## Sunday, August 7, 2016

### How to Calculate an Interest Reserve

In this post we'll look at how to calculate an interest reserve for a construction / bridge loan. Here's a link to the spreadsheet that actually performs the interest reserve calculation:  interest reserve calculator.

### What is an interest reserve?

Some deals might not generate enough cash flow to cover the interest payment on the loan. Development deals, redevelopment deals, or deals where there's a large tenant rolling in the near-term are examples where cash flow might not cover interest payments. Banks, thankfully, will still make loans on these types of deals. On the months where the cash flow is projected to not fully cover the interest payment, the bank will actually lend you the money to pay the interest. Yes, that's right, the bank will let you draw on the loan to pay the interest. The amount you draw will then be added to your loan balance.

### What's so difficult about the calculation?

It would seem that the interest reserve calculation is pretty simple, right? Just take the amount of the interest payment not covered by operating cash flow and that's your interest reserve for the period. That amount is then added to your new loan balance and the next interest payment is calculated off this new balance. While that's all true, the real tricky part is the loan sizing.

A lender will often size a loan based on loan-to-cost (LTC). LTC is simply the Loan Size / Total Project Cost. If the loan size is \$1.5M and the total project cost is \$2.0M, then the LTC is 75%. Now, the tricky part is the interest reserve is often factored into the lender's total project cost calculation, creating an iterative calculation.

### What is an iterative calculation?

An iterative calculation is summarized by the following: calculation A's answer depends on the answer of calculation B, but calculation B's answer depends on calculation A's. A more specific example would be the following: Function A = Function B + 1 and Function B = Function A + 1.

In our interest reserve calculation, we have an iterative function because our loan size is dependent on the size of the interest reserve, but the interest reserve depends on the size of the loan. We already saw how the interest reserve size affects the loan size above, but how does the loan size affect the interest reserve size?

### Loan holdbacks and loan proceeds at acquisition.

Typically a construction / bridge loan is funded in two portions. The first portion is funded at acquisition. The other portion is funded for costs associated with improving the property, called the holdback. A holdback is literally what it sounds like: the bank will have the money sitting in an account that they control and will hold it back until the property owner has an approved use for the money. An approved use could be capital improvements, tenant improvement allowances, leasing commissions, or the interest reserve.

In our previous example we had a \$1.5M loan which was 75% of the total project cost of \$2.0M. Let's assume our costs for the deal break out the following way:

Land: \$1,000,000
CapEx: \$500,000
TI's: \$250,000
LC's: \$125,000
Interest reserve: \$125,000

In this example, the total loan size is \$1.5M. The size of the holdback is the sum of the CapEx, TI's, LC's and interest reserve, or \$1.0M. We can then infer that the loan proceeds issued at acquisition is \$500k (\$1.5M - \$1.0M).

Our first interest payment is then the interest rate multiplied by the loan amount at acquisition (\$500k). Assuming we don't have sufficient cash flow, the interest payment for that month will be covered by the interest reserve.

However, if the total interest reserve is only \$100,000, but we still have a 75% LTC loan, then the total loan size is 75% of (\$2,000,000 - \$25,000), which is \$1,481,250. Our holdback is then (\$1,000,000 - \$25,000) = \$975,000. Our proceeds funded at acquisition is then \$1,481,250 - \$975,000 = \$506,250. That's \$6,250 more than the previous version. Since this loan balance at acquisition is different than above, the interest payment is going to be different than above, resulting in a different interest reserve!

Hopefully this example wasn't too confusing and demonstrated why the interest reserve calculation is iterative.

### How to handle iterative calculations.

Luckily, excel can handle iterative calculations. To enable excel to handle iterative calculations, click on File -> Options -> Formulas -> check Enable Iterative Calculation. Excel can now handle the iterative calculations we'll throw at it.

For a full interest reserve calculation example, click on the link above and take a look at the spreadsheet. It should give you a basic understanding of how to calculate an interest reserve.