Holdbacks & Earnouts - Strategies to Get More Capital
In commercial real estate, there are sometimes situations where owners need to refinance but the property’s business plan is not entirely complete. For example, the business plan might be to add value through renovations and increasing rents.
What do you do if you are only 70% of the way through your business plan but there are other forces that require you to refinance now? What are your options? Holdback & Earnouts could be your answer.
We are seeing that in today’s real estate environment, Sponsors are looking to lock in interest rates now before they continue to rise; however, the Sponsor might still be in the process of increasing rents to their pro forma levels.
What is a Holdback?
A holdback, in a commercial real estate loan, is when a commercial lender holds back part of the proceeds of a loan when the loan closes.
Let’s provide an example here. Assume you are buying a property and you know that the tenant’s lease is coming due. Thus, there is an opportunity to add value by negotiating a longer lease with higher rents after you close on the property. With the current in-place lease, your lender is comfortable giving you a $5,000,000 loan. In your discussions with the lender, you determine that if you increase the rents by 20% post-close, then they will release an additional $1,000,000 in funding.
In this scenario, the total loan will be $6,000,000. $5,000,000 will be provided at close to help you buy the property and $1,000,000 will be held back and disbursed once you have successfully negotiated that 20% increase in your tenant’s lease rate. An important factor to keep in mind is that the Sponsor will be paying interest on the full $6,000,000 so a holdback agreement should be short-term.
What is an Earnout?
An earnout on a commercial real estate loan is similar to a holdback, but it is slightly different. An earnout is a promise by a commercial real estate lender to loan a commercial mortgage borrower more money on their new loan if the borrower successfully increases the scheduled rents.
Let’s use the same example above. You are buying a property and the lender is willing to loan you $5,000,000 with the as-is tenant lease. Your business plan is to negotiate a longer lease and higher rents after you close the acquisition. Instead of structuring a holdback, you decide to structure an earnout.
In this scenario, the total loan will be $5,000,000. $5,000,000 will be provided at close to help you buy the property and $1,000,000 will be earned out and disbursed once you successfully negotiated that 20% increase in your tenant’s lease rate. An important factor to keep in mind is that the Sponsor will be paying interest on the only $5,000,000 and that additional $1,000,000 is only a contingent promise. The lender might be able to change their mind if market conditions change and are not obligated to fulfill the earnout since you have not been paying interest on that additional $1,000,000. The language negotiated in your loan docs for an earn out will be very important here.
What is the Difference?
In a holdback structure, the Sponsor is paying interest on total proceeds promised (including the portion held back) and there is a bit more certainty that the holdback funds will be funded once the business plan is fulfilled. In an earnout structure, interest is only paid on the funded dollars and the formality of the earnout structure is determined in the language negotiated in the loan docs.
Good luck out there my friends.
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