By Chris Kirkham

Gary Godden used to specialize in designing condominiums for first-time buyers near Denver, often completing eight to 10 projects a year before the real-estate crash.

But while the Denver area has re-emerged as one of the nation’s hottest real-estate markets, Mr. Godden’s architecture firm has all but exited the condo business. The reason: The threat of litigation for potential construction defects in Colorado makes most projects impossible for developers to finance, he said.

“We have a saying here that there are two types of condo projects,” said Mr. Godden, principal of Godden Sudik Architects in Centennial. “The ones that have been sued, and the ones that haven’t been sued yet.”

Condos have been the slowest to bounce back of any segment of the U.S. housing market. Over the past five years, construction of apartments has nearly tripled, while that of for-sale multifamily units has increased only about 53%.

The slow comeback stems partly from developers’ increasing confidence in rental-apartment buildings as young adults and middle-aged families stung by the housing crash have turned to renting. But developers also point to increased exposure to construction-defects lawsuits, which they say have made insuring large projects much more expensive.

Some lawmakers say the legal landscape is limiting the supply of entry-level housing. Although the term “condo” often conjures images of luxury penthouses in New York and Miami, such housing, usually consisting of individually owned units in a building or a complex, has historically provided a moderately priced transition into homeownership from the rental market.

In Denver, the lack of condo construction has become a central part of a debate about the local housing market. A coalition of Democratic and Republican mayors, real estate developers and affordable-housing activists have pushed for changes to state construction-defects laws to encourage more condo building.

Condo developers are particularly susceptible to litigation because homeowners’ associations govern the common property of the building, making it possible for boards to file suit on behalf of potentially hundreds of individual owners.

Jonathan Harris at his condo in Denver.

Jonathan Harris at his condo in Denver. Photo: Theo Stroomer for The Wall Street Journal

The issue goes beyond Colorado. Lawmakers in Texas and Nevada have approved legislation in recent years meant to curtail litigation, while a housing affordability study in Seattle last year suggested the city and state explore changes to its condo laws.

But developers say several aspects of Colorado’s law make it a tougher environment for them. One provision in particular makes insurers responsible for covering a broad array of problems that could arise on a project—a factor that has made premiums more expensive. Another part of Colorado law prevents developers from having a say in whether claims should be decided by an arbitrator before going to trial.

No one tracks such litigation in a comprehensive way, but studies of the market for general contractors’ liability insurance for residential construction have shown that costs are much greater for condos than rental-apartment projects of the same size. One study of Denver’s market by land use consultant Economic & Planning Systems Inc. in 2013 found that a developer’s insurance costs per condo unit are more than three times that of similarly sized apartments. The risk of construction defects liability added an additional $15,000 in costs per unit, the report found.

Denver, the priciest U.S. housing market not on a coastline, has recorded home price and rent growth among the top five of all large U.S. metro regions over the past two years, conditions that would normally invite builders to pounce. Instead, “There’s a great deal of chill,” said Denver Mayor Michael Hancock, a Democrat. “We need every tool in our tool chest to help us begin producing as much affordable and market-rate housing as we can.”

Condo associations argue that easing state laws would leave homeowners at the mercy of developers who might shortchange needed repairs.

The condo association where Jonathan Harris lives in Denver sued its builder after years of unsuccessful fixes to leaky windows and drainage problems that caused water to back up into some units during storms.

“I don’t understand this resistance to stand behind what they do,” said Mr. Harris, who has represented homeowners associations in front of the legislature. “Don’t build crap and you won’t have these lawsuits.”

For the past four years, Colorado’s legislature has debated changes to the laws that would require homeowners and developers to try settling disputes in private arbitration process before going to civil court. Another proposal would require that a majority of homeowners in a building vote to proceed with a suit, as opposed to just the board members. Lawmakers ended the session in May without voting on a package.

Meanwhile, critics of the current system say condo boards can continue to pursue lawsuits even when individual owners might not be on board.

Allison Boerner said she and her husband were unable to sell their unit in Parker, Colo., in 2013 because their homeowners’ association decided to pursue a lawsuit. Potential buyers were unable to get mortgage financing because of the pending litigation, she said.

“There are so many people living in the same building,” Ms. Boerner said. “It’s not going to be perfect.”