REOC

What is REOC?

REOC means real estate operating company. It is the real-estate version of the plan-asset exemption that venture funds reach through VCOC status. A fund that qualifies is not treated as holding the assets of the ERISA plans invested in it, so its manager does not become an ERISA fiduciary over the buildings.

The problem it solves

The plan-asset rule works by look-through. When a plan invests in an entity and the exception does not apply, the plan's assets include not just the equity interest but an undivided interest in each of the underlying assets of the entity. The consequences the NVCA's own ERISA note describes for venture funds apply identically to property funds: the trust requirement attaches, the manager becomes an ERISA fiduciary, and the prohibited-transaction rules follow into every asset.

There are two exits. The first is quantitative. ERISA section 3(42) provides that an entity's assets are not plan assets if, immediately after the most recent acquisition of any equity interest, less than 25 percent of the total value of each class of equity interest is held by benefit plan investors, disregarding interests held by a non-benefit-plan-investor who has discretionary authority or control over the entity's assets or provides investment advice for a fee, or an affiliate of such a person. The regulation frames the same line as the point at which participation becomes significant: 25 percent or more of the value of any class of equity interests held by benefit plan investors.

That exit is unstable. It is tested immediately after every acquisition of an equity interest, it applies class by class, and a single large pension commitment can break it. The second exit, operating-company status, does not depend on the investor mix at all. Paragraph (c) of the regulation routes to it: the look-through does not apply where the entity is an operating company, which the regulation defines to include a venture capital operating company under paragraph (d) or a real estate operating company under paragraph (e).

The two-part test

Paragraph (e) runs the status over the same clock as VCOC: from an initial valuation date through the last day of the first annual valuation period, or for the 12-month period following the expiration of an annual valuation period for an entity that already had the status. Both prongs use the definitions in paragraph (d)(5). An initial valuation date is the later of a date designated by the company within the 12-month period ending with the section's effective date, or the first date on which the entity makes an investment that is not a short-term investment of funds pending long-term commitment. An annual valuation period is a preestablished annual period, not exceeding 90 days in duration, beginning no later than the anniversary of the initial valuation date, and once established it may not be changed except for good cause unrelated to the determination.

Prong one, the asset test. On the initial valuation date or on any date within the annual valuation period, at least 50 percent of the entity's assets, valued at cost and other than short-term investments pending long-term commitment or distribution to investors, must be invested in real estate which is managed or developed and with respect to which the entity has the right to substantially participate directly in the management or development activities.

Read that clause slowly, because it contains three requirements, not one. The real estate has to be managed or developed, not merely held. The entity has to have a right to participate in that management or development. And the participation has to be substantial and direct.

Prong two, the conduct test. During the same period the entity must, in the ordinary course of its business, be engaged directly in real estate management or development activities. As with VCOC, holding the right is not sufficient; the entity has to be doing the work.

Worked example, arithmetic shown

All figures are hypothetical.

A fund's assets at cost total $500,000,000 on a date inside its annual valuation period.

Step one, strip out the excluded short-term investments. $50,000,000 is in Treasury bills held pending long-term commitment, which the regulation excludes. Denominator: $500,000,000 minus $50,000,000 = $450,000,000.

Step two, sort the remaining $450,000,000 by whether it satisfies the participation requirement.

• $260,000,000 in development and value-add joint ventures where the fund holds approval rights over annual budgets, leasing and capital plans and its own people run the development program. Qualifying.
• $120,000,000 in stabilized triple-net-leased buildings held for yield, with no right to participate in management or development. Not qualifying.
• $70,000,000 in mortgage loans secured by third-party property. Not qualifying.
• Check the sort: $260,000,000 + $120,000,000 + $70,000,000 = $450,000,000. Correct.

Step three, run the test. $260,000,000 / $450,000,000 = 57.8 percent. The requirement is at least 50 percent, so the asset prong passes.

Step four, run the conduct prong separately. The fund's asset management team directly manages the development program at three of the joint ventures during the period, which is what engaged directly in real estate management or development activities means. Document it inside the valuation period, not afterwards.

Now break it. The fund sells $80,000,000 of development joint ventures and redeploys into net-leased assets.

• Operating bucket: $260,000,000 minus $80,000,000 = $180,000,000.
• Passive bucket: $120,000,000 plus $80,000,000 = $200,000,000.
• Loans unchanged at $70,000,000.
• Check the total: $180,000,000 + $200,000,000 + $70,000,000 = $450,000,000. Same denominator.
• Test: $180,000,000 / $450,000,000 = 40.0 percent, below the 50 percent floor. The status fails for that period.

Nothing in that second scenario looks like a legal decision. It is two acquisitions and a disposition, and it costs the exemption.

How it shows up in documents

• The limited partnership agreement, which typically covenants to maintain REOC status, defines the annual valuation period, and sometimes restricts the fund's ability to hold passive or debt positions above a stated share of the portfolio precisely so the 50 percent test cannot be breached by accident.
• The joint venture agreement or operating agreement for each asset, which is where the right to substantially participate directly in management or development actually lives. Approval rights over budgets, business plans, leasing guidelines, major capital expenditure and the selection of a property manager are the usual formulation.
• The annual REOC certificate, the file that records the valuation date, the cost-basis schedule, the percentage computed, and the management or development activities the fund conducted during the period.
• Subscription documents and side letters, where ERISA representations let the manager measure benefit plan investor participation class by class and where a pension LP may require notice if the status lapses.

Common mistakes

• Measuring at fair value. The regulation says valued at cost, which means a fund whose operating assets have appreciated cannot lean on that appreciation to pass.
• Counting stabilized net-leased assets as qualifying real estate. Without a right to substantially participate directly in management or development, they are not.
• Treating mortgage or preferred-equity positions as real estate for this test.
• Holding participation rights on paper and outsourcing all management, which satisfies neither the participation requirement nor the conduct prong.
• Letting the annual valuation period lapse or moving it for convenience. It is preestablished, capped at 90 days, and changeable only for good cause unrelated to the determination.
• Relying on the 25 percent threshold while closing a large pension commitment, since the threshold is tested immediately after each acquisition of an equity interest and applies to each class.

How it relates to adjacent terms

REOC and VCOC are the two operating-company routes out of the same look-through rule, share the same valuation-period machinery in paragraph (d)(5), and impose the same pairing of a contractual right with actual exercise. Both sit upstream of fund formation, because the covenant to maintain the status shapes what the portfolio is allowed to contain. And both are the reason an institutional LP's ERISA questionnaire arrives before the subscription agreement rather than after it.

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