Interest Reserve

What is an Interest Reserve?

An interest reserve is a portion of a loan set aside to cover interest payments during the development or construction phase of a project. This reserve is calculated based on the loan amount, interest rate, and expected duration of the construction or lease-up period. By incorporating an interest reserve, lenders enable borrowers to defer interest payments until the property begins generating income.

How Do Interest Reserves Work?

The mechanics of interest reserves are straightforward:

1. The lender holds back a portion of the loan proceeds in a separate account, known as an interest reserve account.
2. Each month, the lender draws from this account to pay the monthly interest expense on the outstanding loan balance.
3. This process continues until the property starts generating sufficient income to cover debt service or until the reserve is depleted.

For example, in a $1 million, 12-month bridge loan at 11% interest with monthly payments of $9,166.67, the lender would set aside $110,000 at closing to cover the interest payments.

Benefits of Using Interest Reserves 

Interest reserves offer several advantages in commercial real estate financing:

• Cash Flow Management: They enable borrowers to manage cash flow during the construction and lease-up phase when the property is not yet generating revenue.
• Project Focus: By alleviating the immediate pressure of interest payments, developers can concentrate on timely project delivery and tenant acquisition.
• Lender Security: Reserves provide additional security for lenders, ensuring interest payments even if the property is not generating income.
  
  

Risks Associated with Interest Reserves

Despite their benefits, interest reserves come with potential risks:

• Depletion Risk: If a project experiences significant delays or cost overruns, the interest reserve may be exhausted before the property generates sufficient cash flow.
• Masking Problems: Poorly underwritten loans with excessive interest reserves can conceal underlying issues with a project, increasing risk for the lender.
• Monitoring Challenges: Lenders must carefully track construction progress and lease-up to ensure appropriate use of interest reserves.
  
  

Accounting Treatment for Interest Reserves

The accounting treatment of interest reserves is critical for accurate financial reporting:

• Under GAAP, interest reserves are typically treated as a contra-asset account, reducing the outstanding loan balance.
• As interest is paid from the reserve, the contra-asset account decreases, and the lender recognizes interest income.
• This treatment ensures that financial statements accurately reflect the loan's economics and the borrower's financial position.
  
  

Best Practices for Managing Interest Reserves

To effectively manage interest reserves, consider the following best practices:

• Establish clear policies for calculating reserve amounts and monitoring project progress.
• Structure reserves based on realistic project timelines and budgets, including contingencies for potential delays or cost overruns.
• Regularly review project status and be prepared to take action if a project encounters difficulties.
• Utilize property management software features for raising invoices for future rent to help manage these reserves effectively.
  
  

Red Flags for Interest Reserve Misuse

Watch for these warning signs of potential interest reserve misuse:

• Projects significantly behind schedule or over budget without a clear recovery plan.
• Premature depletion of interest reserves with no additional capital from the borrower for future interest payments.
• Completed properties with stalled lease-up or sales, indicating possible market misalignment with proposed rents or prices.