(Real) Estate Earnouts: The Risks and Rewards of Density Bonuses

September 18, 2024

Written By Craig Garbe, Andrew Jeanrie and Brooke Ash

Valuing a commercial asset is a tricky business.Often, in the eyes of a purchaser, an asset's value is tied in part to the likelihood of future events—a significant customer order, a change in purchasing patterns, a government approval, etc. So, it is only natural that, where a vendor and purchaser cannot reach agreement on an asset's price, the parties would agree to connect that price (or some of it) to the occurrence of those future events. In the world of mergers and acquisitions, that connection frequently crystallizes as an 'earnout payment'—a future payment from purchaser to vendor that is contingent on business performance post-merger. In the real-property development world, a simplified version of this corporate earnout concept is fast becoming (or perhaps is already) commonplace: the density bonus.

At its basic level, a density bonus is typically structured as an obligation to make a future payment, taken on by a purchaser in favour of a vendor, which is triggered upon a change in entitlements to permit the development on a property of a building/improvement of a particular size/scope. There are fewer variables to a density bonus than an earnout payment (earnout payments typically turning on calculations of corporate earnings which inherently involve subjective accounting and tax positions and determinations), but, as we will explain in this post, the variables in a density bonus agreement can pose just as significant a basis for disagreement if not carefully constructed. Just as earnout payments have been pilloried as a 'great way to avoid litigation now by ensuring it later', density bonuses can seem like a simple fix to arrive at agreement on a purchase price, only to discover years down the road that there was never any agreement on price at all. Proper consideration and construction of these contractual concepts is critical to giving each party a clear understanding of their rights, and risks.

When is the Rezoning, and How Valuable is Future Value?

One of the thorniest, and most often overlooked, issues in creating a density bonus is the 'when': the determination of when a change in entitlements has occurred. Zoning and land-use changes may be confirmed by a specific administrative adjudication body (e.g., the Ontario Land Tribunal in Ontario, previously the Ontario Municipal Board/the Local Planning Appeal Tribunal) or may be imposed by a municipal or provincial government. If confirmed by an adjudicative body, is the decision final as of its issuance, or do statutory appeal periods need to expire first, and then what happens if an appeal is filed? If imposed by a municipal or provincial government, is the law final as of the date of passage, or does it need to be proclaimed in force or given royal assent?¹ And even once 'final', what if the 'grant' of permission to permit a particular development is contingent or conditional on other events or circumstances? And does it matter if those events or circumstances are within, or outside of, the control of the vendor or purchaser?  For example, if a site-specific zoning bylaw is 'final', but the completion of nearby highway or infrastructure improvements must be completed by the municipality are necessary prior to the construction of the intended building/improvement, is it actually final? What if the completion of those infrastructure improvements is within the control of the developer, as it will bear the cost of them and has agreed to ensure their completion pursuant to a development agreement with the municipality? Does it matter if these infrastructure improvements are the subject of a hold or conditions in the zoning? Do any of these change the analysis? What if permission for increased density is granted but is conditional upon payment of a ten-fold increase in community benefits or affordable housing which make any development financially unfeasible—in such case has the density ever really been permitted? And even once density has been determined to have been granted, does the bonus obligation continue to live on in the event that subsequent density increases are later obtained?

A properly drafted density bonus agreement can address these various scenarios, but such an agreement requires the parties to turn their minds to the many potential scenarios that could occur and to include provisions to address them. At some point, parties should also consider whether it is the entitlements themselves that is sufficient to give the paying party the certainty that it will ultimately realize value sufficient to justify the density bonus payment. Government permission through a rezoning is an important piece of the development puzzle but is not the only one.  Leaving aside market-dependent factors relating to any development (construction costs, development sale or rental value, etc.) which may also impact value realization, additional government approvals (site plan agreements, contribution agreements and building permits) are likely to be required at various other stages throughout the development process. Instead of rezoning, would development completion be a better trigger for this future payment? Or, perhaps, is risk allocation through a present-set purchase price the better resolution?

What Can be Built, and Did I Even Want it Anyway?

Second only to the difficult 'when' question is the 'what' question: what exactly does the rezoning need to permit in order to trigger the payment obligation? Often, the trigger for the payment, as well as the determination of the amount of the payment will turn on the permitted development area (either in square feet or square meters, with care taken to ensure that any price per square unit is clearly determined for one or the other). But not all square feet are created equal. Is a square foot of below-grade space of equal value to an above-grade space? What if an above-grade parking structure is contemplated? Is a square foot of lobby or common area or amenity space of equal value to space within a residential or commercial unit? Is residential area of equal worth as commercial area, and should the trigger test (or the payment amount per square foot) take different valuations into account? If residential development is contemplated, will the building/improvement contain government-mandated affordable housing area requirements which should be excluded for the purposes of determining a square footage calculation where the affordable housing generates no profit? What if the level of affordability actually triggers a loss on the space constructed? And what if, as in 249 Ontario (see footnote above), the land that is subject to the density bonus is 'combined' with other lands for the purposes of redevelopment? Does such an aggregation of land affect the bonus price calculations and, if so, how?  Again, proper drafting can address each of these questions, but without careful consideration of such terms the common law is unlikely to step in to fill in the gaps to the satisfaction of each party.

