Real Estate "Earn-Out" Structure
Does any one have experience with earn-out structures in real estate that aren't on the lending side. I realize this happens in development quite frequently, but what I'm looking for is on existing property. The situation would look like this: Investor owns a couple of properties and is looking to sell as markets are currently very strong and trends suggest that rates and other factors might be going in the wrong direction. Current vacancy in these assets is below desired occupancy level but sellers expectations for price would be based on a target occupancy (I.e. 75% v.s 90%). There is a gap in what an investor would pay because of the vacancy but seller is hoping to dispose. Would some sort of earn out where the buyer pays a market price based on current value and allows seller to participate in increased value based on lease-up work? Or would the typical scenario find the investor projecting for a certain period of vacancy and balancing risk v.s upside in their discount rate (with an aggressive mindset to try to close deal)
The latter. Never heard of earn outs outside of mortgages
I've done a couple off-market deals that had earn out features like the one you described.
Just to make sure I read this correctly... The owner wants to liquidate an under performing asset and seeks to devise a structure that will allow him to capture a portion of the upside potential, that the new buyer may or may not be able create? Common sense would indicate that If you want to share in the upside potential, you must be willing to share in risk (share in costs to re-position) or take less up-front in order to receive a portion of the future cash flows
If these are desirable property types in tier 1 markets (i.e. Class B, MF in LA) you may choose to take your cash and run. There is lots of capital chasing higher yielding deals, these value-add opportunities are becoming rarer to come by and are trading at record levels
I'd be curious to hear others opinions/criticism. Depending on how much liquidity you need, you may choose to:
Sell a partial interest in your venture. It doesn't sound like your the most experienced sponsor in the arena (given your comments about under performance in a strong market) and it also sounds like your willing to give up control, so selling a interest and remaining a minority stakeholder seems reasonable. You could partner with a more experienced value-add investor and arrange some form of tiered payout (waterfall) that splits distributions based on different yields.
If you elect to do this, you need to ask yourself if your goal is to 1) earn long-term income stream based on cash flow from operations or 2) potentially receive a large sum of cash assuming your partner can successfully re-position and dispose of the asset. You have to decide this early on b/c the overall strategy, especially leverage levels, vary dramatically.
If your hoping to earn on-going CFFO than you could partner with a long-term holder and have the waterfall tiers based on cash-on-cash returns. If you don't need the cash flow from operations and want to bet on re-positioning/disposing of your asset, than base your cash flow splits on an IRR and hope for a strong back-end reversion.
I know you said you didn't want a lending side example, but it may be good to talk to a lender who puts debt on opportunistic deals and learn how they structure their lender participation.
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