A history of rare payouts and narrow policy language has builders looking more closely at their options for long-term warranty coverage. By Rich Binsacca

The perfect house has yet to be built and never will be. Even Philip Russell, a custom builder in Pensacola, Fla., who spends about $500 a year in callbacks on $5 million worth of projects and has never had a complaint filed against him with the Better Business Bureau in 23 years, admits that. So do the vast majority of his builder peers, regardless of volume, target market, location, or snappy marketing slogans.

How to protect the less-than-perfect house, however, is a question that leads to far more discord within the housing industry. At least a third or more builders purchase insurance-backed, 10-year structural warranties to provide some backup; others rely on a self-administered, one- or two-year express warranty. Some, like Russell, do nothing at all beyond the implied warranty established by each state's case law history. "My word is my warranty," says Russell.

Without a doubt, however, an increasing number of builders are being forced to confront issues related to housing quality and long-term performance. Hypersensitive homeowners with unrealistic (and un-checked) expectations, defect litigation, rising callback costs, and a shrinking pool of skilled construction labor all have contributed to confounding and often confrontational circumstances between buyers, builders, and attorneys.

Where to turn?

Are insurance-backed structural warranties the place to turn for protection? That industry, of course, supports its corner of the warranty shelter. But builders--even those enrolled in such programs--are less convinced. "I don't believe in them," says Ron Barney, vice president of Trend Homes, a 900-unit builder in Chandler, Ariz. "It's an appeasement to homeowners that really doesn't do anything for them. I have a problem wasting money like that."

Photo: Jonathan Barkat

The common builder refrain against insurance-backed, 10-year structural warranties is that their narrow and vague policy language excludes most homeowner claims or common residential construction problems, from drywall cracks and nail pops to more severe issues of foundation fissures and beetle-infested framing. In fact, the warranty industry pays claims on only about 1 percent of the homes covered by such policies. "They're in the business of collecting fees and not paying claims," says Jack Dorwart, manager of Holladay Group in Lakewood, Colo., which will close about 40 homes this year--all with insurance-backed, 10-year warranties to pacify buyers. "For the types of things a homeowner wants [covered], there's always an excuse [to deny the claim]."

Even those in the industry admit their policies are limited. "Most construction defect lawsuits don't fall under warranty protection," says Wallace "Em" Fluhr, CEO of 2-10 Home Buyers Warranty (HBW) in Atlanta, which leads the industry with a 22-year history and more than a million homes currently enrolled.

According to Fluhr, HBW's policy language specifies that a building has to be structurally unsafe, unsanitary, or unlivable, as determined by the Code of Federal Regulations, to qualify for coverage. "If you read the warranty, the home almost has to be uninhabitable for [the policy] to kick in," says Dorwart.

What's the option?

Even if only one new house per hundred enrolled each year is lucky (or unlucky) enough to fall under insurance-backed warranty protection before year 11, the value of such programs appears to be worth more than a rare structural repair. "Our job is to solve legitimate differences of opinion between builders and homeowners," says John Gill, vice president and general counsel for Quality Builders Warranty Corp. in Camp Hill, Pa., speaking to that company's arbitration and mediation services.

Mike Burns, executive vice president of Professional Warranty Services (PWS) Corp. in Chantilly, Va., puts third-party credibility and outside dispute resolution services on par with, if not higher than, the actual protection offered by the warranty. "Builders are finding out that not having a warranty is a negative marketing issue," he says. "A warranty provides both parties with some valuable protection."

Builders see that logic, with some forced to apply it in markets with mainstream consumer fear or anticipation of defects in new-home construction. "Ten years is attractive [to a buyer] and does offer some assurances that the builder will be around after the standard one or two years," says Diane Glenn, a former custom builder and now an industry consultant and independent inspector in Seattle.

The alternative is to self-insure--albeit without insurance beyond general liability policies that are themselves excluding high-risk circumstances or entire markets (see "Gathering Storm"). Self-administered, one- or two-year express warranties put the risk of a potentially costly fix entirely on the builder's shoulders. "It opens a builder up to all types of consumer activity," says Fluhr. "He's placing all of his assets at risk with every home he builds."

