Build To Rent: unique insurance implications that developers and owners are closely monitoring

In the 2023-24 Federal Budget, the government proposed income tax concessions to boost investment in the "build-to-rent" (BTR) housing sector.

These measures include increasing the capital works tax deduction rate (depreciation) to 4% per year and reducing the final withholding tax rate on eligible fund payments from managed investment trust (MIT) investments from 30% to 15%. The government has also pledged to consult on the implementation details, including:

Whether a minimum proportion of dwellings should be designated as affordable tenancies

The duration for which dwellings must remain under single ownership before they can be sold, with an initial suggestion of a 10-year period.

Such changes have led to significant interest from both local and offshore investors. Across the next decade, this increased appetite could lead to 150,000 more apartments in Australia.

Since the developer retains ownership and manages the buildings in the BTR model — sometimes in partnership with an investment fund or a pool of investors — there are unique insurance needs that developers and owners must address.

Different model, distinct insurance implications

Whilst traditional developer conversations have typically been based on fundamental insurance responsibilities, specifically the procurement of Contract Works (CW) Insurance, the most successful developers are now challenging what has been done in the past and evolving their thinking. One aspect that some developers continue to overlook in 2024 is the financial exposure they may face if an insured event causes delays in project completion such as the impact of weather or strikes. This is not something a general CW Insurance policy is designed to cover. To better understand the realities and financial consequences of only procuring CW insurance, a fire broke out on the roof of a development in New Zealand before the COVID-19 pandemic. The impacted venue was set to earn significant revenue from events which had to be cancelled. Years later, the venue is still yet to be built.

More recently in Australia, the cost of refurbing a major organisation’s headquarters soared from $260 million to nearly $500 million. The completion date is currently uncertain due to asbestos removal required in the building.

Lockton is increasingly observing the impact of getting it wrong with developers in similar situations seeking to claim for project delays (with only standard CW insurance in place.

So how are the most resilient developers responding in the midst of an uncertain, ever-challenging construction landscape?

1. Delay in Start Up or Advanced Loss of Revenue Insurance

To mitigate this risk, proactive developers are urgently exploring Delay in Start Up (DSU), alternatively known as Advanced Loss of Revenue (ALOR) insurance. This insurance policy is designed to be an addition to the owner's or developer's typical CW policy. Importantly, this cover can only be obtained under a policy arranged by the developer in joint names with the contractor.

These policies are intended to cover various financial losses resulting from delays following damage to an insured building. DSU coverage can also encompass additional debt finance costs or loss of expected rental revenue.

Consider this: outside the construction industry, business interruption coverage is often a no-brainer for typical property insurance and ISR policies. In the construction industry, DSU insurance is meant to provide a similar safeguard, yet some developers still struggle to see it this way. They mistakenly believe they can recover losses from delays through bonds or CW insurance, which is not the case.

2. Owner Controlled Insurance Programs

With rising uncertainty and insolvencies across the industry, there has been a surge in enquiries and increased take-up of Owner Controlled Insurance Programs (OCIP). An OCIP program is where the owner or developer controls insurance requirements, not the contractor. In the Build-To-Rent market, contractors, lacking financial interest in the development, cannot procure DSU as the insurance responsibility for Contract Works rests with them.

While it's often assumed that developers can recoup delay costs from contractors, this relies on the contractor's financial capability to respond to such claims. The shift to OCIP programs is also because claims typically pertain only to the contractor's performance, excluding instances of force majeure.

3. Latent Defects Insurance:

In 2024, The Sunday Age revealed that as many as 60% of new apartments in Australia suffer from construction issues, such as cracked foundations, water leaks, balcony defects, and flammable cladding.

That’s why developers are increasingly considering the adoption of Latent Defects Insurance (LDI) which safeguards property developers or owners against damage resulting from post-completion defects in design, materials, or construction.

The defects can arise due to faulty design/specification, faulty materials, or faulty workmanship. Unlike professional indemnity, it does not rely upon proving a legal liability to pay and it provides a long-term warranty against material damage caused by a structural defect.

LDI typically necessitates technical audits by an insurer's engineer throughout the construction phase. Upon the engineer's approval of project construction and sign-off, coverage can be arranged from the practical completion date for 10-12 years. Policies can be assigned to new owners if a development is sold, with tenants also eligible for inclusion as insured parties.

Not only does this approach provide assurance if the asset is sold within the 10-12 year period, but it also shields the developer's balance sheet. Important to note, operational property policies also commonly exclude collapse due to defective workmanship.

Case Study: financial comparison of LDI insurance vs. strata bonds

As an example, in NSW, the standard strata retention bond serves as the traditional alternative protection mechanism to LDI insurance. With strata bonds, developers can only recover the 2% up-front cost two years after completion. However, the cost of strata bonds in NSW has recently risen from 2% to 3% and looking ahead, the government is planning to mandate LDI insurance, which will offer a 10-12 year guarantee. When comparing the financial implications of a 3% bond that covers only 2 years to an insurance product that can be obtained for a similar cost but offers 10-12 years of protection, it is no wonder developers are increasingly investing in LDI insurance.

For instance, consider a recent case where a developer completed a residential block. After a year and a half, severe cracks were discovered in the foundation slab, along with inadequate structural support, putting the building at risk of collapse. The substantial cost of remedying such a defect far exceeded the 2% or 3% strata bond.

Contents of this publication are provided for general information only. It is not intended to be interpreted as advice on which you should rely and may not necessarily be suitable for you. You must obtain professional or specialist advice before taking, or refraining from, any action on the basis of the content in this publication. Lockton arranges the insurance and is not the insurer. Any insurance cover is subject to the terms, conditions and exclusions of the policy. For full details refer to the specific policy wordings and/or Product Disclosure Statements available from Lockton on request.