One of the more significant of these risks arises from the potential liability for design and construction defects in the event an apartment project is converted to condominiums and sold in the future (Conversion Risk”). While the likelihood of such a conversion may seem remote in the current environment, a great deal of time and energy is spent negotiating how to allocate or reduce the Conversion Risk from not only the purchaser's and the seller's perspective but also from the designer's and the contractor's. The purchaser must balance the competing needs of wanting unrestricted flexibility to use the asset however it sees fit, while protecting itself against latent defects in design and/or construction that are not discoverable during pre-closing diligence, versus the need to prevail as the successful purchaser in a bidding war for the particular asset.

On the other hand, the seller weighs the need to complete an “as-is” sale with no extended liability beyond the post-closing representation and warranty survival period against the need to secure the highest purchase price for the particular asset.

Finally, the designers and the contractors, whose work is typically completed well before any sale of the asset, must assess how to price the cost of the design and construction, including insurance, based upon the owner's intended hold and exit strategy for the asset.

Strategies to manage the divergent Conversion Risk include, but are not limited to, the following:

(i) deed restrictions and/or contractual prohibitions against any conversion of a for-rent asset into a for sale asset (including condominiums, townhomes and tenancy-in-common interests) until the expiration of the applicable statute of limitations for latent defects has expired;

(ii) contractual and statutory releases and waivers of all claims arising from any such conversion;

(iii) “type 1” indemnity, defense and hold harmless obligations flowing to the seller and the original contractor and design professionals with a corresponding third party guaranty to stand behind such indemnity, defense and hold harmless obligations;

(iv) assignment of design and construction agreements, subcontracts and/or express contractual warranties from the seller to the purchaser in exchange for a complete release and waiver of claims by the purchaser;

(v) procurement of additional insurance (typically a WRAP-owner controlled insurance program) expressly covering condominium development, construction and sales to protect the owner, design professionals, contractors and subcontractors for all prior work;

(vi) mandatory quality assurance (peer review) requirements during and/or after completion of the project;

(vii) restrictions and/or prohibitions upon purchaser's ability to assign rights the purchaser may have against the seller to third party buyers post conversion;

(viii) procurement of a maintenance bond by the purchaser or subsequent converter in an amount sufficient to cover any warranty and/or defect claims during the duration of the applicable statute of limitations for latent defects;

(ix) creation of an escrow holdback to cover any warranty or defect claims until the expiration of the applicable statute of limitations for latent defects;

(x) creation of a “condominium addendum” that is recorded and runs with the land whereby subsequent post-conversion third party buyers are required to purchase the units as-is and subject to purchaser's releases and waivers of all claims arising from any such conversion and/or in the alternative pre-litigation right to repair provisions;

(xi) mandatory alternative dispute resolution procedures typically requiring judicial reference of all disputes arising from design and or construction defects; and

(xii) creation and recordation of CC&Rs that bind any subsequently created homeowners association to the restrictions, waivers, releases and indemnity obligations discussed above and the mandatory obligation to create and enforce maintenance and repair obligations and reserve accounts necessary to fund the same.

Which strategies are ultimately used is largely a function of negotiating leverage between the parties and the purchaser's exit strategy for the particular asset; however, as the multifamily frenzy continues, post-conversion risk mitigation will continue to play a significant role in most purchase and sale transactions.

Michael C. Polentz is co-chair of the real estate & land use practice group at Manatt, Phelps & Phillips LLP, located in the Palo Alto, CA office. The views expressed in this column are the author's own.