That's a risk, however, that builders of more than half of the new homes built this year will incur--one of the least subtle and potentially most devastating among a variety of hidden costs that can be found in the new-home warranty quagmire.

Hidden costs

One could argue that perhaps the most obvious "hidden" cost of a long-term, insurance-based structural warranty is the price of the policy itself, given the narrowness of the coverage language and infrequency of actual payouts.

But with some value among home buyers and a measure of catastrophic protection for structural risks that typically occur after the fourth year at an average of $30,000 per claim, the $500 price tag for insurance-backed warranties is often a cost builders and buyers can handle. "It's pennies in the overall scheme [of housing costs]," says Randy Birdwell, president of Emerald Builders in Houston, which will start about 800 single-family homes this year as a division of D.R. Horton. "If it makes the customer feel more comfortable, then great."

Other costs are much more stealthy, with the potential to slice margins, ruin a builder's reputation, and/or put him in court. From policy premiums and sneaky fees to keeping egos in check, there are ways builders can save on their express home warranty costs, including:

Premiums and fees. There is money to be saved on the premium for a 10-year structural policy, a one-time cost per house that includes an application fee and additional dollars per square foot. While such premiums reflect several factors--a builder's experience, years in business, risk avoidance, loss and litigation history, and even the location of the house or project--those same factors can be leveraged to obtain more favorable rates in some cases.

There are also additional fees associated with VA or FHA mortgages. Policies underwritten by risk-retention insurers (instead of comprehensive carriers) may also require capital contribution fees from builders to boost the insurance company's coffers when reserves dip below an acceptable amount to pay anticipated claims.

Unfinished business. Birdwell has one rule: "We don't close unfinished houses." By taking care of punchlist items before settlement, builders can avoid more costly and intrusive callbacks after move-in and deliver something at least approaching perfection. "It sets us up better with the buyer from the start," he says. "If you're 'slamming' houses and really not finishing them, it's a huge mistake."

Underpriced for service. Despite his diligence to deliver a finished house to a happy family, Birdwell (like most builders) allows new owners to work up a list of typically cosmetic items--based on well-communicated standards and expectations for which and when those will be addressed by his crews. Not pricing a home to accommodate that aspect of the warranty process can be costly.

The key, Birdwell says, is to get those costs out in the open by pricing the house accordingly. "Warranty work is a cost of doing business, and it can be calculated on a per-home basis," he says. "We consider it a hard cost, even if it's only .1 percent. It should be figured in the price and your margin."

Yes men. Russell is a self-admitted yes man, having gone back to homes built 12 or more years ago to change the water filter for a widow. He even dropped $400 to completely replace a rotting front porch railing after a new owner neglected to paint it as instructed.

For Russell, such efforts pay off in the form of referrals; he's never purchased an ad anywhere. Other builders are less willing to incur the cost of always agreeing with a home buyer--an approach that creates a fine line between integrity and potential litigation. Builders also have been criticized for over-promising just to make a sale or appease homeowners who want too much for too little, then scrambling to deliver.

A series of articles on how builders can identify and mitigate hidden costs that decimate profits.

Gathering Storm

Full Disclosure

Risk Retention

"You can tell people 'no,'" says Birdwell. "Some of them are just testing you. You have to stand on principles. If you do something for one of them, it applies to everyone." And therein lies the hidden cost of being a yes man. Birdwell even hired an industrial psychologist to train his sales team on the finer points of saying no and explaining why a certain complaint isn't covered under Emerald's warranty terms. "We don't always offer a solution. Sometimes buyers just want you to empathize and work with them," he says. "It's a skill we develop continuously."

Relying on your general liability. If you think your general liability insurance is enough backup for a costly warranty claim, check the finer print. "Many builders believe that general liability provides all the protection they'll need," says Burns. Generally, however, such policies only cover resulting damage from faulty work or materials, not the work itself. And treble damages from a defect lawsuit judgment against you may also be excluded in your GL policy.

Litigation and legislation. What does a defect lawsuit cost? The legal fees to defend yourself aside, you could be facing a multimillion dollar judgment, not to mention lost sales from a damaged reputation. It's enough--or should be--to push the housing industry to adopt better warranty practices that would mitigate such costs.

