Episode 104: Why We Don't Build Condos with Muhammad Alameldin (Incentives Series pt. 7)

Shane Phillips 0:05
Hello, this is the UCLA Housing Voice podcast, and I'm your host, Shane Phillips.
This is episode seven in our ongoing incentive series, supported by UCLA's Center for Incentive Design. Throughout this series, we'll be exploring the misalignment between what we say we want our policies and processes to achieve, the behaviors and outcomes they actually incentivize, and potential solutions.
Muhammad Alameldin is joining us this time to talk about his research on construction defect liability and its impact on condo development. Condos matter because they often offer a dramatically more affordable entry point to homeownership than single-family homes. Multifamily housing is the most affordable housing type in urban neighborhoods, and cities are in big trouble if the only multifamily anyone's able to build is rentals. Even in suburban areas, condos often are a better match for many households, including older people and people with mobility challenges for whom driving or stairs can be difficult, if not impossible. Owner-occupied multifamily housing has always been underrepresented in the US, but condo production has fallen off a cliff since the Great Recession, and if we're going to fix this problem, then we need to first understand what's causing it. Construction defect liability laws are not the only cause, but Muhammad makes a strong case for why they're an important piece of the puzzle, and I liked this topic as a transition between incentives in building codes and incentives around homeownership because it really touches on both. We'll have a few more homeownership episodes in the new year.
Before we get to the interview, some very exciting news. We have a Substack page. We created it for listeners to discuss and comment on each episode, and to ask questions of us and each other, and the first post just went live with this episode. You can find it at uclahousingvoice.substack.com. The first post shares a few logistics for our upcoming book club, and it'll be the best place to share your comments and questions about chapters one through four of Stuck. That said, you're always welcome to email me directly at shanephilips@ucla.edu. Expect to hear some of your feedback on the show, and the sooner you get it in, the better. Going forward, we'll be posting comment threads for the book club and regular research episodes on Substack, with the goal of having a more permanent and organized record of everything we learn from each other. I'll see some of you there, but nothing is changing if you just want to keep listening.
The Housing Voice podcast is a production of the UCLA Lewis Center for Regional Policy Studies, with production support from Claudia Bustamante, Brett Berndt, and Tiffany Lieu. You can reach me at shanephilips@ucla.edu or on BlueSky and LinkedIn. With that, let's get to our conversation with Muhammad Alameldin.
Muhammad Alameldin is Senior Policy Advisor at California YIMBY and a former researcher at the Turner Center for Housing Innovation, and he's with us today to talk about why we build so few condos in California and in much of the U.S. Muhammad, thanks for joining us, and welcome to the Housing Voice podcast.

Muhammad Alameldin 3:32
Thank you for having me, Shane. Big fan, excited to dig into this with you in a little bit.

Shane Phillips 3:35
We have a special guest co-host today, Minjee Kim. Minjee, you are a former guest, very early in the podcast, episode eight. You're also a UCLA professor now, and you were not at the time that we recorded that episode. Maybe you can tell us a little bit about what you've been up to and why we're having you co-host on this episode specifically.

Minjee Kim 3:59
Right. Well, thank you, Shane, for inviting me to co-host. I'm super excited and also feel very lucky that I was one of the early ones to record this podcast because given the lineup, I don't think I would have gotten the invitation at this point. So thank you for the invitation and for this opportunity. So yes, you're right that I wasn't at UCLA at the time of the recording. I was with Florida State University. Since July of last year, I joined the UCLA Urban Planning Department as an assistant professor in urban design and real estate development. Ever since joining, I've been mostly wrapping up projects, research projects that I have in Florida context, but also picking up some additional design and especially fire recovery related work in LA, which is still going on and is very new to me and exciting. I feel like I've been literally thrown into the fire and learning as I go. So it's been a wonderful experience. What brings me to this particular episode and this podcast is that being at FSU in 2021, there was the Surfside condo collapse incident or accident that happened. And that really sparked intense debates over condo regulation. And so I had some exposure and familiarity with the condo regulation in Florida. So that's one angle beyond of course, condo being more of an affordable form of home ownership. But more personally, I am personally on the market to buy a condo in the LA region. So I'm also like, I was excited to learn about the California condo laws and what would increase the production of affordable condos. So I'm interested and I'm here both personally and professionally. So yeah, very, very excited for this conversation.

Shane Phillips 5:49
Well, thank you again for joining us to co-host. Muhammad, before we get into the research, we always ask our guests to give us a tour of somewhere that they know, somewhere they've lived and want to share with our audience. This can be from a sort of housing urbanist perspective or just like, you know, some restaurants and the cool streets that you really like. Take it how you will. But where do you want to take us?

Muhammad Alameldin 6:13
I'm from Stockton, California. If you ever read the book Happy City, they go in depth of how the urban planning in Stockton was terrible and has led to the city being like the epicentered foreclosure crisis in 2008. And, you know, growing during that time and seeing how housing impacts everything, right? Like family structures, education, you name it. Housing is such a big determinant on people's health and wealth. And the reason why I ended up researching construction defect and condos in general is, you know, I finally, like you, Minjee, I was thinking about, oh, I could own a condo one day and that would be awesome. And I was looking at this condo complex that I wish I bought into when interest rates were low that I wasn't able to buy into because there was ongoing litigation and no one was really able to sell and few banks would lend for people to buy condos there. Which made me miss my opportunity to be a homeowner, but it's okay, I'm subleasing a rent-controlled unit in Oakland right now that I enjoy and yeah, just the housing journey every part of my life has led to my passion to pursue housing research and housing policy.

