if the prior owner had a public report in place, the acquiring owner will need to obtain its own public report from the DRE. It cannot sell under the previous owner’s report. This does not, however, mean the new owner must start from scratch. The new owner should evaluate the stage of DRE processing reached by the previous owner and review the existing management documents, such as the homeowners association budget, CC&Rs and the like. If they are in reasonably good shape and do not require a complete overhaul, the new owner should be able to process an amendment to the previous developer’s application, significantly reducing the DRE’s processing time.

PROJECT PHASING

One of the many issues all new home sellers face in the current market is how to phase their projects with the DRE. Phasing can save money for the developer both in terms of bonding requirements for incomplete common area improvements and in the developer’s responsibility for homeowners assessments. Phasing can also facilitate purchaser financing, because both Fannie Mae and Freddie Mac impose pre-sale requirements of up to 70 percent on common interest development projects. These pre-sale requirements are imposed on a phase by phase basis.

Phasing is particularly challenging for high-rise condominiums, because neither the DRE nor Fannie Mae currently recognize marketing phases within single condominium buildings. For single buildings with a large number of units, it is virtually impossible to meet the 70 percent pre-sale requirements in order for buyers to qualify for Fannie Mae financing. Many banks are willing to make and “warehouse” home loans by holding them until the minimum pre-sale requirements are met, then selling them to Fannie Mae or Freddie Mac, but the price of this financing is generally higher.

Subdivision governance

Just as previously owned projects may be in varied states of completion, they may also be in various stages of sale. Acquiring owners/ developers should assess the current state of sales and should engage experienced counsel to review, among other things, the standard consumer sales documents being used, project disclosures, existing completion bonds in place, the covenants, conditions and restrictions (CC&Rs) affecting the subdivision, and the consumer ADR processes contained in the sales and management documents (including whether they are enforceable under current case law). If a homeowners association is already in existence, the new owner/ developer may need to arrange to acquire the declarant’s interest under the CC&Rs and to appoint a new board of directors and officers for the association.

PARTIALLY SOLD PROJECTS

While challenges exist in taking over any ongoing project, overwhelming complexities can arise if sales have already begun. If CC&Rs are in place already but no residences have been sold to the public, the new owner unilaterally may change the configuration of the project, amend or redraft the CC&Rs, or change the project budget (all subject to DRE approval). Not so if some units have already been sold to consumers. In that case, amending the CC&Rs and other aspects of the project can require the vote not only of the new developer, but also a majority or supermajority of the other owners. Existing owners may have expectations or rights based on disclosures or promises made by the previous owner. Further, the DRE must review and approve any material change to the project, including material changes to CC&Rs, by means of a time-consuming procedure under Business and Professions Code Section 11018.7.

DECLARANT STATUS

A question always arises as to whether the new owner/developer should become the “declarant” under the CC&Rs. Generally, the answer is “yes,” if possible. There are a great many advantages to becoming the declarant under most CC&Rs, including 3 to 1 voting rights within the homeowners association for a period of time, the ability to appoint a majority of the association directors and to control any design review committee, and the ability to change aspects of the project without association approval. Becoming the declarant, however, may not be an easy task if residences have already been sold, because the CC&Rs may allow only the original declarant to assign its rights. Usually this assignment must be recorded. Unless (i) the homeowners cooperate in allowing the CC&Rs to be amended to create a new declarant, or (ii) the original developer cooperates by assigning its rights to the new developer, there may be no easy way for the new developer to become the declarant under the CC&Rs.

Becoming the declarant is not without its risks and liabilities, but in California these risks are not as severe as some other states, particularly those that have adopted the Uniform Condominium Act (the UCA). The UCA creates a statutory warranty, liability under which is imposed on the “declarant” under the condominium project CC&Rs. By contrast, in California, no statute requires that construction warranties be given in the context of project CC&Rs, and liability for construction defects does not necessarily flow solely from becoming a successor “declarant.” Certainly, as stated above, liability could arise by other means, including (i) participating in the construction of the residences or (ii) falling within the category of “builder” within the meaning of Title 7 of the Civil Code. That said, a declarant under project CC&Rs, as the majority owner and controlling party of the homeowners association, may have a fiduciary duty to be sure that the project budget is adequate to fund the ongoing operations of the homeowners association.

A fertile source of plaintiff’s claims against developers comes from failures by developers to establish original budgets that create adequate maintenance funds and reserves for the common area. As successor declarant under the CC&Rs, this responsibility could potentially fall on the new investor, even if the investor is protected from liability elsewhere.

LEASING OF UNITS

In some cases, an acquiring owner or investor may have concluded that it can maximize its financial returns and minimize its liability by leasing the unsold units for a period of time. This can raise a host of management and liability issues of which the investor should be counseled.

If some units in the project have been sold and the homeowners association has been formed, the investor must review the existing CC&Rs and previous developer’s marketing materials, consumer sales documents and project disclosures to determine the viability of a leasing program for the remaining units. Even if the CC&Rs allow leasing of units without restriction, language of the previous marketing materials may give the existing owners reason to object to “conversion” of portions of the project to apartments or rental product. Owners may believe that renters are less likely to respect the project and more likely to cause damage or create nuisances than would owners who occupy their units.

