-
Posts
-
Very sorry if this is covered (am a tad behind), but I have seen two interest rates used in development models – accrual and current. What is the difference and when would one be used instead of the other?
Is the current rate the rate if you pay every month, and accrual the rate at which your debt balance accrues interest if you don’t? If that is the case, in what scenario would you ever use current for development?
Thanks!
Hi N2,
Michael teaches you how to model construction interest reserve, so in a way this is covered. But this is a good question to bring up at this point in the Accelerator. I too have seen the ‘Current’ vs ‘Accrual’ toggles in development models. In my experience the terms are used in the context of what source (i.e. debt or equity) covers the construction interest.
In ‘Current’, the borrower pays the interest in the month that the interest is charged. Thus from a modeling perspective, that interest cost is paid for by equity (i.e. the partner’s capital account grows accordingly). In ‘Accrual’, the construction interest is paid for by the debt; or in other words the interest is added to the loan balance each month with interest charged on accrued interest over time – hence the need for an interest reserve.
Now when are you likely to see ‘Current’ interest treatment vs. ‘Accrual’ interest treatment? Keep in mind that, from the lender’s perspective, ‘Current’ interest is less risky because theoretically the borrower has more skin in the game. So whether current or accrual is used depends on property location, property type, profile of the borrower, market norms, etc.
Anecdotally, accrual is the norm in the U.S. on development loans for institutional, income-producing (i.e. for rent) real estate. When I developed single-family in the U.S. that was also the case. However, when I developed single-family projects in Latin America, all banks used the Current interest treatment. Meaning, we had a debt service payment each month during development, rather than that interest accruing.
So at the end of the day, it’s a lender decision driven by market convention and deal risk.
Great questions!
Spencer
Quick addendum.
I should point out that using the ‘Current’ and ‘Accrual’ toggle in real estate financial modeling is not very common. That’s because we generally build models for the property type, market, investment type, and lender convention that we work in. I think it would be unusual to be in a market where your development model needed a toggle to switch between Current and Accrual.
Of course, that’s my perspective and it certainly doesn’t hurt to include the toggle. But more than likely, adding the toggle to the models you build is an unnecessary exercise.
Big help. Thanks!
One more follow up on this, will the lender ever let the “current interest payments” be funded by the debt? I.E. set aside a reserve from the original loan proceeds. Thanks!
Based on the definition I’m using, no:
In ‘Current’, the borrower pays the interest in the month that the interest is charged. Thus from a modeling perspective, that interest cost is paid for by equity (i.e. the partner’s capital account grows accordingly). In ‘Accrual’, the construction interest is paid for by the debt; or in other words the interest is added to the loan balance each month with interest charged on accrued interest over time – hence the need for an interest reserve.
Then again, that’s based on my experience with institutional commercial investments and single-family residential development in the U.S. and Latin America. Perhaps with smaller deals, niche lenders, niche property types or in other countries, such a structure could be dreamed up. One of the things I love about real estate is that no two properties, no two markets, no two partnerships or capital structures are ever really the same. But generally speaking, the answer is no.
Thanks again!
- You must be logged in to reply to this topic.
