The Financial Impacts of Construction Defect Liability on Housing Development in California

Author: William Fulton, Terner Center Fellow

Despite significant state legislation over the past decade to boost housing production, new housing construction in California has stagnated at 100,000 to 120,000 new units per year^[1]—less than half of what’s needed to meet the State’s goal of producing 2.5 million units between 2023 and 2031.

One important part of the housing ecosystem that is particularly struggling is for-sale multifamily units known as condominiums. A recent Terner Center report suggests that the number of new condominium units in both the Bay Area and Southern California has dropped by 90 percent from the peak in 2005–2006.^[2]  With single-family homes now extremely expensive in many California markets, condos could be an important ownership option. But in order to unlock condominium construction in California, the barriers to development need to be better understood.

One key driver in the significant decline in condo construction appears to be California’s construction defect liability laws.

A new report, “The Financial Impacts of Construction Defect Liability on Housing Development in California,” commissioned by the Terner Center and SPUR, highlights a particular challenge with construction defect liability laws: the enormous cost of insurance for condominium builders. The report, prepared by Economic & Planning Systems (EPS), finds that developers often pay three to four times as much for insurance for condominiums as they do for similar rental apartments.

For example, in Los Angeles, EPS estimates the insurance cost as between $8,000 and $18,000 more per unit for condominiums than for rental units.

This finding is particularly problematic during a period that has seen insurance providers pulling out entirely from California or significantly raising premiums well in excess of inflation year after year in the face of increased costs due to climate disasters and regulatory changes.

This commentary shares key findings from the EPS study, including potential options for reform identified in the research.

Construction Defect Liability Laws Increase Condo Insurance Costs

Under California law, homeowner associations (HOAs) have a 10-year window to sue the condominium developer over construction defects. That window (known technically as the “length of repose”) is longer than the average across other states. The EPS report finds that trial lawyers often reach out to HOAs to solicit business as the end of the window approaches.

Another factor driving litigation is California’s broad definition of a construction defect, which can include a wide range of cosmetic problems beyond more serious defects created by the original construction of the building. In talking with experts, EPS finds that under California law, almost any condo building in California could potentially claim between 50 and 100 defects.

Also under California law, HOA boards—made up of volunteers who don’t necessarily have expertise in building defects—can initiate a lawsuit without consulting their members. In fact, under state law Senate Bill (SB) 326, HOA boards are prohibited from having members vote on whether to litigate. Because construction defect liability lawyers typically work on a contingency fee basis, the lawsuit doesn’t cost the HOA any money up front, thus reducing a barrier to entering the litigation.

California attempted to reduce the number of construction defect liability lawsuits with the passage of SB 800, the so-called “Right to Repair Act,” in 2002. SB 800 created a structured process through which developers and HOAs can resolve repair claims out of court. However, EPS finds that developers don’t often use this process because resolving repairs in this manner does not insulate them from future lawsuits. Instead, developers wait to be sued—which activates their insurance policies—before making repairs.

Because California’s construction defect liability laws are so favorable to owners, EPS finds that insurance companies simply assume that all HOAs in the state will eventually sue their project’s developer. One insurance broker interviewed for the EPS project estimated that 80 to 85 percent of the condo projects he had insured had been sued over alleged construction defects. In essence, a whole litigation industry has been built up around condominium construction defects.

The Role of “Wrap” Policies

The proliferation of construction defect liability litigation has also led insurance companies to require a different type of insurance policy for condo developers than for most developers of rental housing.

EPS notes that until the 1990s, insurance companies offered developers and contractors the same project-specific insurance policies for condos as for rental properties. Whereas the previous policies only covered the developer, now insurance companies require a “wrap” policy, which covers the developer, the contractor, and all subcontractors—thus increasing the cost. By contrast, EPS finds, insurance companies typically do not require wrap policies for rental projects because the risk of litigation is so much lower.

Some industry experts interviewed by EPS suggested that wrap policies may also disincentivize subcontractors from doing quality work because they are not liable for it, which in turn requires developers to spend more on inspections and quality assurance. Meanwhile, some subcontractors simply aren’t interested in working in condominium projects due to liability concerns and complexities. In addition, even with the higher cost, according to the EPS report, wrap policies have a very large deductible (technically known as a “self-insured retention”) of $25,000 to $50,000, or more for large projects.

EPS estimates that high insurance-related costs add roughly 2 to 4 percent to a condo project’s hard cost, as compared to an identical rental project.

EPS illustrates the problem by focusing on an apartment-to-condominium conversion in the Bay Area. The developer originally insured the building as rental apartments, paying $2 million for $42 million in insurance coverage. After converting to condos, a modest undertaking that added only $800,000 in cost, the developer’s insurance costs ballooned to $4 million for half the coverage offered to the rental building.

EPS finds that the cost of construction defect liability is one of several factors that have resulted in condo development projects being concentrated in more exclusive urban locations, such as high-rise towers in San Francisco or boutique projects in Santa Monica and Beverly Hills, where developers can bear the cost of insurance. Smaller and more moderately priced projects, on the other hand, have more challenges achieving profitability.

Options for Reform

EPS finds several options for policy reform that could reduce insurance costs and make it more likely that condominiums of all sizes will be built. Their recommendations include the following:

• Shorten the “length of repose”—the time period during which litigation is allowed— from ten years to five.
• Give developers protection from liability for repairs if they follow the SB 800 process.
• Require that HOAs obtain member approval to file lawsuits and inform members of the risks of litigation.
• Require HOAs to perform better building maintenance and establish more robust financial reserves to cover routine maintenance.
• Limit attorneys’ contingency fees to less than the 33 percent typically charged.

One interesting alternative, which has been implemented in New Jersey and parts of Canada, is a so-called “warranty” system. Under such a system, the developer and contractor provide the HOA with warranties for various aspects of the building (workmanship, plumbing, major structural defects), usually varying in length depending on which aspect is being considered. In New Jersey, for example, warranties for workmanship might be one to two years, while major structural defects are covered for 10 years, the same as California’s current length of repose. A warranty system also holds the potential to reduce the role of litigation attorneys and therefore the cost of litigation.

Middle-income Californians deserve many options for homeownership. Given the fact that so many California communities are focused on infill development (building in existing neighborhoods), condominium ownership should be one of those options. State policymakers should consider lowering the cost of insurance, and addressing the overall challenge of construction defects, in order to see rates of new condo construction materially increase.

Acknowledgments

Thanks to the following Terner Center colleagues for their review of this research: Sarah Karlinsky, Muhammad Alameldin, and Ben Metcalf. Thanks to Michael Lane, SPUR state policy director, for his review as well. Special thanks to the Lambda Alpha International’s Land Economics Foundation for their support of the EPS study.

This research does not represent the institutional views of the University of California, Berkeley, or of the Terner Center’s funders. Funders do not determine research findings or recommendations in the Terner Center’s research and policy reports.

 

Endnotes

[1] Federal Reserve Board of St. Louis. “New Private Housing Units Authorized by Building Permits for California.” https://fred.stlouisfed.org/series/CABPPRIVSA

[2] Alameldin, M. & Karlinsky, S. (2024). “Construction Defect Liability in California: How Reform Could Increase Affordable Homeownership Opportunities.” Terner Center for Housing Innovation, University of California, Berkeley. Retrieved from: https://ternercenter.berkeley.edu/wp-content/uploads/2025/01/ConstructionDefectLiability01.08.25.pdf