PRINT THIS STORY:

CHANGE TEXT SIZE:

‘EARN-OUT’ DEALS GAIN POPULARITY

Last September Feldman Equities agreed to buy the 1.2 million-square-foot Colonie Center, in Albany, N.Y., for $84.2 million. But Feldman could end up paying the seller about $9 million more later on.

Why? Well, Feldman Mall Properties (as Feldman Equities is now called, following its December IPO) will pay the seller — The Blackstone Group — the additional amount upon the latter’s signing up certain tenants that were in negotiations at press time, and when those retailers start paying rent.

Under this kind of deal, called an earn-out, the buyer is in effect agreeing to pay the seller for a shopping center’s future revenue-generating capability — but only after agreed-upon improvements, whether leasing changes or renovations, are completed. When the transaction closes, the clock starts ticking. The seller generally has a six-to-18-month window to make the changes.

The practice is in fact an old one, but industry professionals say it is resurgent, mainly because interest rates are going up.

Sellers provide the initial impetus for earn-out transactions, but investor demand further drives the market, says Larry Feldman, chairman and CEO of Feldman Mall Properties.

“The seller may have leases in negotiation, and they want to get credit as part of the consideration,” said Feldman. At the same time, investors would rather get a property that is actually bringing in rent revenues than an empty space with “potential.”

Spaulding & Slye Colliers, a Boston-based real estate brokerage, says it is working on the sale of three shopping centers, totaling about 900,000 square feet of gross leasable area, to an as-yet-unnamed buyer. This buyer will initially pay $85 million, plus an additional $45 million when certain improvements have been made.

The structure holds advantages for both buyer and seller. The purchaser can acquire a property with improvements, while locking in the cost at today’s prices. The device also provides a degree of certainty not available through normal means. After all, in a straightforward acquisition (whatever that means anymore) the buyer agrees to buy at a fixed price that supposedly reflects the property’s potential increase in value. The seller is under no obligation to guarantee any revenue flow, however.

But earn-outs reward sellers, too, of course.

“The benefits to the seller are numerous and substantial,” said James Koury, a senior vice president at Spaulding & Slye Colliers.

First, a seller can seize on the best opportunity to sell a property without having to make those improvements beforehand. This provides some breathing room between the sale and the improvement period. Also, earn-outs can enhance 1031 exchange transactions. In a normal 1031 deal, the seller has six months after closing a deal to identify a like-kind property for exchange. But at the end of an earn-out period, the seller can book the premium payment as a separate sale, in effect “buying” an additional six months to find a like-kind exchange property and complete an additional 1031 deal, says Koury.

Feldman Mall Properties sees potential in Colonie Center, to be sure. In addition to the leasing Blackstone said it would complete, Feldman Mall Properties detailed in an SEC filing that it plans to spend a further $9.6 million on other improvements by adding new upscale junior anchors, redirecting traffic for anchors, improving signage and adding entertainment components.

The drawbacks are minimal, proponents say, especially if the seller has already secured redevelopment permits. Should the seller fail to complete the modifications, the buyer takes the property at the lower price based on existing revenue. The biggest risk would be that a property has in fact very little potential, which would become evident if the seller is unable to lease it within the 18-month window.

For all their attractions, earn-out structures could wane in popularity if the retail property market cools, says Koury. Market participants “look at this potential window of opportunity [that is] closing.”