Parties should also consider the potential for unilateral imposition of highly permissive zoning/development rights. In a world where property development (especially multi-unit residential) is increasingly political, it is possible that future development of a site might be granted beyond an owner's expectations.² A pro-development provincial or municipal government could, in theory, permit an unlimited amount of square footage to exist on a site slated for significant densification in key urban areas.³ In such a scenario, how would a bonus payment that turns on a knowable maximum development area function? What is the product of $10psf multiplied by ∞? Of course, development potential is limited by physical and engineering possibilities, but is that the limit contemplated by the agreement, or by the parties? 

At the same time, that parties are considering what exactly it is that needs to be permitted in order to trigger future obligations, they should also consider to what extent any party needs to take positive actions to seek that permission. It is well established law in Canada that each party to a contract bears an obligation to perform that contract in good faith,⁴ but does that mean pursuing the rezoning at all financial costs? For example, the doctrine of good faith may be breached if a purchaser acts with the intention of depriving the seller of an earnout payment. In spite of this, obligations related to earnout agreements are generally confined to what is explicitly written in the agreement, but the parties do themselves a disservice if they are not clear about the standard of performance they expect.⁵

Mortgages and Taxes and Timelines, Oh My

Once the key terms of a density bonus agreement are settled, the parties' minds should begin to consider the surrounding circumstances as well. From a vendor's perspective, it will be important to ensure that the purchaser's performance of the agreement is ensured, and to consider the timeline that this obligation lives on for. Will this obligation bind future owners of the land if the purchaser is not the ultimate developer and, if so, how will the vendor ensure that such owners are bound? Is there a specified timeline for the payment obligation to end, and, if so, what happens if a rezoning is almost complete on such date? The creation of a contractual right to payment is not, in and of itself, an interest in land that is properly registrable on title to a property,⁶ so will a vendor require additional security to ensure performance? Perhaps the purchaser should be obligated to grant a collateral mortgage to the vendor to help secure the performance of its obligations under the density bonus agreement, but if that is the case then the purchaser must be prepared for the vendor's status as mortgagee of the land. The purchaser will likely need the consent of (and tri-party agreements with) its conventional lenders in order to permit such a mortgage, and must ensure that its vendor does not obtain out-sized rights and covenants that would be typically granted to a conventional lender (i.e., further development approvals, sale restrictions, step-in rights, etc.). If future municipal agreements will be registered, or portions of the property will be transferred to a municipality, the vendor (as mortgagee) must be obligated to postpone or to discharge in order to permit these, lest it obtain de jure control rights over the land that were not necessarily intended.  An alternative security structure (such as letter of credit or posting of cash collateral security) could be considered, but the purchaser must be prepared for the added costs of these methods (and negotiate compensation for them up front as desired).

Similarly, a purchaser must be aware of and consider the effects of such a future payment to the vendor, if and when it occurs. While a contractual right to a future payment may not constitute a registrable interest in land, such a payment may very well constitute additional consideration payable for the land which is subject to land or property transfer tax. In Ontario, for example, such payments almost certainly constitute "consideration…conferred…on any person as part of the arrangement relating to the conveyance" under the Land Transfer Tax Act.⁷ As set out in our prior detailed publication about this and other land transfer tax pitfalls in Ontario, there is also a risk that the additional tax payable will be subject to interest from the date of the acquisition of the land, notwithstanding that the liability for such payment does not accrue until a point in the future.⁸ Purchaser payees should be aware of this risk and consider it when determining whether a density bonus payment is the appropriate mechanism to help fix a property's purchase price.

Final Thoughts

Tying value to a contingent future event is a great way for vendors and purchasers alike to reach agreement and maximize value—it can also create significant uncertainty and risk. This doesn't mean such arrangements are not worthwhile, but key to extracting value from such arrangements is giving them the due time and consideration they deserve. In some ways, a density bonus arrangement is akin to the creation of a pointed and focused joint venture between two parties, aligning them on value creation that they can both benefit from. But just as parties should not lightly enter into partnership together, they should not lightly create a density bonus obligation. With a bit of time and consideration, parties can find the middle ground that is right for them. Please contact the authors of this blog for more information on the issues discussed in this post, or for assistance as you look to identify and implement transactions of this nature.

Authors