Three ways to size the reserve, the closed form in Excel, and what a longer lease-up or a higher rate does to it.
An interest reserve on a bridge loan is the cumulative gap between the interest due and the NOI available to pay it, over the lease-up period, including the interest that accrues on the reserve itself. On an illustrative $30.0M bridge at 8.50 per cent with $1.20M of in-place NOI, an 18-month reserve drawn as needed is $2.15M. The simple shortcut, the annual shortfall times one and a half, gives $2.03M, and if the reserve is funded in full at closing it must be $2.32M.
Worked in full in The Real Estate Debt Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A lender funds a bridge on a partly let building that the sponsor plans to lease up over 18 months. The in-place NOI covers less than half of the interest, so the loan includes an interest reserve: a facility, or a funded account, that pays the difference each month until the building stabilises. The question for the credit paper is how large that reserve must be. All figures are illustrative, and the rate is treated as fixed for the period so that the arithmetic is visible.
| Input | Value |
|---|---|
| Initial funded loan, excluding the reserve | 30.0 |
| All-in interest rate | 8.50% |
| In-place NOI, held flat during lease-up | 1.20 a year |
| Lease-up period to be covered | 18 months |
Interest on $30.0M at 8.50 per cent is $2.55M a year. NOI pays $1.20M of it, leaving an annual shortfall of $1.35M.
The shortcut. Multiply the annual shortfall by the length of the period: 1.35 × 1.5 = $2.03M. This assumes the loan balance never grows, which is untrue as soon as the first reserve draw is made.
Drawn as needed. Each month the reserve pays the shortfall, and that draw becomes part of the loan, so next month's interest is a little higher. The balance follows Bn+1 = Bn × (1 + r/12) − NOI/12, which has a closed form:
Reserve = L × ((1 + r/12)n − 1) − (NOI/12) × ((1 + r/12)n − 1) / (r/12)
= 2.15, so the balance reaches 32.15 at month 18
Excel: =FV(8.5%/12, 18, 0.1, -30) - 30
Funded upfront. Some lenders advance the whole reserve at closing into a controlled account. The borrower then pays interest on the reserve from day one, before it is used, and the reserve has to cover that too. With simple interest over the period:
R = (L × r × t − NOI × t) / (1 − r × t) = (3.825 − 1.8) / (1 − 0.1275) = 2.32
| Method | Reserve | Versus the shortcut |
|---|---|---|
| Annual shortfall × years | 2.03 | |
| Drawn monthly, interest capitalised | 2.15 | +6.3% |
| Funded at closing | 2.32 | +14.6% |
The differences look small in absolute terms, about $0.13M and $0.30M. They matter because a reserve that runs out one or two months before stabilisation turns a performing loan into a payment default at exactly the point where the business plan is closest to working.
The two inputs that actually decide the reserve are the length of the lease-up and the rate. On a floating-rate bridge, the rate is not under anyone's control.
| Months covered | At 7.50% | At 8.50% | At 9.50% | Shortcut at 8.50% |
|---|---|---|---|---|
| 12 | 1.09 | 1.40 | 1.72 | 1.35 |
| 18 | 1.66 | 2.15 | 2.65 | 2.03 |
| 24 | 2.26 | 2.93 | 3.62 | 2.70 |
| 30 | 2.88 | 3.75 | 4.64 | 3.38 |
The reserve is more sensitive to the rate than it looks, because the rate acts on the whole $30.0M while NOI is fixed: 100 basis points adds about $0.50M over 18 months, roughly a quarter of the reserve. An 18-month reserve sized at 8.50 per cent lasts only 14 months if the rate averages 9.50 per cent. And a lease-up that takes 24 months instead of 18 needs another $0.78M, 36 per cent more than the original reserve.
Hold NOI flat at the in-place level, as here, rather than ramping it with the leasing plan. A ramp shrinks the reserve, but it makes the reserve depend on the very leasing assumptions it is meant to protect the lender against. If the plan slips, the ramp slips with it, and the reserve runs out early twice over.
The frequent error is sizing the reserve on the shortcut and on the business plan's own timetable, then treating it as a fixed cost of the deal. The correct reserve is 6.3 per cent above the shortcut for draws and 14.6 per cent above it for an upfront account; the timetable is the sponsor's optimistic case. A reserve sized at $2.03M for 18 months at 8.50 per cent covers neither a three-month delay nor a 100 basis point rise.
The reserve also adds to the loan. At $2.15M it is 7.2 per cent of the initial funding, and all of it has to be repaid at maturity by the takeout lender. Underwriting the exit on the day-one balance ignores it; the exit test should be run on $32.15M, plus any future funding for capital works, as set out in what NOI a bridge loan needs to refinance at maturity.
=FV(r/12, n, NOI/12, -L) - L, $2.15M here, not the $2.03M shortcut.Chapter 11 of the book works a development drawdown test on a scheme that overruns, and the free workbook for this case includes the sizing and exit-test model and a printable working document for that drawdown test. For how lenders size debt in the first place, the loan sizing template runs all four tests.
At least the lease-up period in the business plan, and lenders often test a longer one. In the worked case a reserve for 18 months is $2.15M at 8.50 per cent; covering 24 months needs $2.93M, and a lease-up that runs six months late requires $0.78M more than the original reserve, 36 per cent extra.
Both structures exist. Drawn as needed, interest accrues only on amounts used, so the 18-month reserve in the example is $2.15M. Funded at closing into a controlled account, the borrower pays interest on the whole reserve from day one, and the reserve must grow to $2.32M to cover that extra interest.
Multiplying the annual shortfall by the number of years assumes the loan balance stays flat, but each reserve draw increases the balance and the next month's interest. On a $30.0M loan at 8.50 per cent, the shortcut gives $2.03M for 18 months, while a capitalising balance requires $2.15M, 6.3 per cent more.
This article is one calculation from The Real Estate Debt Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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