The gap in my construction loan sizing turns out to be all interest reserve

Question

Working a 180-unit garden deal, wood frame over slab, total cost landing around $46m all in. That's about $255k a unit which for this market is not crazy. Lender indications are coming back sized to the lower of 60 percent cost or a 1.25x debt service coverage on stabilized NOI at an exit cap they pick, and both tests land me around $27m to $28m. So call it $18m of equity against a project where my stabilized NOI pencils to roughly $3.1m.

The part that keeps eating me is the interest reserve. On a 30 month construction period plus 12 months of lease-up, the carry on that loan is a genuinely large number and it sits inside the $46m, which then gets sized at 60 percent, so I'm funding 40 percent of my own interest with equity. Every month the schedule slips I'm adding cost that gets levered at 60 percent and equity at 40.

What I actually want to know from people who have run this: do you underwrite the reserve to the full loan term with rate caps priced in, or do you build in an assumption that you refi into perm before the reserve is exhausted? And has anyone gotten a lender to size off a stabilized value test rather than cost when cost basis is inflated by carry? Feels like the current structure punishes you for the exact thing the chapter says is temporary.

Rena Expert · Accepted Answer

Nobody sizes off stabilized value on ground-up unless the sponsor is bringing a forward sale or a credit-tenant equivalent. Cost is the test because cost is observable and the lender can verify it against an inspector's draw report. Stop pushing on that one and push on the reserve mechanics instead, where there's actually room.

Three things move the number. First, whether the reserve is sized on a straight-line draw curve or on your actual S-curve. A straight-line assumption overstates early interest by a meaningful amount on a 30 month build, and on $27m that difference can be several hundred thousand dollars of reserve you're funding 40 cents on the dollar. Bring a monthly draw schedule tied to the GC's schedule of values and ask them to size off it. Second, whether the cap is a purchased strike inside the loan or a corridor, and whether the premium is an eligible cost. Third, whether unused reserve at conversion releases back to you or gets swept.

Your real exposure is the 12 months of lease-up sitting inside a floating-rate construction loan. Interest during lease-up is the piece that blows up when absorption comes in at 15 units a month instead of 25, and in a market still digesting deliveries that's the likelier miss. Model the reserve at 60 percent of your base absorption and see where the funding gap opens. That's the number your equity partner will ask for.

All of this depends on your NOI holding at $3.1m, which is a 6.7 percent yield on cost. If concessions on the newly delivered comps knock 4 percent off in-place rents at lease-up, the 1.25x test tightens and the extension request arrives at the worst moment. Confirm reserve sizing method and release language in writing with the lender before you spend money on the guaranteed max price contract.

sonia_alvarez · Answer

On the reserve question, every construction lender I've looked at underwrites it to full term plus a cushion, and they price the cap strike into the reserve calculation rather than assuming your refi lands early. If you show up with a model that runs the reserve dry at month 34 because you assumed a perm takeout at 32, credit will just re-cut it and add the months back, and the added months come out of your equity check.

The cost test versus value test thing isn't really a negotiation on garden product. Cost is the binding test because value at stabilization depends on an exit cap nobody will commit to in writing.

tashaford30 · Answer

The reserve part took me three passes to work out. So the interest you pay during construction is itself a project cost, and because the lender only lends 60 percent of costs, you're writing a check for 40 percent of your own loan interest? That's a strange loop.

ehernandez74 · Answer

@quill yes, and it compounds, because the reserve draw increases the outstanding balance, which increases next month's interest, which draws more reserve. The lenders model it that way, it's just not obvious from the outside.

@compass the piece I'd want nailed down before anything else is what happens at construction loan maturity if lease-up isn't done. Extension options, what they cost in fee and spread, whether there's a partial paydown test to exercise them. On a 42 month total timeline you're one weather season and one transformer delivery away from needing that extension, and negotiating it under duress is how sponsors lose the promote.

paulgrant17 · Answer

Transformer lead times are the thing I'd be most scared of here. Not the loan at all, just whether the utility shows up.

aliyah_b · Answer

$255k a unit for wood frame garden is the number I keep trying to sanity check on much smaller deals and it never gets cheaper per door going down in size, which is depressing.

@compass the S-curve point from rena-expert is the one I'd chase first because it's free money if the lender will take it. But I'd also ask what they'll count as eligible cost. Land at your basis or at appraisal? If you've held the land a while and it's appraised above basis, some lenders will size cost off the appraised land value and that alone can move the 60 percent number more than the reserve fight will. Worth asking before you accept the $27m as fixed.

The gap in my construction loan sizing turns out to be all interest reserve

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