Modular Construction Faces Unique Risks

Anticipating and addressing them can help ensure successful projects.

The global modular construction market is set to skyrocket in the coming years. A July 2020 study by market research firm Reports and Data sees modular construction growing at a rate of 6.4% per year, and the market will reach $191.62 billion by 2027. According to the Modular Building Institute’s 2020 Permanent Modular Construction Report, there are “over 250 regional manufacturers in North America building everything from construction site offices to single-family homes and hotels.” This rapidly growing part of the construction industry comes with its own unique risks — practical and legal — that should be anticipated and addressed.  

Modular Basics

Modular construction prefabricates the components of a construction project in a factory. Traditional construction has done this for years — consider steel trusses, cabinets and window units, for example. The recent modular movement goes further. The Modular Building Institute defines the method as “a process in which a building is constructed off-site, under controlled plant conditions, using the same materials and designing to the same codes and standards as conventionally built facilities.” 

Modular components are being used to construct apartment buildings, residential homes, stadiums, airport terminals, bridges, industrial worksites and even skyscrapers. According to a June 2015 report from CNN, a Chinese company used modular construction techniques to assemble the parts for a 57-story skyscraper in a factory over a four-month period, then erected the building in just 19 days. A video of the construction process went viral. Since then, the use of modular in high-rise construction has continued to proliferate. For example, according to the Building Design & Construction Network, two 40-story luxury apartment buildings in Singapore were completed in 30 months, six months ahead of the initial timeline. The towers became the world’s tallest modularly constructed buildings in 2019. 

Modular Benefits

As the examples of the Chinese and Singaporean skyscrapers illustrate, the greatest potential benefit of modular construction is the ability to complete projects faster than traditional construction. According to the research consulting firm McKinsey & Company’s 2019 report on modular construction, “[r]ecent modular projects have already established a solid track record of accelerating project timelines by 20%–50%.” With modular construction, entire rooms for apartments, offices or hotels can be completed while the building’s structure is put into place. In conventional construction, for example, the workers tiling a bathroom would ordinarily have to wait for site preparation, foundational work and framing to be completed before they could begin their jobs.  

Additionally, modular components are constructed in factory settings where work conditions are completely controlled. This promotes better workmanship, because workspaces can be organized so that workers have room to maneuver, resources can be carefully planned and laid out, and weather impacts are removed. This leads to significant efficiency and time savings. Additionally, waste is reduced, making modular construction environmentally friendly, because the materials are precut to exact sizes and raw materials can be ordered in correct sizes to accommodate precise pre-cutting. 

Modular Risks

The main legal risk areas involve the financial condition of the modular manufacturer, the potential loss of units that are damaged or lost during transit or storage, regulatory compliance issues, and the ripple effects of failures in these areas. Additionally, issues in the supply chain will impede modular projects worldwide because shipping interruptions will have major effects on a modular project’s schedule. The following are some questions that should be considered before beginning a modular project.

What happens when the prefabrication firm goes out of business or is unable to complete the components for whatever reason? This scenario came to pass when high-profile modular construction firm Katerra — which was once valued at $6 billion — went bankrupt in June 2021 and was unable to complete many projects. Some owners had the foresight to require Katerra to provide payment and performance bonds for their projects. Those without bonds, however, had to fend for themselves, at their own cost. Moreover, all projects suffered delays while alternative modular construction could be arranged. Katerra failed because its vertical business model, where it would manufacture everything from the concrete casts to light bulbs, was too bold; but many modular construction firms have gone under largely due to the impacts of COVID-19 globally. Therefore, careful vetting of a modular fabricator is essential.

Does the prefabrication firm have the financial ability to complete all units before installation? Generally, owners pay for materials only after delivery to the site. Constructing modules takes tremendous resources, and fabricators cannot be expected to finance all the modules before payment. But owners do not want to pay for work that they may never receive. Also, owners need to be sure that their money actually goes to constructing their units. Carefully devised payment processes must be put into place. Payment and performance bonds are critical to protect against this risk. 

What happens if components are lost or destroyed before installation? Prefabricated modules coming from overseas, or even from domestic factories, can be lost or damaged during delivery. Parties must ensure that their contracts and insurance, including general liability and builder’s risk insurance, will allocate and cover these events, along with resulting schedule delays and consequential damages such as rental losses due to delayed completion. However, project policies may decrease in price and scope because a substantial portion of the risk is cut from the worksite. 

Because they must be transported via ship or truck, modular components face size and design constraints. The parties must ensure that delivery routes can accommodate oversized loads, which many crowded urban settings cannot. Moving such loads in urban areas may require special permits. Overhead wires must be avoided. Once the materials are delivered to the site, they must be protected and adequately stored.

Modular Contracts

Arguably, modular units could be treated as products, like cars or refrigerators. The Uniform Commercial Code (UCC) would thus apply to sales of such units. (See box) On the other hand, common law applies to the provision of services. Most courts generally hold that modular construction contracts provide for services, and they apply common law. But some courts have found such contracts to be for the sale of goods and have applied the UCC. Depending on the issue, the UCC or common law favors one party over the other. The parties must be careful to draft their contracts to specify which law applies.

In September 2020, ConsensusDocs, a coalition of 41 leading design and construction industry associations, published the first-ever industry standard modular construction contract — ConsensusDocs 753, Standard Agreement Between Constructor and Prefabricator. This form contract allows the parties to stipulate whether the UCC or common law applies.

Modular Licensing and Permitting

Modular construction projects must comply with licensing and permitting requirements detailed in state and local building codes. There are three potential levels of permitting required for a modular project: worksite permitting and licensing controlled by state and local law; state regulations governing fabrication of modular units; and local regulations and approval requirements for modular projects. 

For example, in New York City, prefabricators must work closely with regulators in the city’s Department of Buildings to ensure that the components are up to city code. ConsensusDocs 753 stipulates that work shall comply with the state and local licensing requirements of the state where it is performed; and to the extent allowed by law, the law of the state of the fabrication site will govern all licensing requirements related to the construction of the components. 

Wrapping it Up

Modular construction is a rapidly growing global industry. Because of reduced costs, quicker schedules and demand for environmentally conscious construction work, many owners are becoming more interested in modular construction. Consequently, the construction industry will continue to see a proliferation of modular projects. Prudent owners and contractors will vet modular fabricators, allocate and provide for risks carefully by contract (including specifying whether the UCC applies), provide for protective payment processes, and ensure that proper insurance and bonds are in place.

Daniel F. McLennon is a partner in the San Francisco office of construction industry law firm Smith, Currie & Hancock LLP.