Homebuilder Shares Undermined by Creeping Costs of Construction Boom Flaws

Seattle city planner Alan Justad is reviewing a project that will bring back the cranes, dust and noise absent since the real estate bust. This one will subtract from the skyline rather than add to it.

The owners of McGuire Apartments opted to tear the 10-year- old tower down after discovering corroded support cables and other faults that would cost $60 million to repair, almost double the tab to build it. “We’ve never had anything like this happen before,” said Justad, who expects demolition of the 25- story structure to begin later this year.

The U.S. construction boom between 2000 and 2005 added more than 10 million apartments, condominiums and single-family homes to the nation’s housing stock. It is still generating a repair bill for construction flaws that may hamper the industry’s recovery, as homes with cracked foundations and sagging ceilings add to the supply of hard-to-sell properties.

The rush to meet demand fueled by low interest rates and liberal lending resulted in a doubling of defects per unit from 2000 through 2005 compared with the previous six-year period, according to International Association of Certified Home Inspectors Inc. estimates. Add to that the litigation legacy of allegedly dangerous Chinese drywall imports, and builders are facing a growing liability headache.

“It’s yet another detriment to real estate values,” said Vicki Bryan, an analyst at Gimme Credit LLC in New York. “Homebuilders don’t want to draw attention to it, but they’ve got creeping costs for construction defects.”

‘Liabilities Are Underfunded’

PulteGroup Inc., the largest U.S. homebuilder, recorded a one-time expense of $272.2 million in the third quarter, or 25 percent of its revenue in the period, to increase the reserves that cover losses when homeowners demand repairs to new houses. Chief Financial Officer Roger A. Cregg told analysts on a Nov. 3 conference call that there were a “greater frequency of newly reported claims” by people with company-provided warranties against defects.

Claims for defects can take time to surface, because typical construction warranties are good for a decade -- which is also the amount of time many states allow for filing lawsuits for alleged defects.

That could mean some builders will need to set aside more money for repairs and legal claims in years to come, said Ron Kozlowski, a Hong Kong-based senior actuary at Towers Watson, a consultant to insurers.

“Their liabilities are underfunded,” he said, not specifying the builders. “They have their heads in the sand.”

Off The Peak

Replacing faulty Chinese drywall in U.S. homes may cost more than $15 billion alone, Kozlowski estimated. He said he has reviewed claims for other failings totaling $15 billion to $20 billion, including the kind of water intrusion that doomed the Seattle apartment building.

“The whole construction defect issue is multiples” of the drywall amount, Kozlowski said.

Last year, new home sales in the U.S. totaled 321,000, the lowest level in data dating to 1963, according to the Commerce Department. This year, weak demand and foreclosures may make it harder for builders to maintain profits, Michael Widner, an analyst with Stifel Nicolaus & Co. in Baltimore, wrote in a Jan. 27 note to investors.

While the Standard & Poor’s Supercomposite Homebuilding index has more than doubled since its low of Nov. 21, 2008, it is 74 percent below its July 20, 2005, peak. The index, including D.R. Horton Inc. and Lennar Corp., has risen 1.9 percent in the past 12 months, trailing the 23 percent gain for the S&P 500 Index. Barclays Capital Inc. analysts cut homebuilders to “neutral” from “positive” on Jan. 6 and a Jan. 10 S&P report cited “continued market concerns.”

Neighborhood ‘Stigma’

Mistakes like those allegedly made in a Lennar subdivision in Texas where at least 13 homeowners are suing can have an outsized effect, said Jack McCabe, chief executive officer of McCabe Research & Consulting LLC in Deerfield Beach, Florida.

“If only a few houses in a 600-unit housing development are affected, that stigma exists for all of them -- you can’t sell a house in that neighborhood,” he said. “It can take years to overcome.”

Lawsuits over defects in states where homes went up most quickly may be years from peaking, said Paul Amirata, chief executive officer of Amirata Claims Consulting LLC in Livingston, New Jersey.

Horton, the second-largest homebuilder, put its net liabilities for construction defects and other claims at $319.8 million on Sept. 30, more than double the $137.2 million on Sept. 30, 2003. The increase was due to the number of homes built, not any decline in quality, said Horton spokeswoman Jessica Hansen.

Tapping Insurance

Seven analysts rated Horton “buy” and 14 “hold,” according to data compiled by Bloomberg. Their average earnings estimate for fiscal 2011 is $50.1 million, or 13.9 cents a share. Stock in the Fort Worth, Texas-based builder closed Feb. 9 at $12.46 in New York Stock Exchange trading and has fallen 5.9 percent since it reported a wider than expected fiscal first-quarter loss of $20.4 million on Jan. 27.

The availability of general liability insurance for homebuilders and subcontractors has become increasingly limited and more expensive in recent years, according to Pulte’s third- quarter filing with the Securities and Exchange Commission, which didn’t provide pricing details.

The companies are finding it more difficult than five years ago to tap insurance to cover payments to homeowners because insurers have added so many exceptions, said Dave Stern, vice president at West Coast Casualty Service Inc., an insurance adjuster in Westlake Village, California.

In California, “basically, the thing leaks, it’s the builder that’s liable,” Stern said.

‘Tough Science’

At Pulte, most of the claims in the third quarter were related to water intrusion, Chief Executive Officer Richard Dugas said on the Nov. 3 call with analysts.

“What was unusual here was the number of claims we received in a particular quarter,” he said. “That was completely unforeseen.”

Given the 10-year warranty periods, it’s a “tough science to nail down” when people will decide to ask for defects to be fixed, he said.

