What is an Earn Out in Real Estate?
What is an Earn Out in Real Estate?
In real estate, an Earn-Out is a type of contingent payment structure where a portion of the purchase price is deferred and made conditional on the future performance of the asset. This structure is commonly used in commercial real estate transactions, property sales, and mergers & acquisitions (M&A) involving real estate portfolios.
How an Earn-Out Works in Real Estate
- The buyer and seller agree that part of the purchase price will be paid only if the property meets specific financial or operational benchmarks after closing.
- These benchmarks could include:
- Achieving a certain level of net operating income (NOI) within a set period.
- Leasing up vacant space to a target occupancy rate.
- Securing new tenants or increasing rental rates.
- Obtaining certain government approvals or zoning changes.
Why Use an Earn-Out in Real Estate?
- Bridges Valuation Gaps: If the buyer and seller disagree on the current value of a property (e.g., due to high vacancy or pending approvals), an earn-out allows the seller to prove the asset's worth over time.
- Risk Mitigation for Buyers: The buyer avoids overpaying for unrealized potential and only pays if performance targets are met.
- Incentivizes Sellers: Sellers who remain involved in property management or leasing may have an incentive to maximize performance to receive the full earn-out payment.
Example of a Real Estate Earn-Out
A real estate developer sells a newly built mixed-use property for $50 million but with only 60% occupancy at closing. The buyer is willing to pay $55 million total but only if the occupancy reaches 90% within two years. The seller agrees to a $5 million earn-out, meaning they will receive the additional payment only if the leasing goal is met within the specified time.Key Considerations
- Clear Performance Metrics: Earn-out terms must be well-defined to avoid disputes.
- Escrow or Holdback Mechanisms: Funds may be held in escrow or structured as future payments.
- Time Limits: Most earn-outs have a defined timeframe (e.g., 12-36 months).
- Legal and Tax Implications: Earn-out payments can have different tax treatments depending on the jurisdiction and contract structure.
