Damages Arising from
Construction Defects: Business Interruption
When
construction defects arise impacts how one assesses economic
damages. Defects during construction can lead to
classic delay/disruption/change disputes that arise between
owners and contractors. Our concern, however, are
construction defects discovered in the completed project,
especially where the project involves commercial operations.
Efforts to remediate these defects frequently lead to business
interruption damages. This note offers suggestions to damages
experts and claim adjustors in construction defects cases
associated with business interruptions; suggestions based on
the experience of Litigation Economics, LLC experts in several
large, complex cases involving commercial properties.
First, in
contrast to other types of commercial cases involving loss of
profits and/or business value, construction defect cases may
involve many attorneys, insurance companies, and experts. The
expert list for each side may include contractors,
designers, architects, plumbers, electricians, mold
specialists, soil engineers, and financial experts.
Coordination
and information-sharing thus becomes very important to
successful outcomes. It is important that the financial expert
not get lost in the fray but have clear, ongoing lines of
communication to lead counsel and lead technical expert, if
such a person exists.
A second
critical issue is the timing of the defects and associated
losses. When were the defects discovered, when did
economic damages begin and how long will these last? An
experienced financial expert should lead this inquiry.
Consider, for example, a recent case involving a 280 unit
condo complex in Northern California. The project was
completed in mid-2000 and occupancy grew over the following
year. During winter rains in early 2001 water-intrusion
defects first appeared in external stairwells and minor
repairs were made by the builder. During 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 fell in spite of a rent
concession program that was already in place to increase lease
rates during the winter months, traditionally slow rent
periods. Property management did not begin to capture extra
repair costs incurred until 2003 and a full assessment of the
defects was not known until 2004. In early 2005, a systematic,
building by building repair and reconstruction program began
that continued until June 2006. During this time, vacancy
rates rose as existing tenants moved out and the rate of new
leases slowed. Tenants who stayed were granted special
concessions during time their building was under renovation;
two “swing units” were set aside during reconstruction period
for day use so that adversely impacted tenants could use those
units (no tenants were relocated because no repairs were
inside units); special gift certificates at nearby restaurants
were given some tenants; cars scratched or damaged by
construction trucks or dust were detailed. After the
reconstruction period ended in June 2006 rent losses continued
because it took many months and special efforts to bring
occupancy back to the level it would have been “but- for” the
disruption caused by the construction defects. The point is
that well after the construction defects had been repaired,
there were lingering economic damages from lost rents due to
excess vacancies.
Communication
and timing issues may come together critically if the case
involves scheduling of various repair and reconstruction
options, especially if relocation of existing tenants or
business operations is involved. In our experience, this is
one area in which the financial expert may need to take on
something like an operations research role and work with the
technical/construction side of the project to estimate costs
associated with various repair schedules.
An adjustment
for mitigation is another key issue in these types of
cases. What would have been normal revenue and variable
expenses had there not been an interruption to business
operations caused by the construction defects or operations
changes while repairs and reconstruction were taking place?
From computation of these ‘but-for’ levels of revenue and
expenses one needs to subtract actual revenue and variable
expenses to compute net losses. In the condo case, normal
revenue was projected by use of a multiple regression model
based on pre-disruption monthly data with adjustments for
revenue seasonality and trend. In related but separate
analyses, we used regression models to identify those expenses
that varied directly with revenue. As it turned out,
relatively few condo expenses varied directly with occupancy.
Consideration
of market and economic factors is often overlooked in
these types of cases and if so can be a serious flaw in the
analysis. How were rents set historically vis-à-vis
competitors? Who are competitors? If the disruption took place
during an economic downturn how does the loss expert consider
the impact of this downturn on expected vacancy rate changes
and occupancy rates? To be credible, the expert should obtain
this external information independently from parties to the
lawsuit.
Analyzing
economic loss arising to commercial properties involving
business interruptions requires teamwork across disciplines,
attention to timing issues, mitigation adjustments and
consideration of external factors that may have contributed to
part of the overall loss. This note presents key ideas for
financial experts and adjustors to consider in assessing
damages in such cases.
[For further
information about the ideas presented here, contact Stanley
Stephenson, Managing Principal, Litigation Economics, LLC, San
Francisco, CA 415-835-1212 or email:
stan@litigationeconomics.com]
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