Building Defects Can Derail Your Deal

Legal implications from construction problems can affect a property's financing

Defects introduced in construction can lead to classic legal disputes between owners and contractors, especially when considerable sums of money are involved. What can a commercial mortgage broker learn from these disputes? What risks and potential rewards might arise? Brokers should understand these issues and how they can affect financing, particularly when working with distressed properties or refinances.

If the defects cause business-operation interruptions that are timebound in terms of start and stop date, then damages are commonly measured by lost profits. In some situations, the impact of the defects may lead to operational losses followed by a company going out of business. In this type of case, some courts have allowed lost-profits damages in the past and lost-business value assessed when a company goes out of business.

There are four key issues a mortgage broker should know when dealing with properties with construction defects:

1. The scope of the problem
2. What is owed and who is liable
3. Lost-profits damages and how they are measured
4. Who the key players and partners are

Scope of the problem

What must be considered first is: How big is the problem, and when can it be fixed?

It all begins when the defects are first discovered. This becomes the starting point when analyzing when economic damages begin, who is impacted and by how much, and how long they last.

Do not expect the parties to know the answers to these questions about timing and the scope of damages right away. In some cases, repair timing and scope issues are not fully determined until several years after the construction problems are first detected. Once construction defects are discovered, their impacts can become more pronounced and a cascade of damages starts, including loss of income from paying tenants, followed by added costs as management seeks to remediate the problems the defects caused.

As an example, consider defects in the roofing of a large apartment complex. The project was completed in midyear, and occupancy increased in the following year. During winter rains in the first year, water-intrusion defects appeared in external stairwells, and the builder made minor repairs. At this point, it would be a mistake for the broker to assess the property's economic value because too much remained unknown about needed repairs and economic damages.

In the next two years, as the scope of the defects to the stairwells and external landings became more apparent, many tenants complained or moved out, and the rate of new leases declined.

Property management did not begin to capture extra repair costs incurred until two years later. Even then, a complete assessment of the defects was not known until almost four years after construction was completed. Finally, in the fifth year, a systematic, building-by-building repair and reconstruction program began that continued for a year. In this time, vacancy rates increased as existing tenants moved out and the rate of new leases slowed even more.

Tenants who stayed were granted special concessions in the time the building was under renovation, but none was relocated off the property because all repairs were outside individual units. The property owners gave gift certificates from nearby restaurants to tenants who were inconvenienced by noise or who had limited access to their units or parking. Cars that were scratched or damaged by construction trucks or dust were detailed.

After the reconstruction period, rent losses continued because it took many months and special efforts to bring occupancy back to the level it would have been without the disruption the construction defects caused.

Economic damage began once the defect interrupted the enjoyment and use of the property. Damages expanded in many ways in the remediation period and continued after the construction defects had been repaired. There were lingering economic damages for many months because of excess vacancies and reduced lease rates. Some leases made with concessions during reconstruction could not be raised to normal rates until the following year.

This relatively simple case illustrates the types of damages that must be identified, investigated and documented. In general, "but-for" profits are compared and contrasted with actual profits and further consideration given the costs of gifts, extra marketing and related special factors. The damages assessment also made adjustments for local economic conditions, normal vacancies and seasonality. In addition, damages included repair costs, debt service to finance a loan taken out for repairs, and legal and management costs.

Liability

What needs to be ascertained next is: Who is liable and what is owed? Real estate construction cases can be complex, and the courts may have to decide liability and damages separately with the aid of many lawyers and experts. The expert list for each side may include contractors, designers, architects, plumbers, electricians, mold specialists, soil engineers and financial experts.

For lost-profits damages, an experienced financial expert typically draws on the other experts' work and provides a summary opinion regarding repair costs, lost rents (or value) and other damages. The court, not the financial expert, determines liability and may apportion damages due if there are multiple parties in the suit.

Damages and loss

The next element to consider is: How are lost-profits damages measured and by whom? The financial experts retained in construction-defect cases are often accountants or economists, and each has certain advantages. Forensic accountants may be preferred if tax or accounting standards are a main concern. Economists have more training and expertise in assessing economic factors, competitive conditions and statistical analyses.

Gross profits are commonly used to measure lost profits in civil litigation, but exactly how this is measured varies by state. Some state courts use the term "net profits" but don't really mean all expenses need to be deducted from sales as in net income. Others use "gross profits" but interpret that differently from accounting textbooks, which define gross profits as sales less costs of goods sold (C.O.G.S.). Many courts measure economic damages as in business-interruption cases as sales less C.O.G.S. and variable expenses.

If the construction defect is a breach of contract, lost-profit damages are sales less costs of performance or "expenses saved" because the plaintiff is being excused from performance by the other party's breach. Incremental costs associated with lost revenues must be subtracted from lost revenues to derive lost profits. Economic damages in construction defects may include lost profits plus extraordinary fixed expenses incurred because of construction defects.

It is important to note that the plaintiff must prove lost net profits.

Key players

Real estate defect cases are best handled by those who have had experience with large, complex cases involving commercial properties or housing developments. This is one area in which a financial expert may need to take on something like an "operations research role" and build on the technical and construction plans and various repair schedules before developing associated economic damages estimates.

Coordination and information-sharing is important to successful outcomes. Communication and timing issues usually require people to come together often. This involves scheduling the property owners, the residential and commercial property tenants, the various repair and reconstruction contractors, their attorneys, and the experts they engage to prepare for the case.

Although these are the primary issues involved in construction-defect cases, commercial mortgage brokers shouldn't let this prevent them from raising additional questions if they have the chance.

For example, if future revenue projections are made, what are the underlying assumptions and methods used? How is the cost of debt and equity capital considered?

Being knowledgeable and critical of these issues can show a commercial mortgage broker's true value to clients dealing with construction defects.