After the Great Recession a decade ago, skilled trade workers left the construction industry in droves and never returned. Although the U.S. economy recovered, the construction industry has struggled to recruit new workers. A labor shortage holds back commercial real estate construction projects to this day.
One way the industry has coped is through the use of modular construction. This involves manufacturing the structure in pieces, or “modules,” in a factory. Each room or section of the building is prefabricated off site, then shipped and assembled, or “stacked,” at the construction site. This method solves many on-site construction woes. In terms of financing, however, modular construction presents challenges for commercial mortgage brokers as traditional lenders are often uncomfortable with the upfront cost and process of completing a modular building.
Commercial mortgage brokers and lenders have an opportunity to expand financing options to include modular construction loans. For the time being, however, banks and other traditional lenders remain skittish about making modular construction loans. And yet, more developers are using modular building techniques as a way to control construction costs and avoid delays.
The old adage “time is money” certainly applies to commercial real estate development — and modular construction saves time and money for developers. Snow, rain and freezing temperatures can cause long delays on construction sites. Modular construction is ideal in areas of the country that experience severe winter weather. The bulk of the fabrication is done in a factory shielded from the elements.
It also is easier to control the construction timeline in a factory. On a traditional construction worksite, multiple tradesmen must work in a specific order. This can cause on-site delays as one tradesman waits for another to complete a task. If an electrician hasn’t made it to a site to complete the electrical work, for example, the job site can come to a standstill. The drywall, ceilings and sometimes the flooring can’t be installed without the electrical work. In a factory, the process is more streamlined and efficient. Workers build the same room over and over, and tend to be skilled in multiple trades.
Building off site in a factory also enables a developer to complete multiple stages simultaneously.
Instead of working on the project in linear fashion, the builder can obtain all the permits, prepare the building site and construct the modules at the same time. This can shave months off the traditional construction timeline, reducing the schedule by up to 50%. All of these time-saving benefits also reduce the cost of labor as fewer hours to complete the job equate to fewer hourly wages paid out to expensive tradesmen and contractors. All of these factors boil down to time and money savings.
Traditional lenders, however, remain uncomfortable with the modular construction process. Many banks, in particular, shy away from the idea of a factory-built commercial building. There are multiple reasons why.
Among the most common lender concerns is the large upfront cost associated with modular building. Traditional construction loans are typically disbursed based on the project milestones — foundation poured, framing, trim, etc. By distributing the funds in piecemeal fashion, the lender’s risk is minimal during the early stages of the project. This protects the lender from a huge loss if the project runs into problems or doesn’t ultimately get completed.
With modular construction, however, up to 50% of the capital is required upfront to purchase materials and have them shipped to the factory. This, in itself, is a huge commitment for a bank. The modular process also makes it more difficult to measure the project’s milestones. Given that the entire project is completed in a factory, the bank tends to feel less in control of the process.
Banks also don’t have ready access to the collateral during the modular construction process. On a traditional building site, the lender can typical view the building and materials as the job is being completed. These serve as collateral for the bank. With modular construction, however, the work is sometimes done several hundred miles away and, in some cases, overseas. Building materials that would typically be on site are not there. They are stored in the factory where the modules are constructed for delivery. This lack of visibility can make the bank nervous. As a result, the bank may not be willing to do the deal or it may limit the size of the loan.
Some private lenders have been able to take advantage of these insecurities and offer more flexible terms. Private lenders have stepped up to accommodate the nontraditional deal structure required for modular construction. As conventional lenders learn more about the process and how to navigate its complexities, however, expect to see banks become more comfortable with funding modular projects on a larger scale.
Private lenders have stepped up to accommodate the nontraditional deal structure required for modular construction.
The use of modular construction is clearly on the rise. In the hotel sector, for example, Marriott, Hilton and many other chains have embraced the modular construction process. It’s only a matter of time before this type of construction becomes more of the norm.
Marriott is already well underway in planning the world’s tallest modular hotel. The 26-story, 168-room AC Hotel is in New York City’s NoMad neighborhood. Modules for the AC are being assembled in a Polish factory and trucked to the site in the middle of the night due to the congested streets of Manhattan, according to The Real Deal. Marriott expects the hotel to be fully assembled within 90 days.
Hilton also has gotten ahead of the curve in modular hotel construction. The company has already opened a modular Home2 Suites by Hilton in San Francisco, which went from groundbreaking to opening in 16 months. Hilton has another project in San Jose and two more in the United Kingdom that have already opened. Although traditional construction isn’t going anywhere anytime soon, it would behoove lenders to get ahead of this trend to offer competitive financing options and flexibility for potential developers.