Introduction

An earnout structure in property sales is a contractual arrangement where a portion of the purchase price is paid after closing, contingent upon the property meeting certain financial or operational performance targets over a specified period. Traditionally used in business acquisitions, earnouts are increasingly employed in real estate transactions, particularly for income-producing properties like retail centers, hotels, or office buildings where future revenue performance is critical to the valuation. Earnouts bridge the gap between buyers and sellers when there is uncertainty about a property’s projected income, allowing deals to proceed even when parties differ on the property’s future prospects.

Purpose and Strategic Importance of Earnouts

The central purpose of an earnout is to manage valuation risk. Sellers often have optimistic projections about a property’s revenue growth, tenant stability, or market positioning, while buyers, cautious of overpaying, may discount the valuation based on current performance. An earnout offers a compromise: part of the payment is deferred and tied directly to the asset’s ability to achieve specified results post-sale.

From the seller’s perspective, an earnout provides the opportunity to realize full value if the property performs as expected or better. For buyers, it offers protection against downside risk because they only pay the additional amount if the property generates the anticipated income. Thus, earnouts align the parties’ interests around property performance and encourage transparency and collaboration even after the closing.

Typical Mechanics of Earnout Structures

Earnouts are typically structured around measurable financial metrics. In property sales, these metrics often include net operating income (NOI), gross rental revenues, tenant occupancy rates, or successful lease-up milestones for vacant space. The seller and buyer agree on the performance targets, the time frame for measuring those targets—often one to three years after closing—and the amount or formula that will determine the additional payment.

The earnout may be designed as a binary trigger, where a set bonus is paid if the target is achieved, or as a graduated scale, where different levels of payment correspond to different degrees of performance. Payment timing is also critical: it might occur in a lump sum at the end of the measurement period or be released in tranches as milestones are reached.

Careful drafting is required to address situations such as early tenant terminations, capital improvement projects, force majeure events, or significant changes in market conditions. The earnout structure must specify whether such events adjust performance targets, suspend measurement periods, or terminate earnout obligations.

Challenges and Risks in Earnout Structures

Despite their appeal, earnouts are inherently complex and often become sources of post-closing disputes if not carefully structured. One key challenge is defining performance metrics in a way that is objective, measurable, and not susceptible to manipulation. Disagreements can arise if, for example, the buyer delays leasing activities or under-invests in property management, leading to performance below expectations and eliminating the seller’s earnout entitlement.

Another challenge is ensuring access to accurate and timely information. Sellers typically want the right to review financial reports, property management records, and leasing documentation to verify performance results. Buyers, meanwhile, must balance providing transparency with protecting their operational autonomy.

Furthermore, the tax treatment of earnout payments can introduce complexity, as payments made after closing may have different tax implications than initial purchase price payments. Legal counsel and tax advisors must be involved early to structure the deal in a way that clarifies treatment for both sides.

Negotiating and Drafting Effective Earnouts

Successful earnout arrangements require meticulous negotiation and drafting. The parties must agree on detailed definitions for key terms like “net operating income” or “occupancy,” clearly outline measurement methodologies, and establish protocols for resolving disputes.

Earnout agreements often include covenants requiring the buyer to operate the property according to a defined standard—such as using commercially reasonable efforts to lease space or maintain operating budgets—to prevent manipulation of results. Remedies for breaches of such covenants must be clearly stated, potentially allowing the seller to claim immediate entitlement to the earnout if bad faith or negligence is proven.

It is also common to set a cap on the maximum earnout payable to limit financial exposure, as well as time limits beyond which no further payments are owed, ensuring that the buyer’s obligations do not extend indefinitely.

Conclusion

Earnout structures in property sales are powerful tools for bridging valuation gaps and sharing risks associated with uncertain future performance. When carefully crafted, they align incentives between buyers and sellers and create flexible pathways to complete transactions that might otherwise falter over price disagreements. However, the complexity of defining measurable outcomes, managing operational influences, and preventing disputes requires careful planning, transparent communication, and precise legal drafting. In today’s dynamic and sometimes volatile real estate markets, earnouts provide a creative mechanism to accommodate different views of value while maintaining fairness and protecting both parties’ interests in commercial property transactions.

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