Financing Issues Surrounding Modular Construction

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By ELIZABETH A. BARRETT

Elizabeth Barrett

Modular construction is on the rise in the commercial construction industry, including the new AC Marriott NoMad New York Hotel in New York City, the world’s tallest modular hotel originally scheduled to be stacked late fall 2020.

Modular construction is touted as being faster, better and cheaper than traditional construction; however, many traditional commercial lenders are hesitant to toss their hat in the ring and lend money to such projects due to the collateral timing issues involved with such financing. Understanding the basic distinctions between the applicability of governing law is crucial to structuring the modular build contract and avoiding potential pitfalls. 

Background

Modular construction is an alternative construction method in which 60 percent to 90 percent of a building – usually complete with flooring, ceilings, lighting, plumbing and appliances – is prefabricated offsite in individual modules, under safer controlled plant conditions, using the same building materials and designed to the same building codes and standards as normal construction, yet in about half the time with less waste and without the hindrance of weather-related delays. Simultaneously, excavation and foundation work can be completed at the jobsite, saving time and speeding up the total length of construction. Once complete, the modules are transported to the job site and installed like perfectly fabricated building blocks constructed to seamlessly fit together. When implemented effectively, modular construction results in an efficient high-quality product with greater quality control in about half the time, with more predictable costs and with less waste than traditional construction.

The Financing Hurdle of Modular Building

Despite all its positives, there are still many challenges surrounding modular construction, especially when it comes to searching for financing from traditional commercial lenders. The largest financing hurdle of modular construction is the lack of security for the lender. Because the modules are constructed offsite, some courts have held that the prefabricated modules are considered the personal property of the modular builders as building materials, and the modules do not become real property of the modular builder until they are delivered to the jobsite. Accordingly, when financing modular builds, many lenders will only release loan proceeds after the modules are delivered and installed on the real property to ensure the disbursement is secured. This causes issues for the modular builders, as they need the loan proceeds disbursed up front to construct the modules offsite.

A Potential Legal Fix

A solution may be found in the courts’ treatment of mobile homes, modular homes and prefabricated buildings. Some courts have treated mobile homes, modular homes and prefabricated buildings as “goods” under the UCC. The UCC defines “goods” as “all things (including specially manufactured goods) which are movable at the time of identification to the contract for sale…” If the modules are considered goods, fixtures or commingled goods rather than building materials, this offers lenders the possibility of taking a security interest in the modules as “goods that are fixtures or …goods that become fixtures” prior to the modules being incorporated as part of the real estate. This would allow lenders to disburse loan proceeds to the modular builders to construct the modules offsite, while providing the lenders with their desired security. Win-win, right?

Pros and Cons of Applying UCC to Modular Builders

As stated, from a lender’s perspective, a shift to the UCC view would be beneficial and extend their security interest into the fabrication stage when the modules are offsite. However, this may be easier said than done.  Modular construction is challenging in that it is a hybrid that combines both goods and services; therefore, labeling modules as “goods” may not be that simple. Additionally, from a modular builder’s perspective, labeling modules as “goods” may not be as beneficial or desired. Under the UCC, a seller’s security interests in goods are extinguished upon sale to a buyer in the ordinary course of business, even if the security interests are perfected and the buyer knows of its existence. Thus, if modular construction is governed under the UCC, a modular builder (as a seller of goods) could be stripped of any remaining security interests it may have in the modules after a project owner (as a buyer of goods) has paid the general contractor and incorporated the modules into the finished building. This may cause more hesitation on behalf of the modular builders when considering entering into a modular build contract governed by the UCC. 

The Future of Modular Build Financing

Arguably, if courts would shift their interpretation of modular construction to be within the realm of the UCC as “goods,” it would allow lenders to take a security interest in the modules prior to delivery making it more comfortable for traditional lenders to offer financing to modular construction projects. The courts’ prior treatment of mobile homes, modular homes and prefabricated buildings as “goods” under the UCC opens the door for this possible future shift. However, there is no case law applying this interpretation to larger-scale commercial construction. Until then, careful construction of modular build contracts is required to clarify the parties’ mutual understanding of whether the UCC applies and how the various security interests run with the modules. As modular building becomes more prevalent, we can likely expect to see the nuances of whether the modules are defined as building materials or goods and the applicability of the UCC worked out within the legal system to, hopefully, make modular building more palatable to traditional lenders.

Only time will tell.

Elizabeth Barrett is an attorney at Carmody MacDonald in St. Louis and focuses her practice in the areas of banking, real estate, corporate and business law. She has represented financial institutions and other lenders in complex commercial loans and secured transactions, and other clients in general real estate acquisition and development matters.

This column is for informational purposes only. Nothing herein should be considered legal advice or as creating an attorney-client relationship. The choice of a lawyer is an important decision and should not be based solely on advertisements.

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