Interest Reserve

An interest reserve is a portion of a loan specifically set aside to pay scheduled interest during periods when the property cannot fully support debt service, commonly during construction or lease-up. Lenders fund the reserve as part of the loan proceeds or require sponsor funding, and the reserve is drawn down to make interest payments until stabilized cash flow replaces it. Underwriting models include the reserve to avoid borrower cash shortfalls and to cap negative cash flow exposure, and it affects the overall loan-to-cost and required equity contribution calculations.

In practical underwriting, explicitly model an interest reserve in the sources and uses statement and pro forma cash flow to bridge interest payments during the non-stabilized period. Size the reserve based on projected draws, the lender’s interest accrual method, and the expected length of construction or lease-up. Document how and when the reserve is replenished or exhausted and reflect its interaction with capitalized interest versus current expense treatment. Clear reserve assumptions mitigate lender concerns about interim coverage and can be a condition precedent to funding.

Interest reserves reduce the risk of missed debt service payments during non-performing phases, protecting both lenders and sponsors from payment default while revenues ramp. The presence and size of the reserve influence leverage capacity, cost of capital, and the sponsor’s required equity injection. For investors, a properly sized reserve provides clarity on when operations must become self-sufficient; underestimating necessary interest reserves can lead to unexpected capital calls, covenant breaches, or forced recapitalization, making conservative reserve planning essential in construction and lease-up financings.