Holdbacks and Earnouts Are a Way to Get Commercial Lenders to Make Larger Loans

What’s a holdback you say?  A holdback in a commercial real estate loan is when a commercial lender holds back a part of the proceeds of the loan when a commercial lender closes on a commercial real estate loan.  As an example, let’s suppose a commercial lender funds a $2 million loan on an office building.  Assume the lease is signed, but the new tenant is still working on his tenant improvements.

If the new tenant actually completes his move-in and starts paying rent a loan of $2 million is a prudent investment.  But until then the commercial lender is not comfortable in advancing the full $2 million.  Therefore the commercial lender and the person borrowing the money could agree that the lender will “hold back” $400,000 for 60 days until the tenant actually moves in.

All of the loan docs will actually say $2 million and the borrower might also be paying the interest on the $400,000 being held back.  A holdback is intended to be a short-term arrangement by design.

An earnout on a commercial real estate deal is similar to a holdback, but it is just a little bit different.  An earnout is a promise by a commercial lender loan a commercial mortgage borrower more money on his new commercial real estate loan if the borrower successfully increases his scheduled rents.  As an example, let’s say that a borrower goes to a commercial lender and says, “This apartment building was formerly run by and old and sickly guy who also owned the place.  His rents were 30% below market.  Will you please lend me $2 million today so I can buy the property and promise me that you will lend me another $400,000 if and when I raise the rent by 30%?”  Such an agreement with a commercial lender is known as an earnout.

In an earnout the commercial real estate loan is not written at $2,400,000 with the commercial lender holding back $400,000.  Therefore it is just a promise from the commercial lender to increase his loan to $2,400,000 if – and there is not guarantee that the borrower will be successful – the borrower can actually raise his rents by 30%.

When the commercial lender does increase his commercial real estate loan by $400,000 – the borrower is usually only charged the points on the $400,000 of new money.  Instead of using an earnout, if the commercial lender simply refinanced its original $2 million loan and made a new $2,400,000 commercial real estate loan, the borrower would have to pay points on the entire $2.4 million.  Saving the points on the refinance is the big advantage of an earnout.

We continue to say that each commercial loan is different and unique and they must each be treated accordingly.  The fun of doing a commercial loan versus a residential loan is that one gets the chance to be really creative – on both sides of the deal.  Holdbacks and earnouts are just two more examples of having more arrows in your deal-making quiver!