What Are Interest Reserves and How Do They Work?

An interest reserve is a fund established within a loan agreement to cover interest payments for a set period. It is frequently used in commercial real estate for construction projects, where a property does not yet generate income. The reserve sets aside a portion of the loan proceeds to handle these payments, allowing the project to proceed without the immediate pressure of debt service. This provides a way for lenders to receive timely payments while developers focus on completing the project.

Calculating the Interest Reserve Amount

Calculating an interest reserve involves estimating interest costs during the project’s non-income-generating phase. Lenders determine the reserve size based on the loan amount, interest rate, and the length of the reserve period. This period corresponds to the construction timeline plus any anticipated lease-up or stabilization period, ensuring funds are available until the property generates enough cash flow to service its debt.

The project’s draw schedule, which outlines when loan funds will be disbursed, is a key part of the calculation. Because interest only accrues on drawn funds, the calculation projects the loan balance over time rather than using the total loan amount from the start. For example, on a $5 million loan with a 12-month construction period and an 8% interest rate, the lender would not set aside a flat $400,000.

The lender models the anticipated draws, which are often smaller at the beginning and end of the project. Interest is then calculated on the projected outstanding balance for each month of the reserve term. If the rate is variable, the lender will add a cushion by assuming a higher rate to protect against market fluctuations. The sum of these projected monthly payments becomes the total required interest reserve.

Funding and Holding the Reserve

After the reserve amount is calculated, it must be funded. The most common method is for the lender to withhold the reserve amount from the initial loan proceeds. This means the borrower does not receive the full loan amount in cash, as a portion is segregated into the reserve account. This approach guarantees the reserve is funded without relying on the borrower’s separate capital.

Alternatively, a borrower may be required to fund the reserve with their own equity, especially if the loan-to-cost ratio is high. In this scenario, the borrower provides the cash for the reserve at loan closing, in addition to other required equity contributions. This method increases the borrower’s initial cash outlay but can result in more favorable loan terms.

Regardless of the funding source, the interest reserve is held in a separate, lender-controlled account. This account is referred to as a pledged or blocked account, meaning the borrower cannot access the funds directly. The lender maintains sole authority to make withdrawals for paying monthly interest. These accounts do not earn interest for the borrower, as their purpose is for security and payment administration.

The Disbursement Process

Disbursement from an interest reserve account is an automated process managed by the lender. Each month, the lender debits the reserve account for the interest due and applies it to the loan. This automatic process ensures timely payments without any action from the borrower and continues throughout the reserve period.

At the end of the reserve term, the lender reconciles the account. If funds remain, perhaps due to early project completion or lower interest rates, the surplus is handled in one of two ways. The lender may return the excess funds to the borrower or apply the amount to reduce the outstanding loan balance. The outcome is dictated by the loan agreement.

A shortfall in the reserve can occur if the project is delayed, draws are larger than anticipated, or variable interest rates rise. If the reserve is depleted before the property generates income, the borrower must begin making interest payments out-of-pocket to avoid default. Lenders monitor the reserve balance and will notify the borrower if a shortfall is projected.

Accounting Treatment of Interest Reserves

For the borrower, accounting for interest paid from a reserve is governed by the principle of capitalized interest under Generally Accepted Accounting Principles (GAAP). Per ASC 835-20, interest costs incurred during the construction of a long-term asset are not treated as a period expense but are instead capitalized. This means they are added to the historical cost of the asset on the balance sheet. For example, interest paid from the reserve during a building’s construction is added to its value, increasing the asset’s depreciable basis once it is in service. This approach prevents a company from showing large losses during a construction phase when no offsetting revenue is being generated.

For the lender, the interest reserve is recorded as a liability on their balance sheet, representing funds held for the borrower. When the lender disburses funds from the reserve for an interest payment, the liability is reduced. At the same time, the lender recognizes interest income on their income statement, ensuring their financial statements accurately reflect the transaction.