Buyers, Sellers of Distressed Commercial Properties: Caution

The American landscape is littered with partially built, financially distressed or bank owned properties. Whether they are towering condos, gleaming hotel resorts, urban mixed use or suburban office space, many of these are now seeking new investors, developers and contractors to complete what someone else began in a rosier economic environment.

While many of these properties can look like great bargains on the surface, failing to properly investigate the background and potential roadblocks for future development can result in losses rather than profits.

The three main areas that must be explored are property condition assessment, legal issues and encumbrances, and the insurability of the project. These issues are relevant not only to the buyer of the property but also for all the contractors and subcontractors involved in both the original and post-transfer phases of construction.

Project Assessment

Anyone considering the purchase of a partially completed structure should first engage experts who can assess the viability of the project. Construction engineers can assess the condition of the property, determining not only what has been properly completed and what work remains to finish the project, but also what existing work may need to be repaired or remediated. In many instances, a developer in financial difficulty might try to cut corners and make changes to the original plans and specifications or substitute inferior (cheaper) materials.

A purchaser should not only retain a qualified construction expert for the physical inspection and documentation of pre-purchase work, but should also check for available city inspection documents, change orders, and course of construction inspection documents and/or photos. Many of these documents can be difficult to locate. A buyer should have the original plans and specifications reviewed by qualified professionals to ensure they are code compliant and error-free. Also, if the prospective purchaser wishes to alter the project from its originally approved size or use, architects and local building department experts may also need to be consulted.

A prospective purchaser should also engage expert transactional (acquisition, insurance and tax) and construction attorneys to complete the due diligence required prior to the execution of a letter of intent and through the negotiation process in order to obtain all warranties and representations necessary to clarify assumption of liabilities and avoid post contractual lawsuits.

Insurance Questions

Lastly, the question of insurance coverage can be a labyrinth if there is not proper insurance coverage counsel to determine who will be legally responsible for problems or deficiencies in the original construction; whether recovery from the original parties (developers or contractors) is possible or if such liabilities will be assumed by the acquiring parties. This issue is paramount in the acquisition of a distressed construction project and should be resolved during the negotiation period, in order to avoid surprises in the future. Determination of the availability of insurance for the original developer and contractors is very important because if traditional insurance was in place for them, then each contractor may have its own insurance program. Even if the developer ends up in bankruptcy, contractors’ liabilities may be covered in coming years by their individual insurance, subject of course to the specific terms and conditions in their policies.

However, if the project was originally covered by a Wrap-Up (OCIP or CCIP), then the issues become more complex. A Wrap-Up program of insurance covers all enrolled parties under a single policy; thus, the applicability of that policy must be assessed, as well as the policies of those participants in the construction project who were not enrolled.

Attention should also be paid to the deductible or self-insured retention on the wrap policy. If the policy requires the SIR to be satisfied only by the sponsor or First Named Insured, a developer who is bankrupt or unable to satisfy the SIR creates a question as to whether, and under what circumstances, the policy will respond to a claim. This and other issues may potentially create an “all or nothing” coverage situation for all enrolled participants under an original Wrap-Up program. A prospective purchaser of distressed construction projects needs to get guidance from coverage attorneys on this issue.

Tips for Insuring Distressed Assets

The following are some suggestions that can be used by all parties, no matter which side of the distressed construction project they are on:

• Original contractors on a project should be aware of any signs that the developer is having financial difficulties. Late payments, change orders for cheaper building components or deleting expensive architectural elements can be a sign that there is financial uncertainty.

• If a Wrap-Up insurance program is in effect, check the policies with attention to SIR language and completed operations triggers. You may also seek to add in a contractual obligation requiring that notice be given to enrolled contractors in the event the wrap is cancelled (commonly by the premium finance company), extended or allowed to expire.

• Brokers will need to assist their clients in assessing any gaps or coverage issues in the original insurance and then work to find the best way for their clients to insure their liabilities and exposures for the project going forward. Successor owners and contractors are well-advised to seek experts’ counsel from attorneys and consultants prior to purchasing a financially distressed construction asset.

• Proper use of experts is instrumental in deciding whether a project ultimately results in a profit or a loss.

Bryan, AIC, ARM, CRIS, is assistant vice president and regional underwriting manager for Chartis Excess Casualty – Construction Division. She is based in San Francisco and may be reached at susan.bryan@chartisinsurance.com.