Operating Shortfall Paid by Equity or Debt?

Pudding is generally correct. Assuming you haven't blown through your loan, there will typically be an allowance for operating deficit that you can draw on in your capitalized budget. Otherwise those expenses will need to be funded with equity.

It depends on the type of loan. If this is a construction loan and the building is now operating, there will be specific covenants that you have to meet. You'll be in default (technically) if you miss one of those. That is sort of more important than trying to think about to where the shortfall will be allocated. As mentioned earlier, there is an interest reserve budgeted into certain loans. Those will allow you to run a deficit and have the loan pay for itself. However, any time you have an unplanned shortfall, you're going to be paying for it with equity per the loan agreement. The bank may (perhaps even often) give you some wiggle room on this, but you certainly won't be guaranteed to have the debt pay for itself. 

Typically on a construction deal, the budget is set. Say $50 million. If the construction loan is 65% LTC then the borrower puts their $20 million of equity into the project first. Then, the remaining $30 million of debt funds the completion, interest expense, and budgeted operating deficit prior to stabilization. The sponsor would pay the operating deficit if the total costs exceed the budget. If you are approaching that scenario then you will probably be in discussions with your construction lender because they will want assurances that you will fund it.

Here’s the answer:

If the deficits are planned (e.g. a development, reposition, known-vacate lease-up play, vacant building) almost always the lender will force the borrower to fund a reserve, the operating reserve, at closing to fund operating shortfall. Interest is paid on this reserve if it is funded through debt and not equity. If funded through equity, the underwritten amount, which lender has to agree on, must be placed in a joint-controlled bank account or escrow. Usually it’s funded through debt and functions just as a lender holdback that the borrower is entitled to monthly and pays interest on.

Sometimes this reserve will be combined (sometimes separate) with a debt service reserve, that interest is paid on. Same comment as above to whether it’s debt/equity, but borrowers heavily prefer debt as it helps their returns. Both of these reserves, whether combined or separate, will be drawn down on when needed.

If it is NOT planned, e.g. a stabilized office building where a major tenant goes bankrupt and blows out - the borrower must fund through equity. In this scenario, there is likely a fixed-rate loan in place with all or nearly all proceeds funded at acquisition. Therefore there is no additional debt to fund the shortfall. Further, the borrower is further punished via loan covenants which state (for example) the property must maintain a 1.30x DSCR tested annually. If this test is failed, borrower has certain elections they must choose from or the loan goes into default. Usually the elections are: a cash flow seep (all excess NOI, if any, goes to a lender-controlled bank account), posting a 12-month debt service reserve, or posting a large enough principal payment that the loan is ‘right-sized’ back to a 1.30x DSCR (as in this example).

If the above paragraph is the case, the covenant failure is ‘cured’ when the property maintains a 1.30x DSCR (as in this example) for x amount of quarters. Borrower can also always sell or refinance to get rid of onerous terms if the sale or new terms are economically favorable.