Shane Phillips 7:30
Yeah, I think that's a common type of story where some specific personal event brings you to it and then it kind of, you fall down the rabbit hole and become interested in all the other things that had nothing to do with your initial interest, but it just snowballs. So our series on misaligned incentives is continuing here. Thank you again to the Center for Incentive Design for supporting this series. And this week we're pivoting to a new kind of overarching topic in this series. The last several episodes were about problems with our building codes, but more broadly they were about how siloed agencies and institutions often lack the incentives to worry about issues that are outside their purviews. So we talked about how the US code update process often fails to estimate the cost of code changes in terms of affordability, livability, sustainability, things like that. And it even fails to estimate the impacts on health and safety really, despite that being the motivation behind many of these code updates. The result is building codes that require unnecessarily expensive, often poorly designed multifamily housing, so we end up producing more low density sprawl instead. That undermines health and safety by forcing people into longer car commutes, into more polluted communities, and into buildings where safe and accessible elevators are not provided, among other problems. Even more than the effects on affordability, which we spent a lot of time on of course, my biggest takeaway from those episodes really is that by requiring more stairs and larger elevators and other things all in the name of safety, we are almost certainly killing more people than we save, probably by orders of magnitude. That is not a conclusion I had in mind at the start of the series, but here we are. Our conversation with Muhammad will be the first of several episodes on misaligned incentives in home ownership. We're going to be exploring how policies that are nominally for homeowners benefit, maybe making their lives harder, making it more difficult to become a homeowner, or even closing the door on home ownership altogether, which I guess is really just what we heard from you, Muhammad. We're talking about a report written while Muhammad was working for our UC friends to the north, Berkeley's Turner Center. It's co-authored with Sarah Karlinski and is titled, Construction Defect Liability in California, How Reform Could Increase Affordable Home Ownership Opportunities. The fundamental problem that you're tackling in this study is that California, like most places in the US, builds very few condos as a share of its multifamily housing production. This stat is a little bit shocking, but by your count, Muhammad, just 3% of multifamily homes built in California from 2011 to 2021 were condos, and that compares to nearly 40% in Canada. There are many reasons for that disparity, and we're going to talk about a few, but one of them, and the focus of this conversation really today, is construction defect liability, which I'm going to let you define in a minute. I liked this as a transition episode in this incentive series because it calls back pretty clearly to our conversations about building code and construction quality, and it's yet another example of subjecting multifamily housing to very different standards than single family, which we talked about with Jesse Zwick in particular. And this might go without saying, but let me just give a few reasons we should care about how few condos we build in California and across the country. One is that as far as home ownership options go, condos are way more affordable than single family. In LA, San Francisco, and a few other counties that Muhammad and Sarah looked at, condo prices are 30 to 50% lower on average. That is literally hundreds of thousands of dollars cheaper. Because detached houses are so much more expensive, especially in more urban and walkable areas, if you want to become a homeowner in the US, then there's a very good chance you will have to decamp for the suburbs. That's perfectly good for you if that's your preference, but it is not for everyone, and people deserve alternatives, especially when urban condos come with a bunch of positive externalities for the environment, for public services, for health, economic growth, productivity, et cetera. So those are just a couple reasons. Anything you want to add to that, Muhammad, on why we should care about the supply of condos and the affordability of condos we're able to build, for that matter?

Muhammad Alameldin 11:55
That's a great question. So I think the lack of supply of condos that we're facing in the market, right? If only 3% of multifamily units, multifamily is defined as five plus units in a structure, if only 3% are for sale, I mean, that's 3,000 units just in California last year that were produced and we create more babies in two days than we built condos in the whole year. And this is going to lead to what I fear an even more economically segregated society, where the primary driver of wealth within the United States is through home ownership. And if people's options are either a single family home in the suburbs or maybe a small scale development, but most likely a single family home in cities, it's very difficult when rents are so high for people to save up money for a down deposit without assistance from their families. And intergenerational wealth is great, but a lot of people have been prevented to access that for so long and the numbers prove it, right? Like most people that live in condominiums are first time homeowners and are most likely people of color, right? That's what the data shows. And you can read this report by the Turner Center, which is the Home Ownership Ladder, which really defines how people become homeowners and how homeownership allows them to build themselves economically over a period of time. And it's slipping away for future generations of Californians, right? The median age for homeowners is about 49 years old in California. And if it becomes more and more difficult and less and less people have access, we need to find ways, especially with people that want to live in cities, to be able to live and grow in cities. And a big part of that is condominiums, Tenancies and Commons, co-ops, land trusts, I mean, you name it, any form of somehow some sort of ownership where you could stay somewhere is so vital to the longevity of cities.

Shane Phillips 14:04
Anything you wanted to add to that, Minjee?

Minjee Kim 14:06
Well, I do want to add that I feel so seen in this conversation. This is exactly me that you both are describing. The listeners can't see my face, but I'm smiling because I feel so seen. Suburbs are not for me. And I love the walking environment, the urban environment. I want to stay here. I want to raise my family here. But at the same time, single family homes in LA in general, but detached single family homes in urban LA and in Santa Monica, particularly, are over $3 million. And it is absolutely out of access for me. So I feel seen.

Shane Phillips 14:47
So Muhammad, tell us now about construction defect liability. I think it would be helpful maybe to start with like a 30 to 60 second explanation of what it is and why it makes building condos more unappealing here, more expensive here. And then maybe we can take a step back and walk through some of the laws and core decisions that got us to where we're at today.

Muhammad Alameldin 15:08
Yeah, definitely. So human beings have lived in cities for a long time, right? And you would think that in the last three to 5,000 years, we had something like condominiums. But we actually didn't until like the 50s and 60s. And I believe you covered this in a previous podcast, but you would see more co-op structures, more informal ownership. And what condominiums did is a condo is just an apartment for sale. It is many people owning different stakes within the same building. And this became more formalized in the post-World War II period. The issue is that when things go wrong, how do we hold people accountable? And that's like the core thing of like, what is construction defect liability? When construction defect liability, plain and simple, is in California, within a 10-year period, if you find certain defects, you could go after the builder. There's a right to repair process that's not really followed or well kept or utilized within the state of California. But you know, typically, it goes to the courts, insurance settles, money goes to different people. It might be enough for the repairs, it might not. But it's a way of which people are made whole if there are issues within the structure of something that they invested into as a home ownership option.

Shane Phillips 16:32
And what qualifies as a construction defect? What kinds of things are people, you know, finding as defects and suing over, that kind of thing?

Muhammad Alameldin 16:40
So the issue is that we don't have set standards of what is like quality and not quality construction. Like it's not clearly defined through DRE or the Department of Real Estate.

Shane Phillips 16:49
That's perfect territory for lawyers. That's exactly where they love to be.

