Construction Loan Interest Reserve

Consultant in PE - Other

Hi All- I have a question on the use of the interest reserve for construction loans. Is the purpose of the reserve to allow the borrower to finance interest payments during the construction period? Can loan closing fees be financed similarly? Thank you all for your input.

Comments (5)

Most Helpful
Feb 5, 2020

Yes and yes.

    • 3
Feb 6, 2020

No, Yes.

Interest Reserve is usually one or two months extra that the sponsor has to carry in equity.

Capitalized Interest is the proforma interest cost that is in the budget.

Fees get capitalized as well.

Feb 6, 2020

above comment is spot on...but to elaborate in case you were unsure of the term capitalized...

when submitted a budget to a bank for a construction loan, a line item in your budget is interest expense during the draw/build out period. Obviously you have no cash flow from the asset to pay for this interest. So what happens, is part of the loan proceeds you borrow from the bank, go towards paying the interest. In effect, the bank is lending you money to pay the interest on the very loan they are giving you.

Closing fees, etc are also "capitalized"...or aka paid via the loan proceeds from the bank. Every deal is different, and some banks allocate loan proceeds to specific line items which in turn changes your draw timing and equity contribution timing.

Interest reserve is a completely separate issue. Often times banks will require you to fund, via equity, and interest reserve account that is to remain untouched for any other expense...except in a scenario where capitlalized interest is all spent, and there is still not enough operating CF to pay the loan payments. To ensure the bank receives X amount of its debt service, this reserve account is set up to fund any debt service shortfalls that may occur. Again, every deal is some situations if you were to ever draw down on that reserve account, first priority of next available cash flow would go towards replenishing it. Other deals not so much - as you may imagine it varies.

hope the extra explanation helps.

    • 3
Feb 6, 2020

The term "Interest reserve" can be used interchangeably here, both as a line item for your construction budget and to describe a reserve account required by the bank to cover interest shortfalls. The latter is rarely required for construction loans since the interest reserve line item in the budget should cover all loan interest during construction/lease-up. But say a the developer sells the project to the buyer while it's still in lease-up. In this case the buyer's bank will likely require an interest reserve account, funded by the buyer, until the project stabilizes. Also, Closing fees and other financing fees are typically paid at closing using equity since equity is funded first in a construction project.

    • 2
Feb 6, 2020