Simple example:
Senior Construction Loan of $100MM against total project budget of $175MM.
Project budget assumes $8MM of interest carry. Lender agrees to hold back/fund that reserve as part of their $100M facility.
At pay off, senior lender is owned the fully funded balance of $100MM assuming draws stick to proforma.
How is the lender earning interest in this scenario, when they are effectively funding the reserve? i.e. lender is agreeing to fund $100MM and is being repaid $100MM. In these cases where there is no cash flow and interest is all being capitalized and reserved, how does the math work?
I can understand a situation where equity funds the interest reserve and so lender has $92M funded and $100M coming back to them. But the former scenario seems counter intuitive but I am sure I am missing something.
Based on the most helpful WSO content, here's what you need to know about how a lender earns interest in a scenario where they are funding the interest reserve:
Interest Reserve Mechanism:
Draws and Repayment:
Interest Capitalization:
Earning Interest:
Mathematical Breakdown:
Comparison with Equity-Funded Interest Reserve:
In summary, the lender earns interest by capitalizing it into the loan balance through the interest reserve, ensuring they receive their interest payments without requiring immediate cash flow from the project. This mechanism allows the lender to maintain their expected return while providing the necessary funding for the project's interest carry.
Sources: Working in FIG (Financial Institutions Group) - An Overview., Working in FIG (Financial Institutions Group) - An Overview., Thoughts on Goldman vs Lending Club, A Decade Into IB: Teetering on the Edge of Cataclysm?, Alternative Lenders & the End of Risk Taking for Banks - Opportunity or Risk?
You will not always have 100% of interest reserves funded. Our deals see anywhere from 60-90% of interest reserve funded as part of the loan.
In the case where 100% of the reserve is funded by lender, where they make money is in fees - youd likley see >2.5% origination fees, exit fees, extension fees, high loan draw fees etc
Contrary to the other posted, I very rarely see deals where the interest reserve is NOT 100% funded by the loan. He is right that they earn their upfront money in fees, but OP what you're also not acknowledging is that they are still earning that interest, it's really just effectively accruing rather than getting paid current and they get it at the back end when you take out the loan.
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Would it be a fair comment then to assume all lenders have a multiple that they need to hit, whether it come from interest/fees/etc?
I would agree that most lender quotes I have seen assume the full interest reserve is being funded by said lender.
not multiple but IRR
Once the money in the reserve is funded, they begin earning interest on it. Personally, this is why I’ve never liked bridge and construction lending as a business. The interest is technically paid back at the end and accrues, increasing the balance of the loan for the lender. So they are not technically paying themselves. Just waiting to get paid. But frankly - loans either get paid back in full or have some sort of work out. Effectively you get an either 0 or 1 binomial outcome. No upside. All the downside. Which is why I’ve never liked the business
But the risk a construction lender takes on is pretty low… deals I’m seeing nowadays are getting quoted in the 50-55% LTC range (sub 50% LTV) with solid spreads (SOFR + 325 or higher) and often with ~20% recourse.
This is for ground up multifamily construction where you’re building class A product
Product still has to get finished and be successful enough for the developer to have liquidity to pay back the lender though.
What we do is we grant the loan minus 2.5% in points + 10% interest-only, then we sell the loan in the secondary market at a WSJ prime rate (8,5%). So we earned 4% on the loan. The interest reserve is to ensure that the aggregator receives interest every month and avoid default. These loans are grouped and sold as RTL bonds in the secondary market. In NYC there are funds buying up to $1 billion in RTL loans every month.
Yes interest only accrues while debt is funding and it’s typical all the equity goes out first. I’d argue 1) the lender is not paying the interest reserve the project is and the project has to make them whole on their principal + sofr+x compounded return, just like a pref has to be paid before you get into promote and 2) really borrower effectively funds 1-LTC% of the interest reserve as it is a budget item and they have to fund their share of the whole budget before loan starts funding
I can see the logic here / where you are getting tripped up but you have to think about it at payoff of the loan.
When the Lender funds the construction portion for example what happens, Sponsor owes a vendor money, so the Lender gives money to the Sponsor to pay a vendor. That's the transaction, money from Lender to Sponsor out the door. When the deal is refinanced or sold, what happens then, the Sponsor uses the Refi dollars or Sale dollars to pay back the Lender for that money, money from Sponsor back to Lender. Very plain vanilla.
Now for the case of interest reserve how does that same transaction work. Sponsor owes Lender interest, so similarly Lender gives money to the Sponsor to pay the Lender. The transaction is from Lender to Sponsor back to Lender. 0 Sum for the Lender technically. When the deal is refinanced or sold, what happnes then, The Sponsor uses the refi dollars or sale dollars to pay back the Lender for that money they borrowed, which was the interest the Lender gave to the Sponsor to pay interest back to the Lender. So now the Lender which had a 0 sum when it was getting paid interest with it's own money, but it gets paid back for lending the Sponsor the money in the first place to pay themselves.
Does that kind of make sense? I tried to simplify it without thinking about how that interest then accrues/compounds, etc.
This is the best way I've seen it described. I had a very similar post two years ago asking the same question and still never fully got it.
You’re definitely tripped up on logic. The Borrower will pay interest on that interest reserve holdback once it’s funded…Lenders make money on interest. At any point in time during the term of a loan, the commitment represents the total availability while the outstanding balance is the portion that has been funded (I.e used) and the portion that borrower is paying interest on.
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