Muhammad Alameldin 16:52
Oh, yeah. It gets even better, right? Because anyway, and we could talk about the lawyers in a bit, but it's not really defined. So like it could be like specks of paint being missing to like actual structural issues and everything in between. So like nail pops near the door frame, which are really common, or it could be severe stuff like you have severe water damage or you have like leaky windows. And the main issue here is that you have up to 10 years to pursue litigation. And we could talk about how construction defect affects all types of housing, but why it impacts condos mostly. But you know, you bring a whole bunch of people together for a lawsuit. And you know, litigation takes years. And a lot of the times when a settlement is reached, it's declined, so they could hopefully get more through the courts. And through the system where, you know, a building if you have a leaky window and you're not able to fix it for three years because you're dealing with litigation after a 10 year warranty period, the defects get worse, water has leaked into the home, and sometimes the homeowners aren't made whole. So really construction defect is like it is a system to hold people accountable if there are issues with the original construction of a unit.

Shane Phillips 18:13
Right. So it's typically to hold the developer, the contractor, or maybe the architects responsible.

Muhammad Alameldin 18:19
Architects, engineers, subcontractors, everyone. And it takes so many people to build a building. And sometimes it's kind of unfair on like who is actually held at the stake for defects to happen in construction because like maybe the subcontractor doesn't know. Like they did something with the window and they didn't know, but they find out like 13 years later that this was the wrong way to do this and it's like, oh no, I've built hundreds of units that had the same exact issue and now I'm learning how to mitigate that. And so, yeah, it's this really delayed feedback loop of how to improve quality in construction.

Shane Phillips 18:58
And can you tell us a little bit of the history of how we got here? Because you walk through this in the report, but it sounds like this started around the 70s or 80s when there was a lot of really shoddy construction happening and there were some court cases, there were some laws. We're just going to focus on California here, but I think the story is actually pretty similar in many states. But how did we get to this point?

Muhammad Alameldin 19:24
So what's really important is that through the time of which condos are being built and warranty systems are being established, the courts, they're hearing a whole bunch of cases on a whole bunch of issues before we had statute, which is later SB 800 in 2002, it was really up to the courts to decide like what does the warranty system look like. And for a time in California's history, it was sort of seen as like a used car. Like you buy a used car, buyer beware. You buy a used condo or you buy a condo, buyer beware. Whatever issues happen, it's your fault. Like you should have known better. And the courts later in the legislature said, well, that's not really fair. Like construction of homes, people don't really, it's much more complex than you would assume. And the state legislature passed in 1995, like a pre-litigation, a dispute resolution when confronting construction defect called the Calderon process. And the Calderon process worked pretty well, I would say, because when we're looking at the construction before the implementation of SB 800, like we saw a lot of condominiums being built, the reduction in condominium construction is not only because of construction defect liability, but it is a major factor. So the Calderon process existed, right? And then the California Supreme Court said, homeowners do not have the right to sue for construction defects had it not yet caused actual damage to other properties or parts of the home. And that was huge, right? Because what happened was, is that like the whole system was overturned. You know, it was very hazy. Like what can you sue when it, when it comes to condo construction, what's happening? And there was a reduction in buyer's trust when it came to condominiums, because it's like, if something goes wrong, who was held accountable for this construction? And at the same time, Canada was dealing with something called the leaky condo problem, which is Canadian designers really liked what we did in California when it came to designing buildings, and it wasn't meant for the landscape of Canada, and you're just having these giant leaks and these giant condominiums. And it's interesting because around the same time, Canada pursued a system led by its first like democratic socialist government that focused on condo deposits and construction defect litigation. And California pursued its own, which is through the Rights Repair Act and the system that we see now in SB 800. And as a person that pushes for policy, whenever we pass a law, we wait a few years and we revisit it and we try to fix it and make it better. California was dealing with the Great Recession and had other things to worry about. And we created this process for construction defect, and there wasn't an academic paper in 20-plus years reexamining its effects on the market. And that's what kind of led to the study where we found substantial evidence that one of the causes of the reduction of condominium construction in California is due to pending litigation. And we've created a system where any building, it's not if, it's when, will deal with construction defect litigation. And the whole building industry is scared to build condos in the California market.

Shane Phillips 22:55
Yeah, that's a, I think that's an important point that construction defect liability is important in part because every condo building is getting sued at that 10-year point. You know, I don't know if that's literally true, but it is functionally true. And so if every project is facing this threat and there's a lot of ambiguity about how costly it's going to be, you know, you have to ensure that upfront, essentially, as I understand it as a developer, and that's going to increase the cost of development and just, you know, uncertainty more broadly. We'll get more into that, but you brought up the Right to Repair Act, which is a 2002 state law that was shortly on the heels of that California Supreme Court decision where they said you basically can't sue over this stuff. Can you explain what the Right to Repair Act did or intended to do at least?

Muhammad Alameldin 23:48
The Right to Repair Act was, oh, you find problems within your home? The developer must come in and address those issues and repair. But when people pursue litigation, they're in hopes of pursuing a settlement. And what happens is that the builder will come into the home and the homeowner doesn't say anything. They don't say what are the problems in the home, they don't disclose any information, and they're taught this by their attorneys, so the developer isn't able to do any repairs on the housing unit, so then they could pursue litigation. And it happens over and over again. It's like there isn't a clear-cut process of these are the things that need to be repaired. Please repair them so we don't pursue litigation. It's more like do not disclose anything you don't have to disclose. We will pursue litigation because plaintiff attorneys, so people that are pursuing the sort of litigation, they operate on spec, which means that they get a percentage of basically the settlement when it's determined. The percentage of the settlement or what the court determines what must be the settlement for that construction or for defects.

Shane Phillips 24:59
It's like on contingency, right? Like you're not going to charge the HOA anything for the lawsuit, but if you win and you're going to win something, then you're going to get a share, probably a pretty large share of that settlement.

Muhammad Alameldin 25:13
30 to 40 percent. And the HOA cannot deny pursuing the lawsuit because they are held to a legal standard that if someone comes and says, hey, I could sue for these defects for you and the HOA says no, then they are held accountable for not pursuing litigation. And these HOA boards are like groups of, you know, they're just like residents, like they're not lawyers. A lot of them aren't lawyers. Like they don't know. They don't want to fight it. They're like, you're saying that you could get us a whole bunch of money for these problems that we find in the building? Yeah, go for it. I don't want to be held liable for anything. And so we've created the system where litigation is just part of the process.

