Banks and commercial real estate (CRE) lenders offer a specialized lending product for real estate developers and investors who need financing for their projects. The loan is commonly referred to as a “construction loan.” One of the most unique features of a construction loan is the “interest reserve” account that is used to make the loan payments during the construction phase.
In this article, we’ll explain how a construction loan works and how to calculate the interest reserve, including with an example. In order to fully explain what interest reserve is and how it works, it is first necessary to discuss the specifics of construction lending.
How Does a Construction Loan Work?
A construction loan is a loan in which the proceeds are used to build or renovate a property. There are five features that make construction loans unique:
Most construction loans are closed-end lines of credit, which means that they start with a zero balance at origination and increase over time. As loan payments are made, funds are not available to be re-used for additional needs.
To minimize interest expense, the construction loan amount is not disbursed at closing. Instead it is advanced in stages or draws based on the borrower’s need and the project’s stage of completion. The number of draws available for disbursement are dependent upon the size and scope of the project and the lender’s product parameters.
3. Construction Budget
Prior to construction loan approval, the borrower is required to submit a construction budget with line item detail about how much they think each major component of the project will cost. For example, line items could include things like drywall, electrical, landscaping, and plumbing. When the construction lender advances a draw, the funds are pulled from the relevant line items.
Construction loans have a defined “construction period,” which is an amount of time that the borrower has to complete the project. Upon expiration of the construction period, the loan either becomes due in full, or its payments convert to principal and interest. Either way, it suddenly becomes more expensive at this point.
5. Interest Reserve
Construction loans have an interest reserve account from which the interest payments are made during the construction period. In most cases, the loan’s first advance includes an upfront deposit into the interest reserve account in an amount sufficient to make the loan payments for the entirety of the construction term.
On this last point, ensuring that there is enough money in the interest reserve account can be a tricky calculation. There are several variables that go into it, and these are the primary subject of this article.
How to Calculate the Interest Reserve
The interest reserve is a capital account established from the lender from which the loan’s payments are made during the construction period. In practice, the interest reserve is a checking account from which the payments are automatically drawn. At the start of a construction loan, the interest reserve must be estimated so the lender knows how much money to place into the interest reserve account. But, the interest reserve calculation can be tricky because it depends on six variables:
1. The Loan Amount
The first variable in the interest reserve calculation is the loan amount, and it matters because the amount of interest due is a direct function of the total loan amount.
2. Draw Schedule
Again, the loan balance starts at $0 and increases with each draw disbursed. At the start of the loan, draws are “scheduled” in the sense that the lender provides an indication of how many they will process. In many cases, five draws is fairly standard. Because the loan balance goes up with each draw, monthly interest payments increase in kind and they must be accounted for.
In addition to the amount of each draw, the timing is an important component of the interest reserve calculation as well. This is because the longer the balance is outstanding, the more interest is due. From a modeling perspective, a bank analyst will have to figure out the amount of each draw, as well as when it occurs, to estimate the interest payment each month.
4. Borrower Equity Contribution
Of the total construction cost, it is important to know how much will come from the borrowers’ pockets. From a timing standpoint, most lenders require the borrower to inject equity before loan funds are used, so this affects the distribution of loan proceeds and the calculation of loan interest.
5. Construction Term
Each renovation or development has a planned construction term, over which time the loan proceeds are disbursed. The construction term puts an “end date” on the required interest payments and the loan term usually matches it closely.
With these variables in mind, the analyst can estimate the amount of interest needed by creating a “schedule” of anticipated construction draws, the timing of these, and their individual amounts. This is usually done in Microsoft Excel or a comparable spreadsheet program. To illustrate how this is done, an example is helpful.
Interest Reserve Example Calculation
Suppose that a bank has approved a new construction loan for $1M. The construction period is 12 months, the interest rate is 6% (annually), and the interest payments will begin in month 2 (11 months of disbursements).
Based on the amount and timing of the draws, the first step is to estimate the percentage of the loan balance that will be outstanding over the construction period. As a general rule of thumb, 50% ($500,000) is a safe bet.
With this information known, the interest reserve formula to calculate the estimated interest is:
(Loan Amount * Avg. Outstanding Balance) * (Interest Rate/12) * Construction Term
In this example, the result would be ($1,000,000*50%)*(6%/12)*11 = $27,500. This is the amount that would be deposited into the interest reserve account with the first draw. However, construction does not always go as planned.
What Happens If The Interest Reserve Is Not Enough?
Even the most detailed plans have a way of getting off track. With regard to the interest reserve amount, time is the key component. For each day that the loan balance is outstanding past the initial estimate, more money has to be paid in interest. As a result, if there is a bad storm or the permitting for the project is delayed, the interest reserve funds can deplete quickly.
What happens if the interest reserve funds run out before construction is complete? Typically, one of three things:
- Funds have to be reallocated from other budget line items. If another construction budget line item has availability, those funds can be moved into the interest reserve. However, this must be approved by the lender.
- The loan balance is increased. If there are no line items with availability, the lender may opt to increase the loan balance and deposit the new funds into the interest reserve.
- The borrower pays. If the lender is unwilling to approve one of the above requests, the borrower may have no other choice but to dig into his or her own pocket and make the interest payments until construction is complete and the loan is repaid.
None of the above are a desirable outcome, so it is a best practice for the analyst to estimate high and expect delays when underwriting the loan request.
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