There seem to be completely opposite realities right now. No, I am not talking about the political divide, I am talking about the sentiment of buyers and sellers of commercial real estate. There has never been a bigger gap between buyers and sellers when it comes to the value of a property. Sellers see the economic situation and position their assets as a great, cash-flowing investment in a time where almost all other asset classes are getting trounced in the market. Buyers see the carnage in equities and a slowing economy as a precursor to a pullback in the property market, and so are leery to overpay. For this reason, deal volume is particularly low right now, properties are sitting on the market as sellers refuse to lower their asking price, and buyers are looking to pick up properties at distressed prices. Buyers have gotten cold feet and deals have been falling through.
Some of this discrepancy in how buyers and sellers of buildings see the world stems from the fact that determining the value of a commercial building is a highly subjective process. Since it is difficult, if not impossible to find applicable comparables to establish a market price, cash flows are used as a proxy for their value instead. To determine how much a building is worth, you have to assign a present value to its cash flows. The process becomes subjective if leases expire in the near future. Models are even more stretched if the probability of the tenant renewing their lease is in question.
So how can two sides, both with different visions of the future, come to an agreement on a building price, particularly one with leases that are up for renewal? One answer comes from the mortgage world: Earn-outs. An earn-out is a way for the buyer and seller to agree to a conservative price estimate, one that the buyer would be happy with, but include a profit-sharing clause for the seller if values increase. The structure reduces the downside for buyers but still gives sellers the ability to get their desired price as long as their assumptions are correct.
For commercial real estate, an earn-out looks something like this: Instead of making the buyer pay upfront for an uncertain cashflow from a lease, the building is sold for a price that excludes the value of the cash flow of the lease in question. If the tenant does renew, as the seller says they expect, then the remainder of the price can get paid back to them over an agreed upon amount of time.
“Earn-outs are a great way to tell sellers to put their money where their mouth is,” said John Cona, former Investment Officer and co-founder of F9Analytics. “It’s difficult enough for investors to get comfortable with reasonable market assumptions in a stable economic climate, it’s nearly impossible during economic instability, so the earn-out is a valuable tool,” he said.
As with any profit sharing agreement, there are plenty of complications. The seller would ultimately be relying on the buyer’s ability to service the tenant and negotiate a new lease. But these can be overcome with a bit of foresight. “You can put safeguards in place that require a certain level of performance from the new management,” Cona said. There are often different earn-outs, depending on the credit worthiness of a tenant (a high credit tenant being worth less) or the length of a lease (longer leasing being worth more).
There are certainly unforeseen problems that can arise. An example is if another unit becomes vacant, the leasing agent might have an incentive to steer prospects away from the space that has the earn-out attached. For this reason, often times these deals are done between professionals with a history of working together. “Ultimately you trust the fact that the buyer wants to get the leases renewed,” Cona said. “No one in their right mind wants vacant space right now.”
Earn-outs are also not for everyone. “The mindset of an investment shop determines how earn-outs are received,” said Clint Marchuk, vice president of acquisitions at Vestar. He has noticed that passive investors tend to like them more than ones that want a more active role in the management. “More income-based investors tend to like them more, particularly on the buy side of the transaction,” Marchuk said.
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Marchuk also noted some of the possible downsides of the arrangement. “Lenders may not advance additional proceeds for the earn-out part of the transaction, so that can be problematic,” Marchuk said. Adding non-uniform components to a transaction can give lenders one more reason to pass, so an earn-out clause needs to be worth its risk. But even without the financing component, buyers and sellers have to consider if an earn-out clause is worth the additional attention, negotiation, and lawyer fees. “You always end up with a bit of brain damage trying to think about and cover every possible scenario,” Matchuk added.
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There is also the issue of control over choosing the tenant. Landlords, particularly on the retail side but increasingly office as well, want to be able to choose a tenant mix. It becomes a selling point and a key driver of renewals. If a landlord wants to be picky about who they rent to, they might be worried that it could be a breach of contract. Curating the right tenant mix is especially important since many occupiers are using analytics to understand how their brand associates with customers of others.
Earn-outs are still quite rare in commercial property transactions and will likely stay that way due to the complicated nature of the agreement. Contract language needs to be explicit and fair in order to prevent continuous problems. No matter how much legalese is added to the contract, there needs to be a good amount of trust from each party to make earn-outs feasible. But as far-fetched as an earn-out sale of a building might be, they could help keep deals moving in what is turning out to be a stalled commercial property market.
