What it means
Companies that own property can choose different structures. A REIT is built to pass rental income through to investors and generally must distribute most of its taxable income each year.
A REOC, in contrast, is free to reinvest its profits in buying land, constructing buildings and expanding its operations. Because REOCs retain earnings, they suit businesses that develop property, trade it, or provide services such as hotel management or property management.
These activities often do not fit the rules that REITs must follow, which tend to favour stable rental income. A developer that builds and sells homes, for example, is more naturally a REOC.
Investors judge the two structures differently. REITs appeal to people who want regular income, while REOCs appeal to those who want growth in the value of the company's shares.
A REOC pays tax on its profits at the normal company rate, and any dividends it does pay are taxed again in the hands of shareholders in many systems. Valuing a REOC involves looking at both the property it owns and the business it runs.
Analysts commonly estimate net asset value (NAV), which is the market value of the properties minus the debt and other liabilities, and then compare the share price with NAV. They also consider the value of the development pipeline and the operating platform, which a simple property valuation misses.
REOCs generally carry more business risk than REITs, because their earnings depend on the success of development and operations as well as on rents. They also have more flexibility to borrow and to use profits for acquisitions.
Whether this is a benefit or a risk depends on the quality of management and the state of the property market.
In practice
Real-world examples.
Example
A homebuilder that buys land, constructs houses and sells them to buyers retains most of its profit to buy more land. It operates as a REOC because its profits come from selling property and not from steady rent. Investors expect growth in the share price rather than a high dividend.
Example
A hotel company owns several hotels and also manages hotels for other owners. The management fees do not qualify as rental income, so the company operates as a REOC. Its finance team reinvests profits in refurbishing rooms and opening new hotels.
Example
A private investor compares a REIT paying a 5% dividend with a REOC paying almost no dividend. The REOC's shares have risen faster, but are also more volatile. The investor decides to hold both, using the REIT for income and the REOC for growth.
Formula
Calculation
Net asset value per share = (Market value of properties - Debt - Other liabilities) / Shares outstanding
Suppose a REOC owns properties with a market value of $500,000,000. It has debt of $200,000,000 and other liabilities of $20,000,000. Net asset value = 500,000,000 - 200,000,000 - 20,000,000 = $280,000,000. With 10,000,000 shares in issue, NAV per share = 280,000,000 / 10,000,000 = $28. If the shares trade at $24, they trade at a discount to NAV of (28 - 24) / 28 = 14.3%.Case study
Seen in the real world.
Summit Peak Developments is an illustrative, fictional property company that develops office parks and runs a property management business. Its founders considered converting to a REIT to attract income investors.
The finance director found that nearly 40% of the company's profit came from development sales and fees, which would not fit comfortably within REIT rules. The company would also have to distribute most of its profit, which would limit its ability to fund new projects.
The board decided to remain a REOC and focus on growth, explaining its strategy to investors who preferred capital appreciation. The illustrative lesson was that the right structure depends on where the profit comes from and what the company wants to do with it.
Watch out
Common mistakes.
- Assuming a REOC offers the same steady dividend as a REIT, when it is usually focused on reinvesting profits.
- Valuing a REOC only on its properties, ignoring the value of its development pipeline and operating business.
- Forgetting that a REOC is generally taxed as an ordinary company, so it lacks the tax advantages of a REIT.
Questions
People also ask.
What is the main difference between a REIT and a REOC?
A REIT must generally pay out most of its taxable income and receives special tax treatment, while a REOC can retain profits and is taxed as a normal company.
Why would a property company choose to be a REOC?
It might earn income from development, trading or services that do not suit REIT rules, or it may want to keep cash to fund growth.
How do analysts value a REOC?
They often use net asset value, adding the value of the development pipeline and the operating business, and compare it with the market price.
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