Minjee Kim 25:48
I was actually baffled by that clause, even if there was no actual property damage. Like what does that mean in practice?

Muhammad Alameldin 25:56
So it could be something that could predict to cause damages in the future, right? Like maybe the windows aren't lined as accurately as they should be or sealed as well as they should be. Maybe there's some issues in the foundation. Maybe there's some cracks in the sidewalks near the construction. So that could lead to questions when it comes to the foundation. Sort of like that.

Minjee Kim 26:23
Okay. Well, thank you for explaining because that was just baffling to me. I think the other point that you were going to get to in the end was the reason why condos are disproportionately affected, have been disproportionately affected by the 2002 Right to Repair Act. Because if my understanding is correct, the act actually applies to all new housing construction, right? But what you're saying is that because condo projects are more complex, they're subject to different building standards, they're more likely to organize than single family homeowners. And those are some of the reasons why condos have been more subject to or have been disproportionately negatively affected by the act. And I just wanted to make sure that if I got that correct, did I miss anything?

Muhammad Alameldin 27:08
And I'd like to explain this a little bit more in detail. So when a single family home was built, there's an HOA, there might not be an HOA. It's just a clear subdivision where many homes are built. And number one, easiest thing to build, by far. Building a single family home, as you know, through the building codes, through financing, through zoning. I mean, the labor standards that you have, it's not going to be union labor, it's like the most cost effective thing to build. And it leads to the most profit, which is very important when people build missing middle housing duplexes, tenplexes, it's like, if people make more money building a single family home, they're going to build a single family home, right? It's those incentives. When it comes to construction defect liability, someone builds the single family home, you don't have 100 homeowners that are upset, that are organized within an HOA or the centralized system to reach everyone, right? It's only one homeowner, then maybe another one, then maybe another one.

Shane Phillips 28:09
Right. You might have a situation where the exact same construction defect appears in all 100 homes in a subdivision development. But it's probably more common that just maybe contractors screw up on a few. And you compare that to a condo where if you screw up some key electrical system, the foundation, whatever, that's actually affecting the whole building in a much more dramatic way. So just like the cost of these defects can be much greater, in addition to already having this kind of like built in organization.

Muhammad Alameldin 28:44
Exactly. Exactly. And when it comes to this plethora of single family homes, it doesn't mean construction defect litigation doesn't happen. It does happen. It's a little harder to organize, but it's possible, right? Like it's the same builder, like let's say it's KB or Lenar or something, you know, there's a new subdivision, you could go and ask homeowners, like it's a little bit more groundwork. When it comes to condominiums, it's like you just go to the HOA and they'll tell you all the issues because they've all been there. Another reason why condos are disproportionately affected by this is because the profits from single family home construction make it more worth it. It just does. Like if I am going to make $200,000 more a unit building this, I could deal with the litigation. Like that's fine. But if I'm building condos, which I have to deal with the discretionary approval process, I have to deal with utilities, I have to deal with neighbors, the tax system incentivizes more rental than for sale, more complex building codes, I'm going to deal with the unions, so there's so much more that you have to do if you're going to build a for sale product in a city than even a rental, which a rental has a lot of issues. That's what a lot of reforms are focused on. But if you're going to build for home ownership, like you might in LA have to widen the street, right? Like a rental unit still have to widen streets in LA, but for sale units do and municipalities in LA. The offsite improvements when it comes to upgrading all the lighting on the street, which you don't have to do as a rental. Like there's just all these things that eat up this incentive for builders to want to build for sale, they just opt for rentals.

Minjee Kim 30:27
And reflecting from Florida's, my understanding of Florida's condo market, I think the issue with the Surfside building and some of the older condo buildings in Florida was the collective action problem that is perpetual in any condo building, right? So property owners could defer, I guess, the upkeep and the repair of condo buildings and thus lead more to construction defects as opposed to rental buildings are professionally managed. The repairs do get addressed in time. So that could also explain some of the discrepancy between multifamily ownership versus rental buildings.

Muhammad Alameldin 31:09
Yes. And Florida's interesting because their HOA reserve system was so terrible when they had this condo boom compared to California's. You could say a lot about California, but the HOA structures and how money is reserved and how like buildings are maintained is held at such a higher standard. Everybody looks at Florida and they say, oh, this is why we can't reform construction defect liability because we're going to end up like Florida. And it's like, no, Hawaii has a great system as well that might be changing Canada, British Columbia or Ontario have great systems as well. Actually, the whole world has a very established system of how to pursue warranties when it comes to new home construction, when it comes to for sale multifamily, but we refuse to look at those systems that have already been established because we think that we have the best solution and we have the best consumer protections. And it's kind of biting us in the ass. Like we're not building new condos in California and it's going to have huge societal effects. And we could look at like Australia, we could look at Singapore. We could look at and we could learn from other places, but we just refused to.

Shane Phillips 32:26
Yeah. This idea that, you know, we can do it better and we're not going to learn from other countries that are already doing pretty well on things that we are not is a pretty pervasive and again, a common theme from the last few episodes talking about building codes as well. I can't remember, Muhammad, if your report gave any specific numbers on this. I don't think it did, but I've heard that ensuring a condo project against this liability can add one to 2% to development costs, give or take. I know every little bit counts and developers are not just considering whether or not a condo project will pencil out financially, but also whether they'll earn a bigger profit from building apartments or single family homes instead. But even so, one to 2% does not sound like that much for how much attention I feel like construction defect liability reform gets. So what am I missing in that evaluation or in that assessment? Jumping in here with a post-interview addendum, we recorded this conversation a few months ago before a new Turner Center report was published comparing the costs of construction defect liability for multifamily condo and rental projects built in California. They estimate that liability insurance and related costs can add anywhere between 1.9 and 4.4% of hard costs and hard costs, which are materials and labor, account for well over half of total project costs. For a typical development in Los Angeles, that works out to between $8,000 and $18,000 per unit. We've added a link to the report in our show notes. Back to the interview.

