Construction Loan Lender Includes Unused Interest Reserve as Part of the Outstanding Loan Balance for Monthly Interest Payment Calculations
I'm getting ready to close a $60MM construction loan for a commercial real estate development project and the lender has gotten back to me with their sources and uses.  In their budget, he's got a value for interest that exceeds my own calculation.  Significantly.  He used a draw schedule of his own to come up with this interest expense.  This is when I noticed the math in his draw schedule, he has included the interest reserve, in its entirety, as part of the loan's outstanding balance from closing.  Meaning, as interest is calculated each month, it is not only calculated on the amount of the principle outstanding of the loan which I have used, but it is calculated on the full amount of the interest reserve as well.  Our interest reserve is $4MM.  For the 18 months or so of the construction period, this comes out to about $540M of additional cost to the project.

I have NEVER come across this.  And I've closed lots of construction loans with private lenders, credit unions, banks, etc.  I have never had a construction loan where the unused interest reserve is part of my principle balance and my monthly interest is calculated on an amount including the unused interest reserve .  Am I completely off on this?  Should I re-align my expectations and accept that this is just part of the banking/lending world now (that I just haven't had much exposure to this type of practice until now)?  I know I'm always learning new things but this behavior seems inappropriate and I wonder if there's something wrong here..  Is this common?  Do more lenders do this?

P.S. We  revisited the LOI and most lenders will explain how interest is calculated.  One of my lenders that recently did a $42MM loan has in their LOI: "interest is only charged  on funds disbursed."  This lender, of the $60MM loan had conveniently left out any such language of how interest payments were to be calculated.  Feels kinda sneaky of them...

