Cobra Kai instructor John Kreese is now broke after he loses his students, who left the Cobra Kai dojo after Kreese attacked Johnny Lawrence after his loss to Daniel LaRusso at the All Valley Karate Tournament. Kreese was then stopped and humiliated by Mr. Miyagi. On the present day, Kreese visits his Vietnam War comrade Terry Silver, a wealthy businessman who owns a toxic-waste disposal business and is the founder of the Cobra Kai. After Kreese tells him about what happened, Silver vows to help him gain revenge on Daniel and Mr. Miyagi and re-establish Cobra Kai. Silver sends Kreese to Tahiti to rest and get his life back in order while he plans to avenge him.

Upon arrival in Los Angeles, Daniel and Miyagi discover that the South Seas apartment has been demolished, which puts Miyagi unemployed and leaving Daniel homeless. They also learn that Daniel's mother, Lucille, is in New Jersey taking care of her uncle. So Miyagi permits Daniel to stay at his house for a while. Daniel uses his college funds to realize Miyagi's dream of opening a bonsai shop. Miyagi thanks Daniel and makes him a partner at the bonsai business. When Daniel visits a pottery store across the street, he meets and befriends Jessica Andrews. Daniel has a brief crush on her, but she tells him that she has a boyfriend back home at Columbus, Ohio, but they remain friends.

Meanwhile, Silver hires a vicious karate fighter named Mike Barnes to defeat Daniel at the next All Valley Karate Tournament. Silver sneaks into Miyagi's house to gather information and overhears Daniel telling Miyagi that he will not defend his title this year at the tournament. Later, Barnes and Silver's henchmen attempt to coerce Daniel to enter the tournament. Daniel refuses and Barnes departs in a heated rage. The next morning, as Daniel and Miyagi are practicing kata, Silver interrupts and tells them that John Kreese suffered a heart attack after losing his students and asks for forgiveness for Kreese's behavior. Later, Barnes and his friends attempt to make Daniel sign up for the tournament. When Daniel again refuses to enter the tournament, a skirmish ensues until Miyagi arrives and fends off the three men. After driving Jessica home, Daniel and Miyagi return to find their stock of bonsai trees stolen, with a tournament application hanging in their place.