Muhammad Alameldin 34:07
That's a future paper that I hope gets published soon, is where we look into the financial analysis. But one to 2%, it's just a line on a pro forma spreadsheet and it's a very macro analysis. But when you dig into the details, what we see is that architects and engineers have to have a much different insurance coverage for for sale units versus rentals. And ask any architect, ask any engineer, hey, do you build for sale? And most of them will say, no, I'm not risking that. And that's too expensive for me to maintain for my practice. So you lose a lot of practitioners within the industry.

Shane Phillips 34:47
And presumably the ones who are doing the work are going to charge a premium, which is going to carry through the whole project.

Muhammad Alameldin 34:53
Exactly. So that one to 2% is just like the increased cost to insurance. And that could go up to like 5% of a construction project when it comes to hard costs, which isn't a small number, right? Impact fees could be like one to 3% of construction costs sometimes, maybe even more, but it's seen as a barrier because of financial feasibility. Same thing with construction defects. The biggest demotivator is litigation. General contractors will not purchase this insurance and will not deal with this product because they do not want to be called in 10 years later to stay in a courtroom for two years or more. And subcontractors, it's the same thing and subcontractors, they already lack worker protections in general, but now they might be financially liable for defects that they may have caused in the past. Like there's this thing called indemnity clauses within contracts between GCs and subcontractors, and it transfers a significant financial risk from GCs to subcontractors for the financial payout if insurance doesn't cover enough. So even if you're a general contractor and you're trying to protect yourself with a contract, it goes to the subs and the subs have way less money and they're not going to deal with this either. So the whole litigation system when it comes to construction defect is the biggest demotivator to wanting to build a for sale product when you can build a rental product. And your construction warranty for a rental is four years.

Shane Phillips 36:26
Right, which does not make any sense why it would be different, but here we are.

Muhammad Alameldin 36:33
And you have onsite maintenance and you're watching over the building constantly so you know if there's any defects that arise.

Shane Phillips 36:38
Yeah, yeah. Again, this is an incentive problem to some extent where if you are a homeowner in a condo member of an HOA and you observe these defects and you're going to wait until the end of that 10 year period and then just put everything on the list and sue for as much as you possibly can or get the largest possible settlement. But you've potentially put up with some inconveniences. Maybe the damage or defects you've observed during that time have gotten worse because you haven't fixed them. These are things that as the homeowner who's eventually going to profit from that settlement you might be willing to put up with. But as a apartment owner, that's just a liability for you that you're going to have to pay for. And even if you're thinking ahead and okay, we're still going to be able to sue the developer and get a bunch of money. You have tenants living in these units who are not going to be happy to be dealing with these problems and they're not going to see any profit from it. And so you kind of can't put that on them in the same way as a homeowner might be willing to put it on themselves. So I think there's just much less incentive for a rental owner to let these problems fester for a new building. Exactly. Another thing that does come up in the report, Muhammad, is how the threat of these lawsuits, the cost of these lawsuits and the upfront costs probably disproportionately hurts lower costs, kind of lower frills condo projects where you have a situation with similar insurance costs against a smaller sales price. And so it's going to sort of push things toward more luxury condos, fewer low HOA costs, maintenance fee costs, simpler buildings. And that seems like its own problem where in a way it's amazing that the condos we do have are still so much more affordable on average than detached single family homes. Because I think the condos we're getting are actually kind of gold-plated relative to maybe what developers would be willing to build if they didn't have to face this additional cost and risk.

Minjee Kim 38:42
And I can also share that a very similar dynamic is playing out after Surfside in Florida. So to your earlier point, Muhammad, about the reserve requirement in Florida, there was a couple of Senate bills that passed. One was actually about homeowners association and strengthening that process. And then the other one was about like structural inspections and then mandating financial reserves, sufficient financial reserve funds for structural issues. So these two new bills created for safety concerns, obviously, will real estate professionals in Florida are projecting that these will have disproportionate impact on the older condos that are owned and occupied by low income owners, because those are the buildings that are likely to have waived reserves funds already. And that they are now having to do structural inspections and then are asked to have sufficient funds, which they currently don't maintain. And so there are projections that already developers are buying up older condos for redeveloping them into more of the luxury condos where the homeowners do have the sufficient financial means to support a greater pool of reserves as well as pay HOA fees. So, you know, although the safety concerns and the need to maintain a healthy reserve is an important goal, there's also the unintended consequences on the lower income households.

Muhammad Alameldin 40:07
So this is interesting because I think Florida and California are just like complete opposites of the spectrum here. As with a lot of things, there are other reasons why people are opting more for like luxury condominiums. It's the tax system. If within a capital stack of development, there's debt and equity. And if you invest into a for sale product on the equity side, you get taxed double the rate than if it was for a rental. So that means that you have to show double the returns on building a for sale product rather than a rental product. And this is due to some regulations with the CFPB around like 2012. So that's one reason why we're seeing like this shift to luxury condos in Florida and California and California especially the condominiums are being built are going to be in like downtown San Francisco, downtown LA. The other point here is that the effects on lower income people when it comes to condominium construction is really interesting because Florida has the exact opposite problem where in California, in a healthy condo market, there would be this sort of like, not as high of an appreciation for older condominiums, especially when HOA dues go up to maintain the structure. And the new condos that come in might have a higher price point but a lower HOA. So you have this healthy market of which like people are purchasing condos, people are selling condos, there's condos available. In California now, you will have high housing prices because we haven't been building condos and we haven't been building a lot of housing units and a high HOA and then that prevents lower to moderate income people that want to be homeowners into purchasing entry level homeownership options. I think these two extremes can meet somewhere in the middle. I know I'm complaining about the construction defect system, but I do think homeowners deserve protections and rights, but not at the detriment of condominium construction. And we can't do Florida where it's like, we're going to build a whole bunch of condos by not having a lot of regulations, not just construction defect, but on pretty much everything. I mean, no inspectors when it comes to structural, but anyway, that was wild. There is a happy medium and that's why we did this multi-state analysis. And my personal recommendation is what they have in Hawaii.

