Put out money, charge interest, manage risks.
If a lender can do that successfully, they make money. But a failure to manage risks can see the lender out of their money, and maybe out of a job.
The list of potential risks in a commercial real estate deal is myriad. For a majority of commercial loans, the lender’s primary tools to manage these risks are items common to the Term Sheet: collateral, recourse, and keeping leverage at a reasonable point so the borrower has enough “skin in the game”. All of these tools help the lender mitigate risks in a broad sense that covers them over the life of the loan.
Sometimes, though, there are more specific risks in a real estate deal. Those specific risks may require a more precise tool for reducing the lender’s risk at particular times or for specific contingencies, and ensure they receive their interest payments. That’s where an interest reserve comes in.
How interest reserves work
An interest reserve is capital that the lender will hold in a collateral account. The size of the reserve will be determined by the potential loan payments that are at risk.
These reserve accounts can be funded in a couple different ways, most commonly:
- Upfront — when the lender initially closes and funds the loan, a portion is held back in the reserve.
- Ongoing — monthly payments are made into the reserve account by the borrower, out of the cash flows from the property. Or, in combination with a “lock box”, the lender collects the rent payments for the property directly into the reserve, and releases the portion above the required amount back to the borrower.
Once the lender has the required funds in the interest reserve account, they are able to keep it full until the risk is mitigated.
Common situations requiring a reserve
- Prospective tenant renewal — for a single tenant property, or a property where a single tenant leases a significant enough portion of the property, the lender may require an interest reserve to be held until the renewal or replacement of that tenant is completed.
- Construction completion — for new development or redevelopment of a property. The lender may agree to release additional funds upon reaching certain construction milestones.
Other types of reserves
Similar to interest reserves, these can all be funded upfront at loan closing or collected later on.
- Principal & Interest — covers the lender for a proportionate amount of loan principal in addition to interest.
- TI/LC — TI stands for “Tenant Improvements”, and is a common item to budget for in commercial deals. When a new tenant comes along and would like to lease space in the building, the landlord will often include funds to “build out” the tenant’s space for their requirements. That will turn raw space into the design that fits that tenant — think about offices, conference rooms, etc. for a corporate tenant. LC stands for “Leasing Commissions”, which are paid upfront to a broker that brings that new tenant or secure a renewal. Leasing commissions can be a big-ticket item in order to secure that cash flow for years to come on a long-term lease.
- FF&E — stands for “Furniture, Fittings, and Equipment”, and is a similar concept to Tenant Improvements, though usually a separate category because it’s things that go into the space, rather than changes to the building itself.
- CapEx — construction or improvement costs to the core property and structure outside of the needs of a single tenant.
- Taxes & Insurance — rather than going into the lender’s pocket, this reduces the risk of missed payments to the government or a required insurance policy.
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