Signs of life may be returning to the residential construction industry, but the recession has left banks and developers suffering an unpleasant hangover.

Credit is short, confidence is weak, buyer demand is uncertain.

Financial sector balance sheets are weighed down by a vast portfolio of foreclosed property of uncertain value.

We face a vicious circle. Developers are struggling to fund their businesses, while banks are reluctant to lend until they can realize the cash value of all the unwanted property they hold.

The residential construction market needs a significant boost of confidence to get moving again.

In times like these, financial institutions and property developers need to do everything they can to maximize cash flow and profitability in order to make the most of the opportunities that exist. One area worth a fresh look is the insurance cost related to property development.

HELPING CUT COSTS

Property developers tell us they expect the market to improve in 2010 or 2011. Following the stagnation of 2009 (563,000 home starts versus over 2.1 million in 2005, according to Census Bureau statistics tracked by the National Association of Home Builders), we are now facing a housing shortage, and new units must be built in the next 12 months.

We are seeing the more resilient builders buying land banks, but few have actually broken ground. Some builders are focusing on buying real estate assets from banks to complete them for sale. However, most of this activity is currently confined to the more buoyant and affluent geographic regional and local hotspots where the economy is stronger.

As developers put their balance sheets in order to present a credible case for borrowing, one significant cost they have to account for is insurance.

Traditionally, construction industry liability cover is sold on a wrap-up basis. That means that insurance for the whole construction-to-after-sales life cycle is paid for up front. With typical liability premiums ranging from $50,000 to $500,000 for projects of 10-to-250 units, this can amount to a substantial sum.

Recognizing that this is a heavy burden when cash is tight, the insurance market has responded by providing a new approach that allows developers to buy insurance coverage for different types of exposure as they materialize, allowing them to stagger the premium costs.

One such “pay-as-you-go” policy allows developers to pay 35 percent of the premium up front to cover premises liability at the start of construction. The balance, covering completed operations exposure insurance, is only paid once the building is completed.

This approach provides a significant cash flow advantage and is popular with developers, who are keen to explore every avenue to be as financially efficient as possible. However, it is important for brokers to work closely with clients to ensure they clearly understand the terms governing what is insured and when cover is triggered.

Other programs to respond to the current needs of builders and developers include tiered premium rates that reduce the cost of insurance per house as the number of houses built grows, and owners, landlords and tenants insurance programs for property developers who decide to rent out property that fails to sell.

HELPING BANKS PROTECT VALUE

While builders and developers are used to properly insuring and protecting their assets, banks are just beginning to get to grips with this new raft of liabilities.

American banks have now foreclosed on an estimated one million properties (according to the U.S. Foreclosure Index 2008), commonly called Real Estate Owned. In theory, REO could be worth some $25 billion (assuming average property value of $250,000). In reality, this value is likely to be leaking away in a sluggish market. The banks' current preference is to sell REO off at a loss to developers rather than keep it on the books and allow value to slip further.

However, in selling these projects, many banks find it hard to assess the extent of the exposures they have inherited along with the property portfolio. The problem is further complicated by the fact that if the properties are new or incomplete, banks could still be responsible for correcting any future problems caused by use of defective construction materials–anything from leaky roofs to the more exotic time bombs like Chinese drywall plasterboard.

In selling or completing construction on a foreclosed project, banks are effectively taking on the operations exposures normally ascribed to a developer.

Insuring against these liabilities takes away the uncertainty that can seriously threaten the value of the REO itself, and may prove seriously expensive to banks further into the future. It also provides banks with the flexibility to make the most of the value in the assets.

However, brokers need to be aware these are problematic risks and present significant exposures. It is very important to guide clients carefully, ensuring they get the right breadth of backward and forward coverage.

GETTING BACK TO BUSINESS

Since almost nothing was built in 2009, building new homes remains a priority for the home building sector. It is in everyone's interest for banks and homebuilders to get back to business.

For this to happen, the main prerequisite is confidence–and to deliver that confidence, we as stakeholders in the construction market need to help manage risk.

The insurance market can make a valuable contribution to help builders improve cash flow and banks to address their liability exposures–to put the difficulties of the recent past behind them and get back to business.

Kevin Hastings is managing director of Jansen & Hastings Intermediaries Ltd., a London-based managing general agency providing construction, health care, professional liability and property insurance products including pay-as-you-go construction liability policies for cash-strapped developers and a special REO asset protection program for banks. He may be reached at kevin.hastings@jansenandhastings.com.

Paul Jansen is chairman of Jansen & Hastings Intermediaries Ltd. He may be reached at paul.jansen@jansenandhastings.com.

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