Shane Phillips 42:37
Yeah, and we will get to that. But before we do, one other thing that stood out to me in your report is how many condos were being built in California before the great recession and how little they've recovered since then. San Diego County in particular stands out with about 7,000 condo starts in both 2005 and 2006, which is about four times as many new units per capita as LA and Orange County were building in those years. But since 2008, San Diego hasn't started even 1,000 units in any year. That's from 7,000 in its peak years before the great recession. It's just seen a huge decline with no sign of recovery and it's not all that unique in California in that respect. Obviously there were a lot of things going on before the housing crash in 2007, 2008, but what's the story you tell yourself about that shift? I don't think the construction defect liability regulations were all that different back then. The last one, the last big one anyway, passed in 2002. And that suggests to me that this is not the main culprit behind California's really abysmal condo construction numbers. So what's your thought on that or what else do you think is going on here?

Muhammad Alameldin 43:48
So the interesting thing here is that you can look at the construction numbers and you're looking and you're like, well, condo construction didn't reduce from 2002. So it can't be construction defect, but construction defect litigation happens around year eight. So it passed 2002. So the numbers in 2010 reflect really early on what's going on in the condo market. And then a later time you're going to see what are the long-term effects of the law.

Shane Phillips 44:21
And it was probably many of the developers in 2002, three, four, knew about the Right to Repair Act and thought like, oh, this problem seems to be solved. And so we can go forward and build. And it wasn't until the 10 years starts coming up, which I mean, you say around 2010, but projects that are being built in, we're looking at housing starts in 2002, three, four, five. They're not going to be done for several years after that. So we're talking a lot of these are not going to really start to see the problems until, or at least, you know, get the letter about the lawsuit until 2014, 15, 17. So it's a more recent issue in some ways.

Muhammad Alameldin 44:59
Yeah, definitely. And the elephant in the room is the Great Recession. We had the Great Recession in the middle. Like I'm sure you started your construction in 2002, you completed in 2007, and then boom, the housing crash. And a lot of people just like, you know, a lot of general contractors just decided to retire. A lot of people just lost their shirts during the whole Great Recession. Home building didn't really, it never came back since then. infrastructure isn't the same amount of companies. I mean, I wish I had better data. And that's the big thing is better data. Because the amount of small builders in the US, according to Zonda, reduced by 80% between now and like 2006. So there's an 80% reduction of the amount of small builders across the country. And small builders become medium sized builders that become bigger builders that build condo projects. So we across the board, there's just a reduction in the construction market. I do think that a major contributor of why we're not seeing condos being developed is construction defect liability. This is based on the interviews that we conducted on this paper. It's shown through the quant data, because we're still seeing rentals being built in California. But right, like, why aren't there more condominiums? And we've seen like Canada's market really come back after the Great Recession. Right. And it's mostly for sale. So like, I do think it's a major contributing factor.

Minjee Kim 46:25
I was thinking exactly the same thing when I was reading through the report that the Right to Repair Act, which seemed to have had most impact on condo construction, you know, was already signed into law in 2002. But then we're not, we still see an increase in condo construction before the Great Recessions. I was wondering, you know, is it really the reason why condo construction plummeted? But Mohammed, having heard your explanation, it makes a lot more sense now that you know, you're having the understanding of the time lag it takes between, you know, construction starts and the litigations that actually materialized during and after the Great Recession. But I do think that there's also the point that you just mentioned, that's really important. And sorry, so earlier, you did mention the tax policy favor in rental projects, which is also another reason, you know, partially explaining the lack of preference towards rental products. But I do think that what you mentioned just now about the lack of small builders and how that associates with condo construction is also a very interesting angle to look at. I mean, knowing the development industry, it's a very specialized market, right? Like there's single family home builders, there's luxury apartment home builders, there's, you know, like high rise condo builders, there's not a lot of developers that run the gamut of different building product types. So I was thinking, you know, as I was reading through the report, maybe there's an entire, you know, really interesting real estate history to be told here that the entire condo ecosystem from, you know, general contractors, developers, bankers, and insurers who were just decimated after the Great Recession and never recovered to its previous sort of healthy ecosystem. And how that differs from multifamily rental projects would be an interesting angle and another way of explaining the lack of condo construction.

Shane Phillips 48:16
Yeah. And I don't think, I don't think anyone's saying that construction defect liability is the only problem here. It's a contributor. I think one interesting thing about it in particular, though, is that it's something where every state's kind of doing its own thing. And there's a wide range of approaches you can take. And correspondingly, there's a wide range of success and failure on how many condos are being built in different places and at what price points. So you know, for local and state jurisdictions, I think the fact that they actually have control over this in a way that, you know, federal tax policy, that's just like not something that state officials can do on their own. This is something that we can do. And as you said, Muhammad, I think the impact of it is bigger than most of us appreciate or you can even really tell from looking at just the pro forma for a project. I know we're running out of time here, so I want to move on and really talk about solutions here, because we want that to be an emphasis in this incentive series in particular. In your report for inspiration, you look at Canada and at four other U.S. states, Minnesota, Utah, New Jersey, and Hawaii. What are the main lessons you draw from these places? I think it might be helpful to start in Minnesota because their solution seems the simplest in some ways, probably not enough to solve the problem all on its own, but maybe a good starting point, then we can get into some of the more interventionist programs you find in New Jersey and Canada in particular, which seem to really tackle some of the bad incentives and market failure issues that we're seeing.

Muhammad Alameldin 49:48
So this is what's interesting. I wish I could rewrite the recommendations in this paper, because the more we look at it, the more I'm learning, right? Because people have been calling me, I've been working with more lawyers, I've been more insurance adjusters, I've learned so much. And there are some simple things that we saw Minnesota do, which is adjusting the timelines of when certain things could be litigated, and making the major construction defects at the end of a 10-year period, and having a period of mediation. We see the tail end of how long it takes to see how many construction starts happen due to this change in the defect system is telling. We haven't seen that much change in Minnesota. So the comparative analysis here is like, who is actually trying to address this issue and what have they pursued?

Shane Phillips 50:41
And then what have the results been in terms of production? You know, okay, you passed a law, but did it actually result in more condo construction?

Muhammad Alameldin 50:48
Exactly. And right, like Minnesota, we weren't able to really see those numbers. Utah just went more towards the lane of Florida, where it's like lower years of statute of which you could pursue litigation to like six years, there's no right to repair law. If you buy a used product, it's on your due diligence. These are just more extreme reforms from Utah. New Jersey has a warranty system, which is very similar to Canada, where when you produce new construction, every developer puts this money into a pool. And then when you have an issue or something that needs to be repaired, you kind of submit it to the warranty program, and they send you the money to do the repair.

