Loans > Commercial Construction Loans and Computing the Interest
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.
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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