Introduction
From a developer’s perspective, timely payments of invoices are critical to getting a project finished on time and under budget. But, what if your lender refused to issue the next draw? You’ve paid all the interest payments on time and achieved the agreed upon milestones, so what basis would the lender have to withhold the next draw? In the case where you are financing a modular construction project, there is one scenario that can cause this to happen.
Our previously published article showed that recent innovations in the modular construction industry can reduce timelines by as much as 50% and costs by 20%. But these advances have not come without their share of challenges, especially when it comes to financing modular construction. While the scenario above is far from commonplace, it happens often enough to warrant a closer look.
If we view a construction project from the eyes of a lender, the construction timeline could be considered as a series of smaller projects in which funds would be released as work progresses and milestones are achieved (according to the draw schedule). However, in the modular construction timeline the manufacturer typically requires a large up front deposit (upwards of 50%) before construction commences with the balance of the invoice due once the units are completed.
The problem is that the current lending paradigm is structured such that funds cannot be released until materials are delivered onsite and the work has been verified. On the other hand, manufacturers of modular homes typically require payment in full before the units are shipped to the site.
Defined Risk
If a project were in flight and neither side was willing to compromise, the project would be at an impasse. But which side is correct in their position? Should the lender assume the risk and pay for the units with the expectation that they have been properly constructed and will be delivered in tact? Or, should the manufacturer take the risk and ship the modules to the site based on the trust that the lender will honor payment once delivered? The truth is that in today’s environment many lenders avoid financing modular projects for this very reason. This brings forth the possibility that there are more projects that would utilize modular construction if they could obtain the necessary financing.
The good news is that while the modular industry is still relatively nascent, the problem that the lender and manufacturer face has been around for years. In the world of international trade finance, importers and exporters face this issue on a daily basis. For example, suppose a domestic importer places an order for widgets with an international manufacturer. The importer does not want to pay for the order in full (or provide a substantial deposit) without any tangible product. At the same time, the manufacturer does not want to engage all of their resources if there is a risk that the importer ultimately does not pay. In trade finance, they can solve this dilemma by appointing a mutually agreeable third party to assume the counter-party risk of the transaction. The third party, (typically a bank) underwrites the credit worthiness of both parties, and if the risk is acceptable the bank will extend a form of payment guarantee to mitigate the counter-party risk.
Payment Guarantee
In the trade finance example, the mechanism the bank uses to mitigate the counter-party risk is a financial instrument called a letter of credit, typically issued in favor of the supplier or exporter. As long as the supplier fulfills the terms of the agreement within the specified time frame, the bank will guarantee payment for the services rendered by the seller. Alternatively, the bank may issue what is called a standby letter of credit, where the structure is similar to a letter of credit, except that the buyer, not the bank is expected to provide payment for services rendered. The bank will only step in if the seller fulfills their obligations and the buyer defaults on the payment. In the situation where the developer is financing modular construction, the manufacturer could ship the modules to the site at the time the units are completed with the assurance that if the lender fails to pay upon delivery, the manufacturer can demand payment from the bank.
Performance Guarantee
In the previous example, an argument could be made that the manufacturer still bears most of the risk of the transaction. If these terms won’t work for the manufacturer, it is possible to structure the guarantee in the other direction as well. The lender could require a performance guarantee or bond against the manufacturer, where the third party bank or insurance company will provide reimbursement if the manufacturer fails to deliver on their contractual obligations. Lenders should have a certain level of comfort with this method already as it is widely used in traditional construction. The difference here is that the lender would provide funds on the accelerated schedule with the assurance that if the final product is not delivered in accordance with the agreed upon terms, they can seek reimbursement for damages from the bank or insurance company.
Escrow
Letters of credit can become complex financial instruments, requiring consultants and attorneys with expert knowledge to be executed properly. While larger projects certainly justify the additional expense, smaller projects may benefit from a simpler solution. If the invoice amount is small enough and the manufacturer and lender mutually agree upon an intermediary, an escrow service can provide a viable third option. In this case, lender funds are held in escrow, and the authority to release the funds is entrusted to a third party based on terms drafted in advance, similar to how commercial title transactions are currently done.
Final Thoughts
In our previous article, we outlined the potential benefits that modular construction can offer. However, the fact that so many lenders today shy away from lending on these projects is unfortunate, because the reality is that we can leverage existing practices from other industries to mitigate the counter-party risk. In this article, we outlined three viable methods for financing modular construction by deferring the counter-party risk to a third party. Whether the project be modular or traditional, these methods can provide an effective solution to bridge the gap whenever there is a transaction that carries a high level of counter-party risk. As the modular construction industry evolves and is able to achieve significant cost savings over traditional, the current lending environment will need to evolve to stay on par.