Interest Reserves – Covering Interest Shortfalls During CRE Construction

An interest reserve is a portion of the loan set aside to cover interest payments during the construction and lease-up period when the property isn’t generating income.  The reserve account held with the lender is funded using the initial loan proceeds and is calculated on expected future draws.

Construction loans are typically only accruing interest on funds drawn up to that period.  Unless the loan is using “Dutch Interest”, where interest is charged on the full loan amount even if only a portion of the funds have been dispersed. 

Example:

ABC Corp is building a 175-unit mixed-use development with a retail component on the ground floor.  The construction budget includes land acquisition cost of $15,000,000, soft and hard construction costs of $55,000,000, for a total project cost before financing of $70,000,000.  To finance the development, they secured a construction loan of $52,088,973 (70% LTC) at a 10% interest rate, which includes a loan amount of $47,676,535, an interest reserve of $3,935,673, and a loan fee of $476,765.  The construction and lease-up period is 24 months and will be paid straight-line, the interest reserve ensures that interest payments are covered during this period, allowing for smooth delivery of the project.  

See the draw schedule, equity will fund first and will cover the acquisition costs and some of the initial construction costs.  You can see that the equity funded Months 1, 2, 3, and partially 4.  Then at this point (Month 4), the loan amount of $47,676,535 will begin funding, which is also signaled by the loan fee of $476,765 incurring in this period.  There was $1,843,202 of debt funded in Month 4; therefore, this amount will accrue interest for the next period.  The calculation is:  10%/12 x $1,843,202 = $15,360 interest accrued shown in Month 5.  This process will continue until the end of the construction and lease-up period of 24 months, at which the property can generate sufficient income to cover interest payments.  The sum of the accumulated interest payments is the interest reserve.