Modular construction has been touted as a way for the construction industry to overcome the challenges of a dwindling skilled labor force while also producing high-quality building components efficiently. It allows for an assembly-line approach to construction, with factory workers becoming experts at putting together their particular piece of a project.

Despite the benefits, including much faster turnaround times, Chief Financial Officers have had trouble securing financing because of lenders' unfamiliarity with it. But that's changing. 

Faster, better

Modular manufacturing has two main benefits, said Henry D'Esposito, JLL’s construction research lead for the Americas: speed and quality control. "The process is carefully monitored, highly controlled, and generally safer." 

In addition, while traditional construction projects can be shut down due to inclement weather, and workers risk injury, modular construction occurs in a dry, safe factory setting at ground level.

According to a June 2019 McKinsey & Co. report, not only could modular construction claim a $130 billion piece of the United States' and Europe's construction market, saving the industry up to $22 billion compared to traditional stick-built methods, it can also reduce the standard schedule by as much as 50%.

So, lenders should be clamoring to get on board with a method that has been proven to provide such benefits. Right?

Well, actually, they are not. As it turns out, the square peg of modular construction is having a tough time fitting into the round hole of construction financing.

Modular's penetration into the U.S. construction market is at about 5%, however, according to Kyung Kim, senior vice president of strategic growth markets at Avana Capital. "We’re still in the early stage of adoption," he said.

Unfamiliar underwriting

The fundamental challenge in financing a modular project, D'Esposito says, "is the timing misalignment between capital required for the manufacturing process and collateral available to the lender.

"In a traditional construction project," he said. "the lender provides capital in smaller draw packages as the project progresses, and with each draw, the building onsite becomes more complete, and therefore more valuable, as collateral. In a modular project, most of the materials and as much as half of the total cost is required upfront, and all the lender typically has as collateral is an empty lot where actual onsite assembly may still be months away."

Both developers of commercial construction projects such as hotels and multifamily housing are faced with this financing dilemma.

But traditional project finance difficulties are opportunities for nontraditional lenders.

Gregg Delany, managing director at real estate capital advisory firm Eyzenberg & Co., said his company has facilitated the financing of $150 million of modular housing projects in the Southeast, stepping in where balance-sheet depository institutions would not.

"What's been hard for regional banks to understand, or at least to structure around," he said, "is how [to] collateralize and finance when the units are in the factory, before they get to the real property and become attached to that property."

Getting deals to happen

Delany said Eyzenberg has worked with non-bank lenders, real estate investment funds and debt funds in order to make modular deals happen. Those lenders, he said, see the market opportunity and are thinking beyond traditional paradigms.

In addition, the product is exceptional, he said, given today's manufacturing standards. The units are inspected at the factory before delivery and comply with all state building codes, which are typically much higher than Housing and Urban Development (HUD) standards. Also, he added, the layouts and configurations once the units are put in place onsite are more advanced than what usually comes to mind when one is considering the aesthetics of modular or manufactured homes.

"[Nontraditional lenders] realize that this type of housing actually qualifies for agency permanent financing upon stabilization and have developed with us financing mechanisms to allow for advances to fund the construction in the factories as well as once [the units] are attached and become part of the real collateral," Delany said.

"And that's been the big innovation that we've developed over time by doing multiple transactions. We've been able to bring the community forward so that, in effect, we overfund, if you will, on the real property."

Those funds, he said, are allowed to be used as a working capital line to pay for the completed units while they are still at the manufacturing facility and after they have been inspected by both the developer and state officials. The money can also go toward roads, site work, utilities and concrete pads, as well as community amenities that one would find at most Class A apartment complexes.

Lien as collateral

Still, the units have not been attached to the real property at that point, so Delany said Eyzenberg uses UCC (Uniform Commercial Code) lien filings to collateralize the lenders. UCC filings are commonly used to secure financed items, like leased equipment or vehicles.

While the units are being built at the factory, he said, lenders also have additional protections like third-party inspectors who verify that production is moving along. In addition, there are recourse guarantees included in the manufacturing contract plus the lender is typically listed as an additional insured. It's all of these things taken together, Delany said, that usually wind up providing these non-traditional landers the kind of assurances they need.

Working with alternative lenders also provides a little more flexibility than the traditional draw schedule and allows for friendlier prepayment terms, Delany said.

"We've negotiated the ability to prepay in part or for components of the site, and what's nice about that," he said, "is that it allows you to then quickly go to permanent financing."

If, for example, Delany said, a third of the site is leased and stabilized, the owner can go quickly to permanent financing and pay off the construction loan without exit fees or expensive prepayment penalties.

But traditional lenders aren’t totally out of the game when it comes to modular projects. Once projects are complete, Delany said, they are more than willing to get involved in the takeout financing. When the industry wakes up to the benefits of modular construction, he said, "there will be a stampede" of banks trying to get into the space.

Kim says high-profile projects, like the AC Marriott hotel under construction in New York City, could also drive more lenders into the modular market. The property is slated to be the tallest modular hotel in the world, and Avana, a commercial real estate debt fund, stepped in with $65 million of financing for owner 842 Enterprises.

Cost is a major hurdle keeping lenders out of the modular market, Kim said.

"Right now, it doesn’t really save you that much," he said. "It's pretty much on par to stick-built construction. The real savings is time. Time value of money is a very common corporate finance concept, but it's not as intuitive or as tangible to most people."

For income-producing properties like hotels or apartment complexes, however, the sooner the opening, the faster owners can start realizing income and repaying investors. "There's tremendous value in that," he said.

Another factor perhaps keeping potential modular lenders at bay, Kim said, is that right now banks like Wells Fargo and Bank of America have plenty of other deals to keep them busy. “They won't take the risk, and they don't need to,” he said. Again, the volume of modular construction can’t compare to traditionally built projects.

So, what will it take to get traditional lenders into the modular sector?

First, project teams need to keep getting it right. This means that developers need to make sure they have the right architect, engineer, general contractor, manufacturer — people with experience in factory-built construction and a building team with experience. The right team is very important, Kim said, because this is still the early stages of [modular], and everybody's learning with each transaction.

As far as widespread adoption is concerned, he said, "It's kind of the chicken or the egg, Until higher adoption occurs, and they have to make that mind shift, they won't."

CFO in the Know is an editorial series examining the roles CFOs play across a variety of industries. You can find the entire series here.