Construction loan budgets often include an interest reserve to carry the project from its origination to completion, including the projected lease-up period. When establishing the amount of interest reserves to be provided, a Bank should evaluate the reasonableness of the assumptions used in the project’s feasibility study, including the interest rate sensitivity analysis and the time allotted for the completion and lease-up of the project.
During the lease-up period, any income from the project should ordinarily revert to the Bank and be applied to debt service before there is a draw on the interest reserve. The Bank should monitor closely the lease-up of the project to ensure that the project’s net income is being applied to debt service and not diverted by the borrower for other projects or for other purposes.
In some cases, the budgeted interest reserve is exhausted before the project is completed and lease-up achieved. Ideally, in this situation the borrower/guarantor should be held responsible for providing additional cash to cover the interest payments. A decision to revise the loan budget and replenish the interest reserve should be supported by reasonable economic projections for the project.