Shane Phillips 51:32
So you're avoiding the whole legal process, it sounds like. Yes. You're not suing. You're not suing someone, and that seems on its own to be a big deal. On its face, it does not seem obvious that going through some kind of formal program or arbitration as opposed to a lawsuit would make a big difference, but I kind of gather it really does.

Muhammad Alameldin 51:56
Yeah. The more repairs can be done and the less litigation that occurs is how we solve the construction defect issue while still protecting homeowners. And my main critique of my own previous paper is that we should have looked at more ways of which we could prevent litigation. And I will tell you three main reforms that I think would work.

Shane Phillips 52:20
This is why people listen to the podcast. They're getting the material you can't get from the report itself.

Minjee Kim 52:25
I know, now is the chance.

Muhammad Alameldin 52:28
Number one, the HOA conducts an inspection, which could be paid for by the developer or by the HOA reserves, of any problems that happen within a building every year. And they send it to the developer and the developer goes and fixes it. What's the benefit here is that when it happens to year nine and they go and sue for a whole bunch of damages, where was the history of this in the last eight or nine years in your reports? Like we came in and fixed it each time. So people don't abuse this sort of warranty system that was meant to protect homeowners and at the same time ensure that developers and insurers aren't taken advantage of. So that's number one. Number two, federal courts have this system, and I think the state of Texas has it too, where let's say insurance offers, because it's usually insurance payouts, right? Insurance offers double the settlement amount or triple the settlement amount that it takes to do all the repairs. But the plaintiff wants to pursue litigation still. If at the end of that period you go through the courts and it's less than the settlement amount proposed, then the plaintiff must pay for the legal fees for the defense. How is that beneficial? What happens is that the insurers are going to offer a much larger amount of money to the homeowners on the onset because they know that will prevent litigation and the homeowners know that's enough for them to address all of their concerns when it comes to their homes. So that prevents excessive litigation, right? The homeowners are made whole on year one because insurance is like, look, I'm so sorry for your issues, we're going to offer you double what it takes to repair your home. Are we fine here? And they'll say, yeah, but there's less lawyers or plaintiffs that want to pursue that litigation because they get much less of a payout when it comes to a settlement. It's kind of fun being an advocate. I used to be a researcher. I can't say these things and now I can actually say it. Number three is twofold. Number one, HOA is not legally responsible for defects or for not pursuing litigation. We shouldn't have the system where HOAs feel forced to sue unless they want to. Number two, the Department of Real Estate could develop their own objective performance standards for single family and multifamily home ownership through like administrative rulemaking. Canada has this set of standards where it says the masonry wall or veneer cladding cracks in excess of three millimeters in width are not acceptable. It's a very clear, like the executive branch, the DRE is going to set the standards of what is acceptable and what is not acceptable for a new build or within a 10-year period. And that leads to much less of the back and forth where both sides bring in some random expert to back their case. We have clear standards of what's acceptable, what's not, and that's really helped Canada's version and that doesn't require litigation. It just requires DRE to empower themselves through objective performance standards.

Shane Phillips 55:49
Yeah. Rather than having people basically just argue over whether, you know, four millimeters qualifies as a defect or three or two, you know, there's some right answer to some extent, but none of the parties involved in that debate are actually incentivized to come to the right answer. They want the answer that favors them. Again, this comes back to some of the conversations from our earlier episodes because we talked a lot about how, you know, the International Code Council here in the US is this volunteer organization. The decisions are all voted on by public officials who just kind of go along with the recommendations of industry and actual, you know, fire departments and so forth. And in Europe, they actually just have professional government employees who research and write the code based on estimates of cost and benefits and balancing concerns about affordability and livability and so on. It sounds like we could do something similar here. In fact, if we had a better building code, we might have a better sense of what qualifies as a construction defect and not do these two things are actually very closely related, I think.

Muhammad Alameldin 57:04
Oh, yeah, they are. One of my hobbies is the building codes and it's like we don't really check for quality and safety with building codes. It's totally vibe based and it's based on random people putting in suggestions and it's like, no, we have some of the best research institutions in the world and we have some of the best thinkers. Like, I just think, you know, I'm not going to go too much into the USA, USA kind of thing. But like we have competent people that could do this stuff instead of whatever systems we established 100 years ago, right?

Shane Phillips 57:33
Yeah. Well, and the International Code Council is like 30 years old too. It's not even a longstanding organization. So I think we've probably covered enough on construction defect liability. But as you said, I know you've been thinking about this, talking to a lot of people about homeownership and condos over the past year or so since this report came out. We've touched on a few things, but tell us what else you think should be a priority independent of construction defect liability reform. What else should we be doing at the local level, at the state level, at the federal level to build more condos, to reduce the cost of them, but still make sure that they're quality and that homeowners are not going to be taken advantage of?

Muhammad Alameldin 58:18
How to fix the condo market. You have three minutes. Yeah, I know, right? I do want to say one thing about construction defect. And by the way, the dirty word is condo defect. No one calls it condo defect. If you write something and you call it condo defect, I know you haven't actually read legislative text, it's construction defect. So let's put that out in the air. I'm happy you both have kept to that wordage.

Shane Phillips 58:43
I was worried. I was not sure if I actually had, but I'm glad to hear I didn't screw up. I'm pretty sure I used to call it condo defect in the past before I learned a little more.

Muhammad Alameldin 58:55
Yeah. It's my biggest pet peeve because it's like, okay, you have a group of single family homes and maybe like three of them have this construction defect and they sue over the hundred homes, those same defects that are found in the same three. Like single family homes have an issue here too. And then I also wanted to say, I know this is just random, you can put this wherever you want. A lot of missing middle housing developers that build for sale ensure that HOAs are like very low and they're not well structured or banded together just to avoid the construction defect claims. Like they try to keep it under 30 units. And we also didn't discuss how construction defect killed the co-op. You cannot build co-ops because even if the people that want to establish a co-op go to a GC and say, hey, we want a new co-op, we want to build a co-op, they deal with the same construction defect litigation, the GC, the subcontractors, the co-op owners, because they're seen as a developer. So if you think why are there not new co-ops in California are not rising as often as I can imagine, or why are community land trusts mostly like single family homes and not multifamily when it's new construction, it all goes back to construction defect liability.