Another risk is that lenders may refuse to provide financing for re-sales of the existing, sold units, because secondary market loan purchasers like Fannie Mae and Freddie Mac require that a high percentage of units in a condominium project be owner occupied. This may have a significant impact on the ability of existing owners to sell their units, because their buyers will have a difficult time finding financing.

New investors/owners should look for language in the existing CC&Rs and marketing materials which preserves to the developer the right to modify the project, and which expressly disclaims any duty to continue marketing units for sale if economic conditions or other circumstances change. Disclaimers similar to this may not always be present in the sales materials, but often they are.

Even if no homes or condominiums in the project have been sold, a new owner who wants to lease rather than sell should nevertheless consider obtaining a subdivision public report from the DRE. First, a public report will be required if (i) the project cannot be characterized as an “apartment” project, and (ii) leases will be entered into for in excess of one year (it is DRE policy that leases of one year or less do not require a public report). Second, a public report provides certain vested rights in the local condominium approvals for the project, which will allow for easier transition to sales at a later date.

SALES DOCUMENTS AND RISK MANAGEMENT

Proper risk management for an acquiring owner also involves reviewing the “ADR” provisions of the sales and management documents being used. A threshold decision is whether to “opt in” or “opt out” of statutory provisions in Civil Code Title 7 that allow a builder to fix problems with functionality before litigation or other form of dispute resolution is pursued by a buyer or homeowners association. Typical sales documents and CC&Rs also include standard ADR provisions requiring mediation, arbitration or judicial reference of construction related disputes, and the new owner must decide (i) whether these provisions are enforceable under current California law, (ii) whether they fit the new owner’s preferred dispute resolution programs, and (iii) whether they are consistent with ADR requirements in the new owner’s agreements with general contractors.

Conclusion

The issues that arise in purchasing and reviving ongoing and troubled residential projects are numerous and varied. In the acquisition process, due diligence and extremely thorough checklists are invaluable to help foresee many or potential legal problems.

Be ready for the economic recovery. It is coming. Honest.

• Paul Dubrasich is a partner with the law firm of Cox, Castle & Nicholson. He specializes in real estate transactions, development and financing.

Certification

  • This self-study activity has been approved for Minimum Continuing Legal Education credit by the State Bar of California in the amount of one hour of legal ethics.

  • The State Bar of California certifies that this activity conforms to the standards for approved education activities prescribed by the rules and regulations of the State Bar of California governing minimum continuing legal education.

Self-Assessment Test

Indicate whether the following statements are true or false after reading the MCLE article. Use the answer form provided to send the test, along with a $25 processing fee, to the State Bar. If you do not receive your certificate within four to six weeks, call 415-538-2504.

  1. Under Title 7 of the Civil Code, claims for breach of statutory functionality standards for construction arguably may be brought against a person in the business of selling new homes, whether or not the seller supervised any of the construction.
  2. When acquiring an ongoing development project, there is no benefit to acquiring the plans and specifications and construction contracts.
  3. Counsel should verify a new owner’s construction contracts fully and adequately spell out the proper scope of work, performance standards and obligations for future customer service and repair, as well as warranty, indemnification and insurance requirements.
  4. New revisions to the California Civil Code restrict the scope of construction indemnities in contracts between contractors and subcontractors.
  5. Equitable indemnity against negligent contractors and subcontractors is no longer a remedy.
  6. Liability policies are available that will cover both past completed construction (by a previous builder or contractor) and the new owner’s operations.
  7. New owners/developers are allowed to sell residential units under the previous developer’s subdivision public report.
  8. An amendment to the previous developer’s public report may be sufficient.
  9. DRE phasing has no benefit.
  10. DRE phasing can save money for the developer both in terms of bonding requirements for incomplete common area improvements and in the developer’s responsibility for homeowners assessments.
  11. DRE phasing can also help reduce the number of units subject to Fannie Mae’s 70 percent pre-sale requirements.
  12. The DRE, as a rule, always allows phasing within single residential condominium buildings.
  13. Acquiring owners/developers should assess the current state of sales within a residential project.
  14. While challenges exist in taking over any ongoing project, they are simpler if sales have already begun.
  15. If CC&Rs are in place already but no residences have been sold to the public, the new owner unilaterally may modify the CC&Rs.
  16. Existing owners have no expectations or rights based on disclosures or promises made by a previous owner.
  17. An acquiring owner/developer should never become the “declarant” under the CC&Rs.
  18. A declarant under the CC&Rs often has the right to appoint a majority of the board and any design review committee and thereby retain effective control of the project through the development and sales process.
  19. California has adopted the Uniform Condominium Act.
  20. Liability for construction defects caused by the previous owner does not arise solely by reason of the new owner’s becoming the new “declarant” under the CC&Rs.
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