EDIT: We have discussed with the lender.  This is their model.  They actually said they "fund" the amount of the interest reserve in an escrow account and that they have put it up.  And they charge interest on this. 
[{"id": "i78fue9", "text": "You can just tell your lender that there's a mismatch in numbers and ask them to explain their math. Maybe it's a mistake, may it's not. Only way to find out is to ask.", "replies": [{"id": "i78i7s9", "text": "Thanks.  We have discussed with the lender.  This is their model and it is intentional.  They actually said they \"fund\" the amount of the interest reserve in an escrow account and that they have put it up.  And they charge interest on this.", "replies": [{"id": "i78l2rz", "text": "Makes sense. We do that. \n\nIt\u2019s people who don\u2019t want to deal with the asset management headache + our ROE is better. We also do tons of loans where we do fund the interest at each payment.", "replies": [], "depth": 3}, {"id": "i7bieem", "text": "Sounds like you bite the bullet on this one and never use them again.  That's some bullshit, but I'm guessing you're so far down the road with them that it's too late to use someone else?", "replies": [{"id": "i7gbw3u", "text": "Well, we have been thinking of using someone else (it is still a possibility) but it wouldn't be our preferred option.  We pretty far down the road and I think biting the bullet is going to be the best solution.  I just wish they were upfront about how they handle the interest reserve. and those costs.", "replies": [{"id": "i7gealh", "text": "If the other terms of the loan are good, just think of it as a bigger spread on your rate.  Most of the time, I'm more proceeds sensitive than I am rate sensitive.", "replies": [{"id": "i7gg5o3", "text": "True.  And we are actually the same.  Good way of looking at it. Thanks.", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "i78gl77", "text": "In capital markets. Definitely not the norm.", "replies": [], "depth": 1}, {"id": "i78hgsr", "text": "You are correct - you should not have to pay interest on the undrawn interest reserve balance, and therefore the lender's reserve sizing is likely overstated. \n\nI would bring it up with your lender as it would not make sense to size the interest reserve amount as if all of the interest is paid upfront at closing.", "replies": [], "depth": 1}, {"id": "i78ki0b", "text": "If the full loan amount is advanced at closing and a portion of loan proceeds will fund an interest reserve, then yes. You are paying interest on the total and this is common in the commercial real estate lending biz", "replies": [{"id": "i7gfci8", "text": "Well, this is a construction loan and only a small amount is drawn down at closing (covering mostly the closing costs).  Since they are also \"funding\" the interest reserve at close, this makes the outstanding amount of the loan appears so high early on, and I start paying interest on the interest reserve.  Which again, seems so strange.  The other line items (say concrete) are there to pay my subcontractor expenses as they incur.  Why not just charge me interest on those as well?  How is the interest reserve different from any other construction holdback reserve.  \n\nAnd if the concept is \"they fund the interest reserve amounts so they are outstanding\" then just fund half of my interest reserve or a quarter.  We know earlier on, I won't use half of it in the first 6 months or so.  Just fund a portion of the interest reserve upfront, charge my the interest on my interest reserve (as they want to do) and then replenish the reserve.  But to fund the entire interest reserve, for a two year loan, at once and then bill me interest for it...(without communicating until right before closing..?) No thanks.", "replies": [], "depth": 2}], "depth": 1}, {"id": "i78mcd4", "text": "This is colloquially referred to as \u201cnegative arb\u201d and it\u2019s not uncommon but obviously not preferred. Most banks never do this. Some debt funds do. I find almost all hard money shops do this. Was there never a breakout of the initial funding? Even if they don\u2019t specify you\u2019re paying negative arb it can be seen in the S&amp;U.", "replies": [{"id": "i7gcc0l", "text": "I have closed a few hard money loans and I had never encountered this but maybe the lenders who do smaller hard money loans do this?  And this is the  breakout of the initial funding (they waited quite a bit to show us their expectation of the S&amp;U - we started these talks nearly 3 months ago).  \n\nIs arb in \"negative arb\" for \"arbitrage?\"", "replies": [{"id": "i7gvy5u", "text": "Correct", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "i78uo87", "text": "Forced funding", "replies": [], "depth": 1}, {"id": "i7abv29", "text": "Interesting... I lend on construction loans and have never done it this way nor seen my colleagues or counterparts at other institutions do it like this. This concept is definitely favorable to the lender - what I've typically seen is interest simply getting capitalized over the term of the loan. I can see why they do it but agree that it feels a little punitive.", "replies": [{"id": "i7gfvs8", "text": "Thank you for your feedback.  Appreciate the perspective.  Looks like I'm just learning more and more (especially what to look out for!). I thought I had learned almost all there was on the lending side but no no...there is plenty to still learn.", "replies": [{"id": "i7jv5sl", "text": "I agree with the above. I've been in construction loan asset management for a decade. It's industry standard to draw on the interest monthly vs fully drawing down and holding in escrow.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "i7c9bwp", "text": "Blue light special on isle 14\nONE 12  foot 18 gauge metal stud special today $52 plus tax.\nWelcome to the twilight zone.\nRod Serling is alive and well", "replies": [], "depth": 1}, {"id": "i7gv8yd", "text": "I have worked with a few HML. I used one HML who charged for interest reserve. Was quite taken back but makes sense. The fund a portion of interest (almost a surety / security bond) where they will charge interest on the funds.\n\nI am working with a new lender who does not charge interest reserve.", "replies": [], "depth": 1}, {"id": "ihkhcsb", "text": "Just curious, what is the interest rate fir this type if loan?", "replies": [{"id": "ii12oqs", "text": "This one was one-month LIBOR + 775 bps (spread) with a minimum \"floor value\" of 25 bps for the LIBOR base.  So it was effectively a min of 8%.    Interest accrues on a 360 day year. \n\nGenerally, most construction loans I've seen from private debt funds tend to be in this range of 7% - 10%.  There are a few private sources that are able to lend in the 5%-7% range but they are harder to find.   \n\nAlso, in case you were curious, this loan was a 72% LTC with a constraint of 60% LTV of stabilized value (based on appraised value of the when-stabilized).", "replies": [], "depth": 2}], "depth": 1}]