Construction Loans, Interest Reserves + COVID-19

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Jim Fraser
PUBLISHED: 06/11/2020

As COVID-19 continues to evolve, impacts to commercial real estate loan portfolios will become more apparent. Lenders and borrowers are engaged in deal-by-deal negotiations, including application of the CARES Act which gives lenders the ability to defer interest, modify and extend maturity dates, and forebear defaults if needed.

Real estate secured construction loans cannot generate positive cash flow and are typically capitalized with an interest reserve budget to pay monthly interest accruals. Established and estimated at the origination of the loan, interest reserve budgets are not always sufficient to cover the loan term. Given Covid-19 related construction halts and supply chain disruptions reported by general contractors and material suppliers, a condition of insufficient interest reserve has potentially emerged that may threaten construction loans nationwide. Delay impacts extending construction loan terms and absorbing interest reserve balances is partially offset by Fed interest rate policy. Lower rates mean lower monthly accrual, helping to extend the coverage of interest reserve balances.

Commercial real estate construction lenders on Built Technologies are able to access Insight Reports to identify and measure individual transactions, where interest reserves are currently insufficient based on remaining balances, estimated months to completion and scheduled maturity. A similar, aggregated portfolio sufficiency report is also available to see global exposures to this key risk indicator.

Informal regulatory feedback is promoting additional interest reserve stress testing for lenders with impacted portfolios. Built Technologies is working closely with current clients to help develop interest reserve sufficiency tests under stress scenarios. Each portfolio is unique in composition and market exposures. Property use types and re-opening schedules are likely to affect sufficiency tests.

Stress tests will be critical in the coming months and quarters. Shortfalls identified and confirmed through borrower and lender negotiations will need to be funded. In most cases, the shortfall will be subject to additional equity or borrower funds requirements of the construction loan agreement. In the case of very low leveraged transactions, lenders may find credit support to provide an additional advance to fund any shortfall.

Contact Built Technologies for more information on how our interest reserves sufficiency reporting can help support your commercial real estate portfolios and prepare for future regulatory reviews that are specifically targeted at commercial portfolios where deferrals, extensions, or modifications may have occurred affecting interest reserve balances.