There are two main types of real estate investment trusts (REITs) that investors can buy: equity REITs and mortgage REITs. Equity REITs own and operate properties, while mortgage REITs invest in mortgages and related assets.
What Is a REIT?
A REIT, which stands for real estate Investment trust, is a type of security in which the company owns and generally operates real estate or real-estate–related assets. REITs are similar to stocks and trade on major market exchanges. REITs allow companies to buy real estate or mortgages by using combined investments from a pool of investors. This type of investment allows large and small investors alike to own shares of real estate—without having to buy, operate, or finance real estate themselves.
REITs are generally required to have at least 100 investors, and regulations prevent what would otherwise be a potentially nefarious workaround: having a small number of investors own a majority of the interest in the REIT.
At least 75% of a REIT’s assets must be in real estate, and at least 75% of its gross income must be derived from rents, mortgage interest, or gains from the sale of the property.
Also, REITs are required by law to pay out at least 90% of annual taxable income (excluding capital gains) to their shareholders as dividends. This restriction, however, limits a REIT’s ability to use internal cash flow for growth purposes.
- REITs are companies that own, operate, or finance income-producing properties.
- Equity REITs own and operate properties and generate revenue primarily through rental income.
- Mortgage REITs invest in mortgages, mortgage-backed securities, and related assets and generate revenue through interest income.
Equity real estate investment trusts are the most common type of REIT. They acquire, manage, build, renovate, and sell income-producing real estate. Their revenues are mainly generated through rental incomes on their real estate holdings. An equity REIT may invest broadly, or it may focus on a particular segment.
In general, equity REITs provide stable income. And because these REITs generate revenue by collecting rents, their income is relatively easy to forecast and tends to increase over time.
Mortgage REITs—also called mREITs—invest in mortgages, mortgage-backed securities (MBS), and related assets. While equity REITs typically generate revenue through rents, mortgage REITs earn income from the interest on their investments.
For example, assume company ABC qualifies as a REIT. It buys an office building with the funds generated from investors and rents out office space. Company ABC owns and manages this real estate property and collects rent every month from its tenants. Company ABC is thus considered an equity REIT.
On the other hand, assume company XYZ qualifies as a REIT and lends money to a real estate developer. Unlike company ABC, company XYZ generates income from the interest earned on the loans. Company XYZ is thus a mortgage REIT.
Like equity REITs, the majority of mortgage REIT profits are paid to investors as dividends. Mortgage REITs tend to do better than equity REITs when interest rates are rising.
Risks of Equity and Mortgage REITs
Like all investments, equity REITs and mortgage REITs have their share of risks. Here are a few that investors should be aware of:
- Equity REITs tend to be cyclical in nature and can be sensitive to recessions and periods of economic decline.
- With equity REITs, too much supply—for example, more hotel rooms than a market can support—can lead to higher vacancies and lower rental income.
- Changes in interest rates can impact earnings for mortgage REITs. Similarly, lower interest rates may lead more borrowers to refinance or repay their mortgages—and the REIT has to reinvest at a lower rate.
- Most mortgage securities that REITs buy are backed by the federal government, which limits the credit risk. However, certain mREITs may be exposed to higher credit risk, depending on the specific investments.
The Bottom Line
REITs give investors a way to tap into the real estate market without having to own, operate, or finance properties themselves. Both equity and mortgage REITs are required to pay out 90% of income to shareholders in the form of dividends, which are often higher than those of stocks.
In general, equity REITs may be attractive to buy-and-hold investors looking for a combination of growth and income. Mortgage REITs, on the other hand, may be better suited for risk-tolerant investors looking for maximum income, without much focus on capital appreciation.
What is real estate?
Real estate is the land along with any permanent improvements attached to the land, whether natural or man-made—including water, trees, minerals, buildings, homes, fences, and bridges. Real estate is a form of real property. It differs from personal property, which are things not permanently attached to the land, such as vehicles, boats, jewelry, furniture, and farm equipment.
What is a mortgage-backed security (MBS)?
A mortgage-backed security (MBS) is an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issued them. Investors in MBS receive periodic payments similar to bond coupon payments.
What is a trust?
A trust is a fiduciary relationship in which one party, known as a trustor, gives another party, the trustee, the right to hold title to property or assets for the benefit of a third party, the beneficiary. Trusts are established to provide legal protection for the trustor’s assets, to make sure those assets are distributed according to the wishes of the trustor, and to save time, reduce paperwork and, in some cases, avoid or reduce inheritance or estate taxes. In finance, a trust can also be a type of closed-end fund built as a public limited company.