Capitalised construction interest: solving the funding circularity

Specify the interest convention first

A loan model needs a rate, day-count convention, dates of draws and repayments, and a rule for when interest becomes principal. Interest calculated on opening debt and capitalised at period end is straightforward. Interest on an average balance that includes period-end capitalisation may require a simultaneous calculation. Daily accrual with dated draws is another model and should not be approximated silently.

The OCC handbook discusses interest reserves in construction lending and the need to monitor whether those reserves remain sufficient. The calculations here are invented contractual conventions used to explain mechanics, not recommended loan documentation.

Sources: Office of the Comptroller of the Currency: Commercial Real Estate Lending, version 2.0

Solve one period algebraically

Let opening principal B be 5 million, an additional cost draw D be 1 million, and the monthly rate r be 1%. Assume the cost draw and capitalised interest are both weighted at half a month in the interest base, with no repayments. Interest I therefore satisfies I = r × (B + D/2 + I/2). Rearranging gives I = r × (B + D/2) / (1 − r/2).

Using the stated inputs, interest is 55,276.38 and closing principal is 6,055,276.38. If the agreement charges interest on opening principal only, the answer is instead 50,000. That difference is a convention difference, not an error corrected by turning on spreadsheet iteration.

Use iteration with an explicit stopping rule

The same equation can be checked by starting with I = 0, calculating the right-hand side, and repeating. The first four interest estimates are 55,000, 55,275, 55,276.375 and 55,276.381875. The sequence converges because the feedback multiplier in this example is r/2 = 0.005. Do not assume every circular model has that property.

Define an absolute tolerance, such as one cent, and a maximum iteration count. Preserve an error flag if the solver fails to converge. For a larger model, separate true financing feedback from accidental references, such as an interest row feeding a cost subtotal twice. Successful convergence proves neither the loan rules nor the model structure are correct.

Stop at the facility boundary

If the total outstanding limit is 6 million, the 6,055,276.38 result breaches it. An assumed ability to capitalise interest cannot create an extra commitment. Under a different arrangement, the lender might finance the 1 million cost draw while the sponsor pays 55,000 interest in cash. The interest base then excludes capitalised interest, so the required cash is not automatically the earlier 55,276.38.

Make the switching rule explicit. A model that switches between paid and capitalised interest needs to recalculate the relevant balance and show the equity call. It should never retain interest-on-interest after changing to a convention in which that interest is not borrowed.

Reconcile every period and inspect the downside

Opening debt plus cost draws plus financed fees plus capitalised interest less principal repayments must equal closing debt. Cash interest belongs in project funding but not in the principal roll-forward. Keep accrued but unpaid interest separate if it has not yet become principal under the agreement.

Test a delay, a rate increase and a limit reduction independently before combining them. Compare the solver with a hand calculation for at least one period and with a dated calculation where timing is material. Present the convention beside the result so another analyst can reproduce it.