In addition, builders have lobbied for changes in their state statutes to make lawsuits tougher to file. Historically, legislation at the state level is on the side of consumers, though some builders and trade associations have successfully tightened the language of these laws to help even the odds.

In Arizona, for instance, a recent bill would require homeowners to give builders written notice of problems 120 days before filing suit, with a 90-day response provision for the contractor. "Most builders want to take care of their customers," says Barney. "They just need the opportunity."

Lack of standards. One way to defend or avoid the cost of a lawsuit, and perhaps standard warranty and callback items, too, is to set clear and quantifiable standards for performance--yours and the home's.

Something as simple, marketable, and relatively inexpensive as specifying only kiln-dried lumber, at one expert's estimate of $500 per house, would have negated the potential of inch-long beetles boring into the structural frame of several D.R. Horton homes in Riverside, Calif., a few years back, and the still-pending lawsuit that followed.

Photo: Jonathan Barkat

More specific and higher-grade specifications for each area of the house, from foundation through finishes, are simply a matter of diligence. There's even a book, Residential Construction Performance Guidelines, available from the NAHB's bookstore ( www.builderbooks.com), which can serve as a model, among other references, for a policy builders could give to prospective buyers, in-house crews and supers, and to subcontractors. At least one long-term warranty company also applies more specific standards to its coverage language. "We think the current definition of 'major structural defects' is too harsh," says PWS' Burns of the "unsafe, unsanitary, and unlivable" interpretation. Instead, the company has set structural tolerances that, if exceeded, warrant coverage. "It doesn't need to be a failure ... for us to honor the claim."

A passive stance. Letting a problem come to you instead of taking the initiative to anticipate, communicate, discover, respond, and solve issues with homeowners is a costly approach to warranty service.

In Seattle, for instance, builders have put themselves in front of potential water penetration problems--a lightning rod for litigation--by using consultants like Glenn who offer independent inspections at framing and other construction stages. "The exterior envelope is a critical area that could lead to more severe structural issues if it's not done correctly," she says. "It's about solving problems before they happen, paying for a defect before it becomes a claim."

In Pensacola, Fla., Russell gets nervous when he hasn't seen a new buyer on the jobsite for a week or more. "I require participation from my homeowners," he says, including several in-process walk-throughs. "I call them every two or three days if I haven't heard from them."

More typical, if not always reported, are builders who actively encourage and respond quickly to homeowner calls and concerns. "We respond to and investigate every call," says Barney. "If we did something wrong, in or out of our warranty, we feel responsible and take care of it."

Ignorance and ego. In California--the Mecca of construction defect litigation--builders are implicitly liable for patent (or visible) defects in materials and workmanship for four years and 10 years for latent (or hidden) defects, even though most offer only a standard, self-administered one-year warranty. "Builders believe they will never build a home that will have structural problems," says 2-10 HBW's Fluhr.

Builders may also be put in the legal crosshairs by using untested products or systems in an attempt to lower costs, homeowner maintenance, and/or cycle time. "Builders are putting stuff on homes, and they don't know what it is going to do, but they may be held responsible for it," says Glen Loyd, public information officer at the Wisconsin Department of Agriculture, Trade and Consumer Protection in Madison. The department recently pursued and won a case against composite wood siding manufacturers for defective and deceptive practices that allegedly resulted in warped and rotted material.

Gold diggers. The new-home warranty industry reports that about 5 percent of the thousands of claims fielded and filed each year are "frivolous," a term that might also be applied to a growing portion of defect litigation lawsuits brought by homeowners, homeowner associations, and attorneys.

"It's not about what's wrong, it's about the money," says Barney, who recently settled a class-action suit for his original offer to fix the problem two years earlier. "They think, 'If I put $100 in [for a share of attorney's fees] I might get $1,000, $5,000, or $10,000.' It's like winning the lottery."

The suit against Trend Homes also came out of the blue; Barney had no outstanding or unresolved service calls in his file for that subdivision. "It's like, 'What have I got to lose?'," he says of such homeowners.

Is there a fix for such frivolity? Probably not. But just knowing its potential, and doing everything you can to head it off, might reduce perhaps the most insidious of all hidden warranty costs.

Rich Binsacca, a contributing editor to BUILDER, is based in Boise, Idaho.