Construction Loans > Commercial Construction Loans and Computing the Interest Reserve
Commercial Construction Loans and Computing the Interest Reserve
The Interest Payments During Construction Come Out of an Interest Reserve
Let's suppose you are building an apartment project, and you paid cash for the land.
You therefore own the land free and clear. You then obtain a $2 million commercial construction loan from your bank. The grading subcontractor finishes removing the tree trunks and grading the property. He hands you an invoice, which you hand over to the bank. The banks sends a progress inspector out to verify that the grading has been done and then pays the invoice. Let's further suppose the bank pays the concrete subcontractor and then the rough carpentry subcontractor later that month.
Guess what? At the end of the month, the commercial construction lender (your bank) is going to demand an interest payment (7% annual rate) on the funds they have already advanced! You owe interest on the construction loan during construction. "But George, I don't have any more money. I spent every dime I had to buy the land, and the property isn't generating any rent yet!"
The interest on the construction loan during construction is paid out of an interest reserve, which is a special savings account funded out of the proceeds of the construction loan. Think of your interest reserve as one of the line items in your construction cost budget,
like the Finish Electrical Cost or the Sewer Hook-up Fee. As long as you can complete your apartment building and get good tenants paying rent before your interest reserve runs out, you are golden.
How do you compute the amount of money that needs to be set aside in the interest reserve? At the moment that the construction loan funded, you had not yet drawn down a dime. By the end of the construction term, say one year, you will almost certainly have drawn down the entire construction loan amount. Roughly, therefore, on average, about 50% of the loan funds will have been drawn down.
Therefore to compute a reasonable interest reserve, simply take the construction loan amount ($2 million) times the annual interest rate (7%) times the term of the loan (1.5 years). Then, since on average only 50% of the construction loan will be outstanding, you multiply the total interest cost by 50% to get a reasonable estimate of the interest reserve.
On large projects construction lenders will prepare a Construction Loan Budget, complete with a Schedule of Disbursements, on a spreadsheet. The lender will then compute the actual anticipated interest expense and use this figure in the Interest Reserve.
On smaller projects, however, the construction lender will merely assume that only 50% to 60% of the construction loan on average will be outstanding.
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