An earnout is an agreement by the lender to increase the loan amount at the advent of a certain event. Earn outs are structured so that the additional money can be handled by the operating performance of the property. For example, more money can be released in the form of an earn out if the property has undergone renovations, has upgraded its tenant’s minimum income criteria or increased its tenant occupancy. Resizing criteria for the earn out loan to be triggered could be expressed or measured in forms such as a minimum debt service coverage ratio (DSCR) or as a minimum loan to value ratio (LTV). An earn out is NOT a new loan or a refinancing of an existing loan; it is simply an increase of an existing loan. That means that new funding is available without the costs associated with new commercial property loans such as attorney fees, closing fees, etc.

The greatest benefit of an earnout in a commercial real estate loan is that it allows for additional funding without the costs associated with new commercial property loans such as attorney fees, closing fees, etc. Additionally, the additional money can be handled by the operating performance of the property, such as through renovations, upgraded tenant income criteria, or increased tenant occupancy.

The risks associated with an earnout in a commercial real estate loan include the possibility of the property's value decreasing, resulting in the loan being underwater. Additionally, the monthly payments could increase significantly at the end of the interest-only period when you are required to start paying both principal and interest. Before taking out an earnout loan, be sure to speak with a qualified commercial real estate broker to discuss all of the risks and benefits associated with this type of financing.

There are three main types of earnouts in commercial real estate loans: debt service coverage ratio (DSCR) earnouts, loan to value ratio (LTV) earnouts, and operating performance earnouts.

DSCR earnouts are triggered when the debt service coverage ratio of the property meets a certain threshold. LTV earnouts are triggered when the loan to value ratio of the property meets a certain threshold. Operating performance earnouts are triggered when the property has undergone renovations, has upgraded its tenant’s minimum income criteria or increased its tenant occupancy.

An earn out is NOT a new loan or a refinancing of an existing loan; it is simply an increase of an existing loan. That means that new funding is available without the costs associated with new commercial property loans such as attorney fees, closing fees, etc.

The best practices for negotiating an earnout in a commercial real estate loan include:

• Understand the terms of the loan and the criteria for the earnout to be triggered.
• Be aware of the costs associated with new commercial property loans such as attorney fees, closing fees, etc.
• Be prepared to negotiate with your lender to get the best possible deal on your loan.
• Be aware of the debt service coverage ratio (DSCR) and loan to value ratio (LTV) that will be used to measure the earnout.

Source: 5 Tips for Shopping for a Commercial Real Estate Loan and Earnouts in Commercial Real Estate Loans