With the rise of the COVID-19 pandemic, operating and capital reserves have become a topic of discussion for apartment syndication sponsors and investors alike.

For some, today’s uncertainty is a chance to brag about their foresight in raising a large war chest for tough times, while others fear they will soon pay the price for their lean reserves.

We have certainly seen a change in reserve requirements for multifamily loans, but more on that later.

You may wonder why sponsors don’t simply raise substantial reserves upfront to better capitalize the investment for potential storms.
There are two common answers:

1. Raising money is difficult, so sponsors raise the minimum needed to close the deal.
2. A well-capitalized sponsor or someone confident in their investor relationships may prefer to make a capital call if and when a storm arises rather than keep capital sitting in reserves thus diminishing overall reserves on the investment.

The second point raises the question, just how much do capital reserves erode project-level returns?

Many prudent sponsors are suspending distributions right now due to the uncertain outlook for collections in the coming months as millions of Americans have lost their jobs.

In my view, making distributions in a time like this is likely an unwise use of capital since it may necessitate a capital call should conditions deteriorate further. Delayed distributions are undoubtedly preferable to a capital call.

Let’s evaluate a few different scenarios for reserves, distributions, and capital calls.

Scenario 1 – 1 Months’ Operating Reserve and Debt Service

The first scenario is simply to keep one months’ operating expenses and amortized debt service as reserve of $140,149 at the time of initial investment and refund the reserve in full upon a 5-year sale of the property.

In this case, we have a 17.2% project-level IRR and a 6.9% average cash on cash in our hypothetical deal based on a $12,000,000 purchase price.

Scenario 2 – Zero Reserve

Now, let’s strip the reserve down to an unreasonable $0 to see how much the returns go up: we jump to 17.8% project-level IRR and a 7.3% cash on cash return.

The difference between net-to-investor IRR (after fees and sponsor promote) is only reduced to 12.2% versus 12.5%. This is a reminder that marginal returns disproportionately benefit the sponsor, while investors experience better downside protection with a proper preferred return.

Scenario 3 – 3 months’ Operating Reserve and Debt Service

The next example is a very large reserve of three months’ operating expenses and amortized debt service ($420,450), again to be refunded upon a sale in five years.

This “sleep well at night” reserve gives a projected 16.1% IRR and a 6.2% average cash on cash return.

Touting your big reserve isn’t without cost. Investors seeking stronger total returns would do well to consider a balance between keeping reserves on hand, forgoing distributions in uncertain times, and being ready to meet a capital call if necessary.

Sponsors who choose to carry large reserves that always allow uninterrupted distributions, understand that they do so to the detriment of total returns. And depending on the structure, even more so to their fees and compensation.

So, what’s the right reserve amount from an investment standpoint?

It comes down to the risk of the business plan and property type. For example, larger reserves should be contemplated for a higher execution risk deal with bridge debt than for a newer vintage class A type investment.

The answer also depends on debt coverage ratio at the onset of the investment. You want to account for the debt load placed on the property, and expense ratio, to account for operating expenses. Perhaps the best rule of thumb is to raise one to two months’ operating expenses plus amortized debt service.

Better safe than sorry the old mantra goes. 20/20 hindsight, but given the current climate, as a limited partner/investor, I’d feel more comfortable with more cushion and lower returns. I don’t want to get that capital call.

For the time being, the current requirements for Agency debt really take any questions about reserves out of the equation. Candidly, both Fannie and Freddie have implemented steep reserve requirements on all new debt originated. We’ll now digress from investment theory to the current mechanics of Agency loans’ Reserve Requirements.

Freddie Mac Small Balance Loan Reserve Requirements (Loans $1 – $7.5 Million)

This will be called the Covid-19 Rider. Freddie is considering this essential in order to move forward with funding of any new loans. To emphasize, this is a temporary measure.

Freddie is requiring that 12 months’ worth of debt service (principal and interest) are escrowed as parting the funding of the loan. 12 months’ worth of property taxes and property insurance will also be escrowed.

