Borrower Beware of Funding Reserves
Lending is a very competitive market today. When a lender presents a term sheet, it is very important to scrutinize all of the salient terms. How reserves are to be funded and held can change the dynamics of the transaction.
Most of the time, the borrower and the lender agree that reserves will be included in the loan budget. These funds are set aside and not drawn upon until needed for the stated use, such as interest, tenant improvements, commissions, or stabilization. Once drawn upon, the borrower pays interest on the reserved funds. The reserves play an important role in the borrower’s development. They free up cash, allowing the borrower to use cash for equity in the project and to continue to pay for day-to-day operations. In addition, the reserves, like other loan proceeds, don’t accrue interest until drawn upon. The downside, of course, is that using reserves increases the borrower’s equity requirement and reduces loan proceeds available for construction.
I recently closed a construction loan where the borrower was required to fully fund interest, tenant improvements, leasing commissions, and debt service coverage ratio stabilization reserves in addition to necessary equity requirements prior to closing. None of the reserves were included in the loan budgeted. The reserves amounted to nearly $1 million in cash on a $6.7 million loan and were fully collateralized. This resulted in my client’s loss of use of the funds for the term of the loan for day-to-day operation of the property, including payroll. In addition, the money would sit in the bank, until used, and would not accrue interest. Other than interest reserve, the funds wouldn’t be used until construction was completed. Perhaps some leasing commission reserves would be used as pre-construction leases are signed, but the bulk of the reserves would be held interest free. The loan-to-cost was 65% so the client had significant equity in the project as well. But the reserves would not count towards the equity.
Clearly, this was not the best decision the borrower could have made in selecting a loan. The only possible savings here was the interest savings on the reserves if drawn from the loan proceeds.
It is always important to read your term sheet and understand the implications of each material term before signing. When the terms seem off, use the opportunity to shop for a better deal.