I don't think this question is as dumb as it sounds, so bear with me for a moment. I know it's interest (duh) but I'm asking about the deeper mechanics.
Say you have a $15m construction loan and the interest is paid monthly, not accrued and paid at the end, so you add 1.5m to the loan for interest reserve and start paying the interest on the 15m from the extra reserve you took out. But from the banks perspective they are just giving you 16.5m for you to pay back slowly until you can get a refi loan or disposition, there isn't any extra cash entering the equation, where are their earnings coming from?
I understand if the loan is accrued interest then the bank sees that money at the end of the term so you don't have to take out an interest reserve, but I'm not sure how it works with monthly IO payments. I must be missing something.
Think of it this way.
We develop a $50MM apartment project with 65% leverage, meaning it's a $32.5MM loan. Say that loan is three years I/O. For three years we pay interest on that loan, starting with the interest reserve and ultimately from cash flow, then right before we start having to pay principal, we sell the deal. With the deal proceeds, we pay off the debt in full.
So, for three years, the bank just collected interest (over $4MM) on a $32.5MM loan. Every cent of every payment went to them, not the loan itself. Further, the bank makes you include an interest reserve in the deal itself, so a lot of that interest payment is guaranteed to them. No matter how much you mess up, the interest payment amount is already in the capital stack. Then, if things get super sideways and you run out of interest reserve because you didn't lease fast enough to cover the rest with cash flow or something, the developer and the equity partner are on the hook for a capital call.
Now replicate that many times over. That's how they make money.
I guess my question is where that interest reserve comes from, if its coming from equity or mezz I understand, but I've seen (or maybe misheard) it coming from the lender itself as part of the loan structure. If it does come from the lender itself then that collected interest is just repayment of part of the loan.
In your example they get $15MM and pay you back $16.5MM. The $1.5MM isn't cash to the borrower, it is just accrued interest the borrower hasn't paid back that is added to the loan balance instead of paid.
I get your point of view, that the lender isn’t collecting interest on the full principal amount for the whole construction period. But the answer to your question is really as simple as you said it, lenders make money on those interest payments and fees (originations etc). Dont forget the spread is higher than a typical stabilized loan. Construction loans are also typically recourse, so the GP or developer is really on the hook. In addition, most lenders will only lend on shovel ready projects so you have that entitlement risks out of the equation. Lenders will also typically require you to buyout 60-80% of the subs contracts, so all the costs are mostly locked in - again, lowering risks of changing construction costs. Also, by the time the construction loan draws are made, all of the equity are spent - meaning the project is already 35-50% done on a TDC basis. At this stage, most the costly things that would go wrong in the project (foundations, subs buyouts, entitlement etc...) are already done, you're left with mostly interior works.
Therefore, on a RISK ADJUSTED basis, it’s a better deal for the lender than you think. You can’t just compared interest rates between a stabilized loan and construction loan without taking into account the other hooks. I'm no lender but I'm sure some can elaborate further.
It's just a question of a slightly lower yield. If you're funding an interest reserve, then you are essentially making a larger loan, as you say. So the 4% interest rate might only yield in the high threes, but it's also guaranteed income and so you adjust the risk factor accordingly.
So, not to point the obvious, but if they lend 16.5, they get interest on 16.5, where it comes from is irrelevant cash is fungible. Its Principal + Interest every year, their total earnings is all the interest for how ever long the loan lives. Just like a car loan, credit card loan or whatever.
Does it really make a difference you 'take' lender money and put into escrow then pay contractors with your own cash vs. the other way around? Any any you slice it, they get more $$$ back then they fund over time, each and every time.
I understand that, I'm saying when a developer is putting together the capital stack they can fund the interest reserve from two sources, more debt or equity, right? I have heard of situations (and again, I think this might be a misunderstanding of what other people are saying) where the interest reserve comes from the very same debt source as the underlying loan to begin with. As a result their cash flows are 16.5m to the developer (15m for the loan and 1.5m for the interest reserve) and they're just getting 16.5m back. Some part of the equation has to be missing. And I appreciate everyone's patience with this, haha, no one's insulted me yet!
Yeah, it would be a 16.5 million loan, interest payable on all 16.5 million, the 1.5 to reserve is a "use", the 16.5 is a "source", you payback 16.5 plus interest.
In many instances, the lender pays its own interest reserve.
min your example, for a 16.5 million dollar loan, 15 million would be funded, and 1.5 million held back to pay interest. Every month, the lender will take money from the account holding the 1.5 million, and “pay” itself interest. At the same time, this adds to the total principal balance of the loan. The lender is booking the money and it sounds odd. But think of it this way - it helps the lender get more money out the door and it’s structured into the deal from the start of underwriting.
Bank only gives you 15M, the 1.5M "reserve" is non-cash, and gets added to the loan amount but bank keeps the reserve and just pays itself from the reserve.
+1 SB. You don't get the $1.5 M of interest - it's a non-cash item. In the scenario mentioned, they give you $15 M cash that goes out the door, and they credit (on paper) $1.5 M in interest that you have to return to them.
It's the same as if you loan someone $100 and tell them that they have to pay you back $120 at the end of the year. You're "funding" the interest, but it's a non-cash item.
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