• 12 months of P&I is collected and held back at funding.
• For taxes and insurance, 12 months is not necessarily collected, it would likely be less as they are monthly escrows. The total amount collected at closing is determined by the close of escrow date and when the next property tax bill/insurance premium is due.
• 12 months replacement reserves are collected and held back at funding only if the property has 51+ units.

Release Provisions – The release of the remaining Debt Service Reserve will be within 30 days following satisfaction of the following five items:

1. Lender receives a release request from the borrower.
2. All federal, state and local emergency declarations or similar government actions related to COVID-19 have been lifted for at least 90 days.
3. All due diligence items have been completed to Freddie Mac’s specifications and borrower has remediated all deferred due diligence shortfalls.
4. If borrower and Freddie Mac entered into a forbearance agreement, all the forborne debt service payments have been repaid.
5. Borrower provides evidence satisfactory to Freddie Mac of residential occupancy at a minimum of 80% and collections, on a three-month average and for the last month, that satisfy the policy minimum underwritten Debt Coverage Ratio (DCR) for the loan. For example, 1.20x for Top Markets, 1.25x for Standard, etc., with appropriate adjustments for cash-out, full-term interest-only, etc.

Freddie Mac Conventional Reserve Requirements

• For a loan sized to a minimum 1.40x amortizing DCR or greater, irrespective of the actual interest-only period of the loan, the DSR amount will be six months amortizing debt service.
• For a loan sized to an amortizing DCR below 1.40x, irrespective of the actual interest-only period of the loan, the DSR amount will be sized to nine months of amortizing debt service.
• Same release provisions as noted above for Small Balance Program

Fannie Mae Reserve Requirements:

For Loans 75% Leverage and Less Than $6 Million

• Borrower shall be required to fund, at Closing, twelve (12) months of both tax and insurance escrow deposits and Replacement Reserve deposits.
• The reserves shall be released after a minimum of six (6) months from Closing plus two (2) consecutive quarters of the Property attaining an actual amortizing DSCR of applicable going in DSCR tier threshold.
• Borrower shall also be required to fund, at Closing, eighteen (18) months of principal and interest payments (the “P&I Reserve”).
• The P&I Reserve shall be released at the earlier to occur of: (i) thirty-six (36) months from Closing, or (ii) a minimum of six (6) months from Closing plus two (2) consecutive quarters of the Property attaining an actual amortizing DSCR of applicable going in DSCR tier threshold.
• All escrows described within this section are in addition to standard Fannie Mae Guide requirements for collection of tax, insurance and replacement reserve deposits.

For loans 75% LTV and Greater Than $6 Million

• Borrower shall be required to fund, at Closing, twelve (12) months of both tax and insurance escrow deposits and Replacement Reserve deposits.
• The reserves shall be released after a minimum of six (6) months from Closing plus two (2) consecutive quarters of the Property attaining an actual amortizing DSCR of the applicable going in DSCR tier threshold.
• Borrower shall also be required to fund, at Closing, twelve (12) months of principal and interest payments (the “P&I Reserve”).
• The P&I Reserve shall be released at the earlier to occur of: (i) thirty-six (36) months from Closing, or (ii) a minimum of six (6) months from Closing plus two (2) consecutive quarters of the Property attaining an actual amortizing DSCR of the applicable going in DSCR tier threshold.
• All escrows described within this section are in addition to standard Fannie Mae Guide requirements for collection of tax, insurance and replacement reserve deposits.

For loans 65% LTV

• Borrower shall be required to fund, at Closing, six (6) months of both tax and insurance escrow deposits and Replacement Reserve deposits.
• The reserves shall be released after a minimum of six (6) months from Closing plus two (2) consecutive quarters of the Property attaining an actual amortizing DSCR of the applicable going in DSCR tier threshold.
• Borrower shall also be required to fund, at Closing, six (6) months of principal and interest payments (the “P&I Reserve”).
• The P&I Reserve shall be released at the earlier to occur of: (i) thirty-six (36) months from Closing, or (ii) a minimum of six (6) months from Closing plus two (2) consecutive quarters of the Property attaining an actual amortizing DSCR of the applicable going in DSCR tier threshold.
• All escrows described within this section are in addition to standard Fannie Mae Guide requirements for collection of tax, insurance and replacement reserve deposits.