Hypospadias, or incomplete closure of the urethra along the penis, is the second most common birth defect in the United States. We discovered a population of extra-genital mesenchymal cells that are essential for proper penile urethra closure in mouse embryos. This extra-genital population first appeared in the mesenchyme posterior to the hindlimb of the fetus after the onset of penis formation. These extra-genital cells, which transiently express a lineage marker Nr5a1, migrated centrally and colonized the penis bilateral to the urethra epithelium. Removal of the Nr5a1+ extra-genital cells, using a cell-type specific ablation model, resulted in severe hypospadias. The absence of extra-genital cells had the most significant impacts on another mesenchymal cells, the peri-urethra that were immediately adjacent to the Nr5a1+ extra-genital cells. Single cell mRNA sequencing revealed that the extra-genital cells extensively interact with the peri-urethra, particularly through Neuregulin 1, an epidermal Growth Factor (EGF) ligand. Disruption of Neuregulin 1 signaling in the ex-vivo slice culture system led to failure of urethra closure, recapitulating the phenotypes of extra-genital cell ablation. These results demonstrate that the Nr5a1+ extra-genital mesenchymal cells from outside of the fetal penis are indispensable for urethra closure through their interaction with the peri-urethra mesenchymal cells. This discovery provides a new entry point to understand the biology of penis formation and potential causes of hypospadias in humans.