Interest During Construction (IDC)
What is Interest During Construction?
Interest during construction (commonly abbreviated as IDC) is the interest incurred on debt during a project’s construction period. In a typical project some of the construction cost is funded by debt facilities, but until the asset is built and ready to use, there will be no revenue to pay the interest cost of the debt. In larger projects, such as a toll road or similar infrastructure, this construction period could span many years.
Typically, the project sponsor will set up a separate company, a Special Purpose Vehicle (SPV), which earns no revenue until the assets are built and ready for use. However, without any revenue, there is no cash coming in. So how does the interest on the debt get paid?
Key Learning Points
- IDC is the interest cost of debt used to fund a project before it reaches the point where the project is complete and starts to revenue.
- Until revenue starts to be earned, the project can’t pay the interest cost of its debt.
- There needs to be a method of dealing with the interest expense, so that the project does not go into default on its debt obligations.
How Does Interest During Construction Get Paid?
With no revenue, the only way to manage the interest cost during the construction period is to add it to the debt. The interest accumulates until the project is complete and the assets start to earn revenue from customers. From that point cash begins to be generated, which can then be used to start to repay the IDC. However adding interest to existing debt means that the interest will compound, i.e. in any one period interest will be charged on both the original debt and all the accumulated interest to date. Every time interest is added to the debt balance that debt balance and the interest charged will grow. Over a long construction period, this compounding of interest can add a very large amount to the debt that must eventually be repaid.
Example of Construction Interest Expense in Real Estate
Consider this example of a real estate project; access this in the free download section.
A real estate project incurs capital expenditure costs to build, as follows:
Note that no income will be earned until the construction is complete at the end of Year 3.
Interest in Year 1:
There is no cash to pay this interest expense, so management agrees with the lenders to add the interest to the debt balance.
In Year 2, more funds are borrowed to fund capital expenditures. The interest will be calculated on the total amount borrowed plus the interest previously added:
Note that this is calculated on the total amount borrowed so far, including previous interest added.
In Year 3, more funds are borrowed to fund more capital expenditures. The interest will be calculated on the total amount borrowed PLUS the interest previously added:
Note that this is calculated on the total amount borrowed so far, including previous interest added.
What are the Consequences of Adding Interest to the Debt?
- The debt ceiling needs to be sufficient to accommodate the interest which will be added. For example, if a lender is prepared to lend a maximum of £100m to a project, some of that limit will be used for the accumulated interest, in turn this may limit the amount available for the actual build cost. The project may need seek alternative funding to make up any gap – probably from its shareholders.
- The future repayments will be larger as both the construction cost and all the accumulated interest must be repaid.
Are There Other Ways of Managing Interest During Construction?
If the project had another source of cash to pay the interest during the construction period it would not be added to the debt balance.
Typically, this would involve the shareholders contributing extra equity in cash at each interest payment date. That cash would be used to pay the interest expense, and nothing would then need to be added to the debt balance. However, this would increase the total funding from shareholders, which means they assume more risk and they will seek a return on that additional investment.
Another alternative would be to fund the interest with funds from another business controlled by the same sponsors. This is unusual in project finance; most of the times, each project is in a separate stand-alone company and there are usually no cross-funding arrangements, even between project companies with the same shareholders.
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Can You Claim Interest During Construction?
Detailed tax rules will vary for each country, but in many cases, interest paid by a business is a tax-deductible expense. It does not matter whether it is paid now (e.g. by the shareholders contributing more equity) or paid later by adding it to the debt balance. As there will be no revenue to offset the interest during the construction phase, this may create a tax loss to carry-forward until the project is profitable. There are several rules that may limit how much can be deductible, and this is becoming increasingly common worldwide. You should always obtain detailed tax advice for each specific situation.
What Happens to Interest After Construction is Complete?
Once construction is complete and the project’s assets are ready to use, income will begin to be earned. The cash flow from this income can be used to pay all further interest costs. If there is sufficient cash flow, no further interest needs to be added to the debt – the interest will be paid in cash at each interest payment date. Effectively, the project reverts to being a normal corporate business which makes payments of interest and debt principal in the normal way.
Is Interest During Construction Capitalized?
Interest during construction is a funding issue to be agreed between a borrower and a lender. Both parties need to agree how to manage interest costs during the period when a project company does not have revenue available from which it can pay the interest owed.
Capitalizing interest is adding the interest incurred during construction to the total cost of an asset on the balance sheet. It is an accounting issue, governed by International Financial Reporting Standards (IFRS). It is independent of how the borrower and lender agree to handle interest costs during construction. So, yes, the interest expense associated with the asset will be included in the cost of the asset on the balance sheet, regardless of whether the interest has been paid in cash or added to the debt.
Conclusion
Interest during construction is a key issue in funding a project that will not generate cash flow while its assets are being built. The most usual way it is managed is to add the interest on to the amount borrowed; the interest will therefore compound during the build period. Once the assets start to operate and generate cash, that cash will be used to pay the interest, and no further compounding will occur.