In one sentence
Funds held by the lender to cover loan payments during a period when property income is expected to fall short of debt service.
The longer version
The reserve is sized at closing from the underwriting model, usually to cover the projected shortfall through construction, lease-up, or a known rollover. It is funded either in cash at closing, from loan proceeds, or by a letter of credit, and the reserve agreement sets the conditions for each draw.
Disputes tend to arise over release rather than funding. The agreement should state precisely what test releases the balance, and the file should hold the evidence that the test was met, because an unreleased reserve is a borrower complaint and an over-released one is a lender exposure.
Common questions
- Who controls the debt service reserve?
- The lender holds it, usually in a controlled account, and applies it to payments as the reserve agreement permits.
- When is it released?
- On satisfaction of the stated test, most often a debt service coverage ratio sustained for a set number of months, with any remaining balance returned to the borrower.
- Can a letter of credit replace a cash reserve?
- Frequently yes. The letter of credit has to meet the lender's form and issuer requirements, and its expiry and renewal obligations then become tracked items in the file.
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