Shane Phillips 1:00:07
So the co-op owners themselves are the developer in this situation and so they like sue themselves? There's no one to sue, I guess? Yeah. There's just- And so if there's problems, they're just kind of like stuck with it on their own?

Muhammad Alameldin 1:00:20
What I know is, and this is like anecdotal, right? This is why it's not in the paper, but I talked to like two different people about it. The GC just won't even touch it. They're like, it's for sale, I'm not going to touch it if it's units that touch each other that aren't like townhomes. And then it's like, yeah, who is held accountable when it comes to these construction defect claims? If the co-op is a developer and then they find defects later, you have a whole co-op suing a GC, it just gets messy. Like there needs to be some sort of like stratified system for construction defect. How else to fix the condo market, and I'm sorry, we're a little over time. The tax system is the most important thing. There was this push in the big, beautiful bill to reform the tax system for for sale units where if you're investing into for sale, instead of getting taxed at ordinary income, you're taxed at capital gains, which is what happens when you invest in rentals. You invest in rentals, the rentals held for a year, you get taxed at capital gains. That's like a 20% difference. It really messes up with the pro forma numbers. Most equity firms won't even invest in for sale because the people that they take money from don't want to deal with a bigger tax burden, even if the returns make it worth it. I don't know. I guess Trump heard this and was like, no capital gains on any home sold. And it's like, no, no, no, that's like a much worse problem. That makes the problem way worse. Just equalize the tax system here. Two, you already discussed building codes. Number three is how we finance condominium construction. It's not just the tax code. It's also the deposit structure. So if you go anywhere in the world and I'll use Egypt as an example, but you could even just go to Mexico, you could go to Canada. If you want to buy a new home, you could go to a realtor or you could go to a developer and you give them 5% at signing, 5% when foundation is laid and 10% when construction is complete and you put a deposit on a new home. It's very common in Europe too. And what happens there is that the capital stack for the developer becomes bank debt, but also the deposits from the prospective home buyers. And we limited this to like 3% of the home purchase price of what's returnable to the home buyer. But because there wasn't really a great system on protecting prospective home buyers, but we have this thing called computers and we have bonds and what a lot of other countries do is you put down a home deposit. It gets bonded if the developer has enough experience because bonds are very risk averse. And if you want to back out at any time, you could just sell your deposit to someone else and someone else could fill in. Some people even sell it for a profit because the market changes. And the developer gets the benefit because they get a bank loan and they get a bonded deposit that they could keep at escrow and they could pull it out when it comes to construction and they don't have to pay out equity partners.

Shane Phillips 1:03:26
Rather than using more equity, which has a high return on investment requirement. And so basically the less equity you can have in your project, or at least equity that expects a return and replacing as much of that with deposits as possible is going to reduce the total development cost for you.

Muhammad Alameldin 1:03:44
Exactly. And banks seeing these higher deposits will give you higher loans as well. So it really benefits twofold because it makes building condos a much less risky product. And it's all about incentives, right? I'm building single-family homes and I'm dealing with the lawsuits because I'm making this much money. If we change the condo deposit system within California to something similar to Hawaii or to British Columbia or Singapore, Australia, Mexico, etc. We will solve this issue where we have 10 people bidding for like a 2-1 in Berkeley and raising the price from $1.2 million to $1.7 million. You have it where 10 people could each put down a deposit for a new home and they get to buy this home for let's say $1 million, which is already a lower price because the developer will give a discount on the new construction because you put this investment that's going to hold for like a few years until construction is done.

Shane Phillips 1:04:42
So just to be clear, the existing system, you only have to, or you only can put a 3% maximum 3% deposit?

Muhammad Alameldin 1:04:51
Yes, that's the amount that's non-returnable. So the issue is that people could put down 3% and they're like, huh, I don't need it.

Shane Phillips 1:05:00
It's a small enough amount that you can walk away and now the developer has no one in line to buy this unit and that's a real problem.

Muhammad Alameldin 1:05:08
Yeah, the buyer doesn't have skin in the game and financial institutions like banks will be like, it's only a 3% deposit, why would we invest more into this? And it's not enough to help with construction costs. And the thing about condo deposits is people are very worried about what happens to the respective home buyer if the developer goes under, right? Number one, for a bond to cover deposits for you to even use deposits for construction, their standard is higher than anything you can imagine. Like you have to be like a developer with a GC that's been on time for 20 projects. Like you have to show that you were able to do this. Number two, insurance is required to cover the bond, at least in the British-Columbian system and you get your deposit back within 30 days, 30 to 60 days. Number three, as an added protection, you have an agreement with the developer on the timeline of when this is complete. And if that agreement is breached or delayed, you could ask for your money at any point and insurance will pay you out that money. So you could sell it, you could get the money back whenever you want. Like people have figured out the system. Just California is so risk adverse that it comes to our detriment that we don't see new housing supply or new options for home ownership. And I think it's like condo deposits are the investment for new homes and construction defect liability is the protections of these new homes later. And those are the two main reforms that California could tackle next year.

Shane Phillips 1:06:36
Hmm. Yeah. That's an interesting way of looking at it. So it's essentially deposits are the pre-construction policy where we're a little too overprotective and construction defect liability is the post-construction policy where we're a little too protective and both of them are making it more expensive, more risky to build condos. Exactly. I like that as a closing point. So Muhammad Alameldin, thank you for joining us on the Housing Voice podcast.

Muhammad Alameldin 1:07:03
Thank you so much, Shane and Minjee for having me and it was great meeting you, Minjee.

Shane Phillips 1:07:08
And Minjee Kim, thank you for coming on the Housing Voice podcast again as a co-host.

Minjee Kim 1:07:12
Thank you so much. I really enjoyed the conversation and thank you Muhammad for contributing your research to the Housing Voice podcast. Thank you.

Shane Phillips 1:07:24
You can find our show notes and a transcript of the episode on our website, lewis.ucla.edu. You can talk with us and other listeners at uclahousingvoice.substack.com. The UCLA Lewis Center is on the socials, and I'm on Bluesky and LinkedIn @shanedphillips. Thanks for listening, we'll see you next time.