Are earn-outs the answer to closing the bid-ask spread in commercial real estate?

There seem to be completely opposite realities right now. No, I’m not talking about the political divide, I’m talking about the sentiment of buyers and sellers of commercial real estate. There has never been so much of a gap between buyers and sellers when it comes to the value of a property. Sellers see the economic situation and position their assets as an excellent profitable investment at a time when almost all other asset classes are crushed in the market. Buyers see the carnage in equities and the slowing economy as a precursor to a housing market pullback, and so are hesitant to overpay. For this reason, the volume of transactions is particularly low at the moment, properties are on the market as sellers refuse to lower their asking price and buyers seek to buy properties at ridiculous prices. The buyers were cold-eyed and the bids fell through.

Part of this discrepancy in how real estate buyers and sellers view the world stems from the fact that determining the value of commercial real estate is a highly subjective process. Since it is difficult, if not impossible, to find applicable comparables to establish a market price, cash flows are instead used as an approximation of their value. To determine the value of a building, you must assign a present value to its cash flows. The process becomes subjective if the leases expire in the near future. The models are further stretched if the probability of the tenant renewing their lease is in question.

So how can two parties, with different visions of the future, agree on the price of a building, especially with leases to be renewed? One answer comes from the mortgage world: price supplements. A price supplement is a way for the buyer and seller to agree on a conservative price estimate, which would satisfy the buyer, but which includes a profit-sharing clause for the seller if values ​​increase. The structure reduces inconvenience for buyers but still gives sellers the chance to get their desired price as long as their assumptions are correct.

For commercial real estate, an earn-out looks like this: instead of charging the buyer an uncertain cash flow from a lease, the building is sold at a price that excludes the value of the cash flow from the lease in question. If the tenant renews, as the seller says he expects, the rest of the price can be refunded to him over an agreed period.

“Add-ons are a great way to tell sellers to put their money where they say they should,” said John Cona, former chief investment officer and co-founder of F9Analytics. “It’s hard enough for investors to become familiar with reasonable market assumptions in a stable economic climate, it’s nearly impossible in times of economic instability, so earning out is a valuable tool,” said he declared.

As with any profit-sharing agreement, there are many complications. The seller would ultimately rely on the buyer’s ability to service the tenant and negotiate a new lease. But these can be overcome with a little foresight. “You can put safeguards in place that require a certain level of performance from new management,” Cona said. There are often different price supplements, depending on a tenant’s creditworthiness (a high credit tenant is worth less) or the length of a lease (a longer lease is worth more).

There are certainly unforeseen problems that can arise. For example, if another unit becomes vacant, the letting agent might be incentivized to steer prospects away from the space to which the earn-out is attached. For this reason, these agreements are often made between professionals with a history of collaboration. “At the end of the day, you trust that the buyer wants to renew the leases,” Cona said. “No one in their right mind wants vacant space right now.”

Complements are also not for everyone. “The mindset of an investment store determines how earnouts are received,” said Clint Marchuk, vice president of acquisitions at Vestar. He noticed that passive investors tend to like them more than those who want to take a more active role in management. “More income-based investors tend to like them more, especially on the buy side of the trade,” Marchuk said.

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Marchuk also noted some of the possible downsides to the arrangement. “Lenders cannot advance additional proceeds for the add-on portion of the transaction, which 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 should be worth its risk. But even without the financing component, buyers and sellers have to consider whether an earn-out clause is worth the extra attention, negotiation and attorney fees. “You always end up with a bit of brain damage trying to think through and cover every possible scenario,” Matchuk added.

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There is also the question of control over the choice of tenant. Landlords, particularly on the retail side but also increasingly on the office side, want to be able to choose a mix of tenants. It becomes a selling point and a key driver of renewals. If a landlord wants to be picky about who they are renting from, they may fear it is a breach of contract. Choosing the right mix of tenants is especially important because many tenants use analytics to understand how their brand relates to other people’s customers.

Earnouts are still quite rare in commercial real estate transactions and will likely remain so due to the complicated nature of the deal. The wording of the contract must be explicit and fair to avoid ongoing problems. No matter how much legalese is added to the contract, there has to be a good deal of trust on the part of each party to make earn-outs workable. But as far-fetched as the sale of a building at an earn-out may be, it could help move deals forward in what is proving to be a stalled commercial real estate market.

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