Real Estate Operating Companies (REOCs) are businesses that purchase, develop, manage, and sell real estate. REOCs are not mandated to pay out dividends which means they generally invest profits back in the business. They can be a way to diversify your investments into real estate without paying a premium for the dividend.
Let’s go over how they work and how they differ from real estate investment trusts (REITs).
Definition and Examples of Real Estate Operating Companies
A real estate operating company is a business formed to buy, manage, develop, and sell real estate. They may or may not be publicly traded. Unlike REITs, they are also not required to distribute a certain percentage of their profits as dividends.
REOCs can have other business segments but their main business is real estate. They find distressed properties or develop new ones to sell or manage if the price is right.
Hilton Hotels was the first real estate operating company formed in the U.S. in 1947.
Another example of a U.S.-based REOC is Howard Hughes Corp. Howard Hughes Corp was spun off from REIT mall operator General Growth Properties in 2010.
As a REOC, Howard Hughes does not derive most of its revenue from owning and leasing real estate as a lot of REITs do. Instead, it develops Master Planned Communities (MPCs). MPCs are massive neighborhoods that include amenities such as parks, shopping, tennis courts, etc. in addition to housing. As of 2020, Howard Hughes had MPCs spanning over
80,000 acres, with approximately 7,000 residential acres of more land it was expecting to develop.
Unlike its former parent company, the company’s current management did not want Howard Hughes Corp to be a REIT. Activist hedge fund manager Bill Ackman who also serves as the Chairman of Howard Hughes Corp. said in 2010 that the company chose not to become a REIT.
The decision, according to Ackman, was driven by limitations placed on RIETS when it comes to “assets held for sale in the ordinary course of business, the large amount of capital and time required for development assets, and the fact that investors principally value REITs based on their distributable free cash flow.”
How Do Real Estate Operating Companies Work?
REOCs purchase, manage, and/or develop real estate, including residential properties, high-rise commercial properties, and even malls and other shopping centers.
With no required dividend distributions, real estate operating companies can choose to reinvest net income for future growth.
Like Howard Hughes Corp, many REOCs choose the entity type to have the ability to aggressively grow. Not only can the company choose to limit distributions (or even cancel them), it also has the freedom to branch into totally non-real estate businesses.
That freedom comes into play with real estate development for sale. Where REITs would have a hard time developing and selling new properties, REOCs can purchase land and sit on it until the right time and then choose which properties to lease and which to sell.
REOCs Vs. REITs
There are many similarities between REOCs and REITs. They are both investment vehicles for real estate. They are both led by management comprising a board of directors responsible for protecting shareholder interest. Shareholders in both can vote on company matters.
Despite these structural similarities, there are stark differences between REOCs and REITs.
|Can have business interest outside of real estate without restriction||More than 75% of gross income should come from real estate activities. Other restrictions on asset and development types|
|No mandate to pay dividends to investors||Must pay at least 90% of taxable income as dividend to investors|
|REOC investment liable to double taxation||No double taxation|
|No mandate for number of investors||Requires minimum number of investors|
Real estate investment trusts own and manage real estate like REOCs but REITs must pay out at least 90% of taxable income as distributions, invest at least 75% of their assets in real estate, and derive at least 75% of their gross income from real estate.
If the REIT meets its payout rate, there is no double taxation. REOCs and other C Corporations are faced with double taxation: the corporate net income is taxed and then the investor’s dividend income is taxed.
This tax treatment works in favor of REITs because investors do not have to deal with double taxation, and they benefit from the required distribution rate. The key difference is the flexibility in REOCs to reinvest net income. As far as analysis goes, both business types are valued based on Funds From Operation (FFO). Because many REOCs still pay a dividend (just not quite the 90% of net income that REITs pay) the dividend discount model and other income investing analyses can also be used.
What It Means for Individual Investors
It’s important to diversify your portfolio over different industries and asset classes. If you’re not looking to buy property and prefer passive real estate investing, there are a number of choices available to you.
A lot of investors diversify into real estate through REITs. REOCs can provide a growth opportunity as well as diversification and inflation protection. But weigh the risks and evaluate your financial goals before investing.
- Real Estate Operating Companies (REOCs) purchase, develop, manage, and sell real estate.
- Unlike REITS, REOCs do not have a requirement to distribute any portion of net income.
- REOCs have fewer restrictions on business activities compared to REITs.
- Unlike REITS, REOCs face double taxation, at the entity level as well as the shareholder level.