Sep 18
  • Business

Financing: Modular’s Invisible Obstacle

As modular construction increasingly becomes a darling of the press and the development community, many early obstacles are beginning to soften. Securing financing for modular projects, however, remains a formidable challenge for many. In fact, financing might just be the last hurdle to rapid modular adoption, as the industry moves from today’s methods into a more construction-efficient future. 

Why is financing such an obstacle?  Essentially, the banking sector has no incentive to fund innovation. Lenders prefer to back what they know, and risk-taking is simply not in a bank’s DNA.  As a result, few banks have viable financing products that meet this emerging industry’s needs.  Below are three mind-bending aspects of modular construction that put it outside the traditional construction lending box:

  1. Construction is typically billed and paid for in arrears. Modular requires a much earlier-than-typical finance draw, sometimes two to three months before a project begins. This timeline enables a factory to buy in advance all of the materials for the units it plans to produce. This draw, required to make a factory efficient once production begins, often amounts to 35% of a modular contract, a substantial portion of the overall building contract.
  2. With modular, or any industrialized construction innovation, project progress is happening somewhere other than the construction site.  Purchased material assets are sitting off-site in a factory, unattached to a structure or the land associated with the project. These procurements might even be sitting at a factory in another country.
  3. Many modular factories are startups that have yet to prove themselves. Combine that with the fact that local governments often take years to entitle commercial projects. It’s easy to see that most modular plants lack the years in business and project experience to make a lender comfortable.

To date, the lenders who have stepped in to service this promising market are primarily from either the private equity or the nonprofit world. They have found innovative ways to structure business loans that suit the needs of modular fabrication. Below, we highlight a few lenders who are addressing the surge of client demand in this sector and are helping clients to realize modular’s time-saving potential.

AVANA Capital

AVANA Capital is a private debt fund, based in the Phoenix area, that historically has focused on construction loans in the hospitality sector and has become a player in modular construction financing only in the last couple of years.  “We did the due diligence, as we would with any other loan request, identifying and evaluating the risks,” Kyung Kim, senior vice president for AVANA’s strategic growth markets, says of one project. “We had to educate ourselves about the construction process itself as well as the modular company. So we took a tour of the factory, learning as much and as quickly as we could.”  AVANA learned that, whereas modular introduces some new risks, it mitigates others. “In our view, it is actually a better process,” Kim says. He goes on to explain that the speed of modular returns money to investors sooner, and its controlled environment reduces climate, safety and quality risks associated with a typical site-built project.

“There is also greater budget certainty, because the entire A+E team collaborates on decisions upfront, and change orders are basically off limits after procurement.”

As to mitigating the risk of materials procured that remain offsite, Kim acknowledges that there is no secret sauce.  “You just have to really understand the project and, in effect, make a decision to underwrite the modular company itself.”  AVANA’s first project was a wood modular hotel project in California that was completed in 12 months.  The second, which is underway, is a steel modular high-rise hotel in New York, for which modules are being imported from overseas.  Although the company’s roots are in hotel construction lending, AVANA is branching out and considering modular projects in other asset classes, such as multifamily and student housing. “Our perspective is that the early stage nature of modular construction necessitates a holistic approach,” he says.  “Just as the modular construction process itself requires the developer, the GC, the modular company, the A+E firm and the lender to work collaboratively at the front end of the project, the industry as a whole needs to work collaboratively to educate one another and the general public.  This is the optimal way to increase awareness and to drive adoption.”

San Francisco Housing Accelerator Fund (SFHAF)

SFHAF is a unique nonprofit lender with a mission to accelerate the production of affordable housing in the San Francisco Bay Area. The fund is able to flex its lending to accommodate innovations, including modular, essentially serving as a philanthropic underwriter for factories.  “Our goal is not to carve out permanent market share in any one category, says Rebecca Foster, the company’s founder and chief executive. “Our goal is to find where the fundamental gaps lie, from a financing perspective, and to come up with a financial product to address those gaps. We have done this for over $100 million in acquisition and preservation loans and are focusing now on how capital can accelerate innovation in construction approaches that can bring down the cost and time of housing development.” Since modular projects often require a funding outlay before GMP, there is a perplexing period during which the developer’s construction loan cannot be finalized, but the capital needs to go out to the modular producer.  The purgatorial moment is sometimes extended in cases where a modular factory has low capacity and has to produce orders ahead of schedule, and the developer must pay for storage, to ensure that the project is in the factory queue.

“We are working with one client where we need to cover the cost of the majority of modular construction before closing on the construction loan for the project,”

Foster says. This is significant given that modular orders often make up 40% to 75% of the entire construction cost. The current lack of traditional insurance available for modular providers has given many construction lenders and government lenders, and therefore affordable housing developers, pause about embracing these technologies. “This is another area in need of financing innovation that SFHAF would like to build a new product to address — in hopes of accelerating the adoption of cost- and time-saving approaches in the affordable housing industry,” Foster says. “What we try to do with more flexible philanthropic and private capital. We are able to test   new approaches that can bend cost and time curves around production that are harder for governments to be first movers on, given the regulatory constraints of public funding. Ultimately, if our prototypes work and our products encourage scaling of solutions, the government could step in with more and longer-term public funding.”

SFHAF is also trying to address the underwriting challenges faced by developers using new modular manufacturers.  Most new factories have low to zero bonding capacity and no track record.  SFHAF takes a painstaking look at what it would cost the development team each month if the factory ends up not being able to produce, with the result that the team has to switch to site-built or another construction alternative.  After attaching weighted probabilities, SFHAF decides what the fund can afford to lose, and takes a calculated financial risk to underwrite the innovation.

Genesis LA

Genesis LA is a nonprofit, community loan fund that finances various kinds of economic development and community development projects in greater Los Angeles.  While Genesis LA acknowledges that it has more flexibility than a traditional bank, the company’s process for financing construction is quite similar to that of a traditional lender.  As a result, Genesis LA faces many of the same risks that a traditional bank might identify when trying to lend for a modular project. “We are new to the modular space,” says Tom De Simone, Genesis LA’s president and CEO.  “In this case, we’re the senior lender on the entire project, and not just on the modular contract.  To get comfortable with the idea of an early deposit, we are minimizing our upfront exposure to an amount as close as possible to the underlying value of the land, to ensure there is an asset of value to cover the risk, should something happen to the order or the supplier.”  De Simone also explains the difference between public and private equity investments in affordable housing projects, and how those affect a lender like Genesis LA. “On a typical, private development, the equity is usually in first – the first to take the risk,” De Simone says.

“However, in affordable housing, the early equity is usually public money, and taxpayers are not comfortable taking the same risk position as a typical equity investor…” 

“Hence, public funds always wait to come in at the same time as the lenders or even later. So we are trying to split up the deposit between us and the public sources that are coming into the project, so that we can have less of the real debt, and so that the portion that comes from us is able to be fully collateralized by the land.”  De Simone suggests that if cities acted more like traditional equity investors in the way that they accept early risk, it could be the single most catalytic way to deal with many of the issues surrounding the financing of modular construction for publicly funded projects like affordable housing.

So, can conventional financing work for modular projects?  Yes, but it requires some adjustments.  Steve Orchard, former chief information officer of RAD Urban, an Oakland-based modular producer, offers these lessons learned in the trenches of early modular production in the United States:

In summary, as the industry continues to embrace modular construction, enormous opportunities exist for lenders to capitalize on both the current interest and the risk reduction inherent in industrialized building.