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In a typical commercial construction loan, borrowers are required to set aside loan funds in the construction budget to pay interest on the loan since the property will not be generating income to pay interest during the construction phase. Practically speaking, often an account is funded at the time of the loan closing so that the lender can draw from it to fund interest until the project is leased-up or otherwise generating income. This account is referred to as the interest reserve account. Generally, the presence of an interest reserve benefits both the lender and borrower as the lender can collect its interest and the borrower has means to fund the lender interest until cash flow is generated from the project.

What if the interest reserve account is depleted prior to development or lease-up of the property?

Given current economic conditions, this issue is becoming more frequent for developer borrowers. For construction loans that closed in 2020 or 2021, borrowers are now finding it increasingly difficult to lease-up their space during the construction phase. Outside of general macroeconomic conditions, this problem may arise if construction ends up taking longer than expected or if the interest reserve was miscalculated on a loan with a floating rate due to a failure to properly forecast rising rates. When the funds in the interest reserve account run out, the borrower and lender are left with a few options to solve the problem:

1. Borrower Funds the Difference Out-of-Pocket
Unfortunately, this is the direction many lenders are leaning towards. This is why negotiation of the loan documents is critical. For example, the loan documents may have a requirement that in order to extend the maturity date of the loan, the interest reserve account should have enough funds deposited into it that the borrower can continue to pay the interest until the new maturity date. It is likely that the borrower and the lender may have different ideas of how much money is required to be deposited into the interest reserve account in order to continue to pay interest until the new maturity date. If the loan agreement requires that the amount to be funded into the interest reserve account be “reasonable” or “determined in lender’s reasonable discretion,” the borrower will then have ammunition to argue that the amount the lender is asking for may not be reasonable, or in other words, the borrower may argue that other lenders do not have such stringent requirements when it comes to interest reserves.

2. Budget Line Item Reallocation
This option seems to be the simplest solution to the problem, but the loan documents must first allow the reallocation. Typically, reallocation provisions in the loan documents are heavily negotiated. Lenders are unlikely to agree to such redistribution of funds upfront in the loan documents. It is likely that the loan documents may allow such reallocation upon the lender’s written consent which means that the borrower is left asking for the lender’s consent in the eleventh hour when the interest reserve has run out. Further, to get to the point of development where the interest reserve has run out, it is possible the construction and development phase has gone so awry, there may not be any line items to take funds from to reallocate to interest reserve.

3. Loan Increase
This one also sounds like an easy fix, but getting the lender to agree to it may be difficult. A depleted reserve account is a red flag to the lender that the borrower will not be able to pay the loan on the maturity date; therefore, the lender will be reluctant to pour more cash into the project. If the lender does agree to this route, they may first want to get a new appraisal and analyze if the project is still feasible given the current market.

Although interest reserve shortfalls are becoming increasingly more common in today’s market, there are solutions to the problem if the lender and the borrower are willing to work together. Borrowers should plan ahead and negotiate the loan documents with these potential solutions in mind.

Sources:
https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/commercial-real-estate-lending/pub-ch-commercial-real-estate.pdf

https://www.fdic.gov/regulations/examinations/supervisory/insights/sisum08/sisummer2008-article03.html

CONTACT:

Paige LancePaige Lance  I  214.745.5853  I  plance@winstead.com

Paige Lance is a member of Winstead’s Real Estate Development & Investments Practice Group. Paige is experienced in representing both lenders and borrowers in acquisition and construction loan transactions as well as representing real estate developers in all stages of real estate development.