Financial Savviness: Ways to Get More Capital with Holdbacks & Earnouts

Commercial real estate owners sometimes need to refinance, but their property's business plan might not be entirely complete. For instance, the plan may aim to increase value by making renovations and increasing rents. However, what if the owner is only 70% through the plan, but other forces necessitate refinancing immediately? The solution might be Holdback & Earnouts. 

If you remember from my course, I was able to obtain two refinances on the same property just two years apart. In addition to refinancing, there are additional strategies as discussed below. 

Today's real estate environment prompts sponsors to lock in interest rates before they continue to rise. However, sponsors might still be in the process of increasing rents to the pro forma levels. In this scenario, Holdback & Earnouts come into play. 

In commercial real estate loans, a holdback refers to when a commercial lender holds back part of the proceeds of a loan when it closes. For example, a lender might agree to provide a $5,000,000 loan to buy a property, with the possibility of releasing an additional $1,000,000 after the owner successfully negotiates a 20% increase in the tenant's lease rate. In this scenario, the total loan would be $6,000,000, and $5,000,000 would be provided at close, while $1,000,000 would be held back and disbursed once the owner increases the tenant's lease rate. 

On the other hand, 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. In this case, the lender might agree to provide a $5,000,000 loan, with the possibility of disbursing an additional $1,000,000 after the owner successfully negotiates a 20% increase in the tenant's lease rate. 

The difference between a holdback and an earnout lies in the interest payments. In a holdback structure, the sponsor pays interest on the total proceeds promised, including the portion held back. In contrast, in an earnout structure, interest is only paid on the funded dollars, and the lender is not obligated to fulfill the earnout if market conditions change. Therefore, the language negotiated in the loan documents for an earnout is crucial. 

In summary, Holdback & Earnouts are options for commercial real estate owners (such as RAL owners) who need to refinance but have incomplete business plans. The choice between a holdback or an earnout structure depends on the owner's preferences and financial circumstances. Nonetheless, these structures provide flexibility and give owners the chance to fulfill their business plan and increase value.