You’ve been there. You find a commercial property with potential, but the seller isn’t just selling you the building they’re selling you the dream. They see a bustling, fully-leased plaza, not the two vacant storefronts you see. They want a price based on that future vision, but your wallet can only pay for today’s reality. The deal dies.
But what if you could offer the seller a performance bonus… for the building itself? This is the core idea behind an earnout, a powerful creative financing tool that can bridge the gap between a seller’s high expectations and a buyer’s current reality, unlocking deals that might otherwise seem impossible.
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What is an Earnout?
An earnout is a contractual provision where a portion of a property’s purchase price is paid to the seller after the sale, contingent on the property achieving specific, pre-agreed performance milestones. Forget the complex legal jargon think of it as a performance bonus for the property. You pay a fair base price today (the “base salary”) and promise an extra payment later (the “bonus”) only if the property proves it can perform as projected.
Key Attributes
- Base Purchase Price: The initial amount paid at closing, based on the property’s current, verifiable market value.
- Earnout Payment: The additional, contingent payment made to the seller if the performance targets are met.
- Performance Metric: The specific, measurable goal that triggers the earnout. This could be a certain occupancy level, a target gross rental income, or securing a key zoning approval.
- Timeline: A defined period after the closing during which the performance metric must be achieved (e.g., 12, 18, or 24 months).
The Earnout in a Nutshell: You pay a fair price for the property today. The seller gets a bonus payment later—but only if their predictions about its future success come true. You pay for results, not promises.
An Earnout in Action: Real-World Application
Let’s put you in the driver’s seat with a common scenario to see how this works.
The Scenario: “Main Street Plaza”
You find “Main Street Plaza,” a 5-unit strip mall. Only 3 units are currently leased. The seller is firm on their $1,000,000 price, arguing it’s worth that much once fully occupied. Your analysis, based on current income, shows it’s worth $800,000 as-is. You’ve hit a wall.
The Earnout Structure
Instead of walking away, you propose an earnout. You say to the seller, “I can pay
850,000 today. But I’ll happily pay you an additional 850,000 today…
150,000 bonus if we can get this property performing the way you believe it can.”
You formalize this in the purchase agreement with a clause like this:
- “The buyer will pay an additional $150,000 to the seller if, under the buyer’s management, the two vacant units are leased at a minimum of $2,000/month each within 18 months of the closing date.”
The Two Possible Outcomes
- Success: You hustle, find two great tenants within a year, and stabilize the property. It’s now a cash-flowing asset generating the income the seller projected. You gladly write the check for the $150,000 bonus. The seller is happy, and you’re happy because you only paid for proven performance.
- Protection: The market softens, and you can only lease one of the vacant units after 18 months. The earnout target isn’t met. You do not pay the bonus. Your wallet is protected, and your final purchase price remains $850,000 because you didn’t overpay for potential that didn’t materialize.
Why is an Earnout Important for Real Estate Investors?
An earnout is more than just a clever negotiation tactic it’s a strategic tool that offers significant benefits for an investor.
- Reduces Upfront Risk: Your largest capital outlay is based on the property’s known, current performance. You avoid overpaying for a seller’s unproven “blue sky” projections.
- Unlocks “Impossible” Deals: It provides a creative solution when you and a seller are too far apart on price. It turns a “no” into a “yes, if…”
- Aligns Buyer and Seller Interests: The seller is now financially motivated to ensure a smooth transition. They may be more willing to share tenant information or introduce you to local contacts to help you succeed.
- Informed Decision-Making: It forces a clear definition of success. By setting a specific metric (e.g., rental income), you and the seller agree on what a successful turnaround looks like from day one.
When to Use an Earnout (And When Not To)
Let’s be clear: you won’t be using this to buy your first single-family rental. Think of the earnout as a Level 2 strategy for deals with a “story”—properties that need a turnaround. It’s best used for:
- Value-Add Commercial Properties: Buildings with significant vacancy or below-market rents are the classic use case.
- Land for Development: The final price could be tied to successfully obtaining zoning approvals or permits for a certain number of units or lots.
- Properties with Unproven Income: A property where a business is included (like a motel or laundromat) and the seller is projecting future income growth.
Common Pitfalls and Limitations
While powerful, an earnout must be structured carefully to avoid future disputes.
- Vague Metrics: An agreement that says “once the property is doing better” is a recipe for disaster. Metrics must be specific and binary—either they were met, or they weren’t.
- Complexity: This isn’t a DIY clause on a napkin. It requires a detailed, unambiguous legal agreement drafted by an experienced attorney.
- The #1 Red Flag: Seller Interference: A seller might want a say in your management decisions (e.g., approving tenants) to “protect” their bonus. This is a non-starter. Once you own the property, you must have 100% operational control.
To protect yourself, your lawyer must nail down these four non-negotiables in the agreement:
- The Crystal-Clear Metric: What exact number must be hit? (e.g., “$120,000 in Gross Annual Rent”).
- The Firm Timeline: What is the exact start and end date for the earnout period?
- The Simple Payout: How is the bonus calculated and when is it due?
- The “You Are in Control” Clause: A statement confirming you have sole management authority.
FAQs: The Earnout
What is a typical earnout amount?
There’s no set rule, but the earnout amount typically represents the value gap between the buyer’s valuation and the seller’s asking price.
Is an earnout the same as seller financing?
No. In seller financing, the seller acts like a bank, and you make regular payments to them. An earnout is a one-time, contingent bonus payment that may or may not happen.
Do I really need a lawyer for this?
Absolutely, yes. An earnout’s success or failure lies entirely in how well the legal agreement is drafted. This is not a place to cut corners.
Conclusion
Incorporating the earnout into your investor toolkit transforms you from a standard buyer into a creative problem-solver. It allows you to build a bridge with an optimistic seller, mitigate your risk, and close a deal that others would walk away from. By focusing on paying for results, not just promises, you can safely buy a property’s potential and turn it into your own success.