Pulte, of Bloomfield Hills, Michigan, said Feb. 4 that it reversed $10 million of the reserve expenses after further review in the fourth quarter. Its net loss widened in the period to $165.4 million, or 44 cents a share, from $116.9 million, or 31 cents, a year earlier. Pulte shares rose 4 cents to $7.82 yesterday and have dropped 29 percent in the past year.

In the rush to make deals, buyers often didn’t ask for inspections, which some mortgage companies didn’t require, said Bruce Barker, an inspector in Phoenix for more than a decade.

No Inspection

Natalie Crump didn’t have her house inspected before moving into Hutto Parke, built in an old cotton field a 30-minute drive from Austin, Texas. She bought a three-bedroom home there with her husband Mike for $136,490 in 2006. Since then, the Crumps and owners of 12 other houses have filed lawsuits against builder Lennar, claiming foundations are fracturing and fences sagging because the homes went up on unstable soil, according to their lawyer, Kyle Pugh of Dallas.

When neighbors see one another, “it’s never, ‘Hey, let’s get together for barbeque,” Crump said. “It’s, ‘What did Lennar do to you and what did you notice in your house today?’”

A year after they moved in, the Crumps spotted bubbles in the ceiling of their daughter’s room that turned out to be nails sliding out of sheetrock, she said. Lennar officials told them it was because workers hammered the nails incorrectly, she said.

‘Consistent Quality Standards’

Then the driveway sprouted a crack more than six feet long, she said, while ceilings inside bowed. Lennar offered to make repairs, she said. She and her husband sued instead.

“Who wants a brand-new, repaired house?” said Crump, a horse trainer.

A Lennar spokesman, Marshall Ames, said the “nail pops” the Crumps saw are common in homebuilding. The company offered to make sheetrock repairs to the 443 houses in the subdivision and 221 homeowners accepted, Ames said by e-mail. The accusations in the lawsuits are unfounded, he said.

“Our homes have been built to the same consistent quality standards for years,” and the construction boom didn’t change that, he said.

The lawsuits, claiming negligent misrepresentation and fraud, ask Lennar to buy back the homes and pay damages. A trial date hasn’t been set.

Laborers, Plumbers, Electricians

Eleven analysts rate Lennar “buy” and nine “hold,” according to Bloomberg compilations. Their average fiscal 2011 earnings estimate is $114.5 million, or 77 cents a share. The company earned $95.3 million, or 51 cents a share, in fiscal 2010. The stock closed Feb. 9 at $20.85, up 18 cents, and has risen 34 percent in the past year.

A material defect is defined as one that would, among other things, affect a purchase decision or compromise safety. The boom produced so many because companies “just moved everybody up,” said Nick Gromicko, founder of the Boulder, Colorado-based International Association of Certified Home Inspectors.

“Laborers became plumbers,” Gromicko said, “and plumbers became electricians.”

During construction of townhouses in Portland, tempers boiled over when an inexperienced foreman pressed workers to get the job done faster, said Rich Vial of Vial Fotheringham LLP, who represented homeowners in a water damage suit that settled in 2007 for an undisclosed amount. Vial said workers left the foreman dangling by his toolstrap from a two-by-four one day.

Scaffolding Goes Up

“There’s no evidence that the quality declined” during the boom, said David Jaffe, a vice president at the National Association of Home Builders in Washington. “There was so much more building, so naturally you’re going to have more claims.”

U.S. builders imported more than 600 million pounds of Chinese drywall from 2004 to 2006, enough for 60,000 to 100,000 homes, according to the law firm Weinberg Wheeler Hudgins Gunn & Dial LLC, which has represented defendants in litigation. More than 7,000 homeowners in Florida, the Gulf of Mexico and other regions are plaintiffs in drywall lawsuits, according to Christopher Seeger, a lawyer at Seeger Weiss LLP in New York who has represented families who say fumes leeching from the drywall cause respiratory and other ailments.

The drywall was made with fly ash, a byproduct of coal- fired power plants that can break down into sulfide gases. The gases emit a rotten-egg smell, corrode wiring and blacken wall fixtures, according to the Consumer Product Safety Commission. In October, a federal judge endorsed a supplier’s plan to repair 300 homes in the first step toward a settlement of coordinated litigation against suppliers, builders and insurers.

‘On The Cusp’

Insurance and legal claims can result from seemingly small mistakes in installing windows or roofs. A 2007 study by University of Florida researchers found that 69 percent of 17,000 defect claims they reviewed related to moisture penetration. About 53 percent were because of poor workmanship, the researchers found.

“There’s a whole list of ways you can screw up the exterior of a building, even something as simple as the vent for a clothes dryer,” said Alan Mooney, president of Criterium Engineers, a home inspector in Portland, Maine.

Seattle hairdresser Quint Eby suspected routine repairs when scaffolding went up in 2008 at the McGuire building where he rented space for his salon. Then merchants got notices ordering them to vacate. The owner, Carpenter’s Tower LLC, told them the city had determined the building was unsafe, he said.

“I had to liquidate everything,” said Eby, 40, who now rents a chair at another salon. “Hairdressers started to leave and the business declined.”

Carpenter’s Tower settled a suit against St. Louis-based builder McCarthy Building Companies Inc. for an undisclosed amount last year, according to court documents. McCarthy spokeswoman Susan Garritano provided a statement that said terms were “mutually agreeable.” Exposed rods weren’t sealed properly with paint and grout, causing them to rust, said city planner Justad.

The Seattle tower may not be the last to be torn down because of defects, according to McCabe, the consultant.

“A lot of construction flaws slipped through the cracks,” he said. “We’re just on the cusp of it now.”

To contact the reporters on this story: Peter Robison in Seattle at robison@bloomberg.net; Kathleen M. Howley in Boston at kmhowley@bloomberg.net

To contact the editor responsible for this story: Gary Putka in Boston at gputka@bloomberg.net

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