A Real Estate Investment Trust, or REIT, 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 its investors. This type of investment allows large and small investors to own a share of real estate.
To qualify as a REIT, a company must satisfy many standards including having at least 100 shareholders, being managed by a board of directors and paying at least 90% of its taxable income in the form of dividends every year.
There are two major classes of REITs: Equity REITs and Mortgage REITs.
Equity REITs are securities managed by a group of financial advisors that are responsible for acquiring, managing, building, renovating and selling real estate. Equity real estate investment trusts’ revenues are mainly generated from rental incomes from their real estate holdings. Equity REITs typically invest in office and industrial, retail, residential, and hotel and resort properties. For example, assume company ABC qualifies as a REIT. It purchases an office building and rents out office space with the funds generated from investors. Company ABC owns and manages this real estate property and collects rent every month from its tenants. Therefore, company ABC is considered an equity REIT.
1. Dividends: Equity REITs are synonymous with high dividend payouts. This means that a very large share of REIT investment returns are derived from dividends. This is why most financial advisers prefer equity REITs for income seeking investors, as well as for investors seeking both income plus capital appreciation.
2. Portfolio Diversification: Due to relatively lower correlation with other assets in a portfolio, Equity REITs provide important diversification benefits. Equity REITs also have had less of a tendency to move in tandem with the stock market and its fluctuations.
3. Inflation Hedging: Listed equity REITs have provided, in part, a natural hedge against inflation in ways that match up well with investors’ needs. Commercial real estate rents and values have tended to increase when prices do, which has supported equity REIT dividend growth, providing retirement investors with reliable income even during inflationary period.
4. Liquidity & Transparency: For many years, investors considered real estate an illiquid asset. However, the liquidity of REITs listed on major stock exchanges makes real estate investing as simple and straight-forward as any other stock. REITs also provide market transparency for investors, with real-time pricing and valuations. As with other stocks, investors can get in and out of their investments to optimize their exposure to real estate. Listed REITs in the U.S. are also registered and regulated by the SEC, ensuring adherence to SEC standards of corporate governance, financial reporting and information disclosure.
Like other stocks, equity REIT share prices are influenced by market conditions and may rise or fall. Additionally, while the real estate market cycle is different from the market cycles for other stocks, commercial real estate remains a cyclical business. Changes in the values of the property portfolios owned by equity REITs affect the valuations of their shares.
Mortgage REITs generally lend money to real estate buyers, acquire existing mortgages or mortgage-backed securities (MBS). While equity REITs typically generate their incomes from renting out real estate, mortgage REITs mainly generate their revenues from the interest that is earned on their mortgage loans. For example, assume company DEF qualifies as a REIT and loans out money to a real estate developer. Unlike company ABC in the equity REIT example, company DEF generates income from the interest earned on the loan. Therefore, company DEF is a mortgage REIT (mREIT).
mREITs hold mortgages and MBS on their balance sheets and fund these investments with equity and debt capital. Their general objective is to earn a profit from their net interest margin, or the spread between interest income on their mortgage assets and their funding costs. mREITs typically use less borrowing and more equity capital to finance their acquisitions of mortgages and MBS than do other large mortgage investors.
mREITs provide funding for mortgage credit for both homeowners and businesses. By using private capital to buy residential mortgages and mortgage-backed securities (RMBS), mREITs help provide liquidity and credit to home mortgage markets. Likewise, mREIT purchases of commercial mortgages and commercial mortgage-backed securities (CMBS) provide another source of mortgage credit for business investments in commercial real estate.
1. Interest Rate Risk: One of the most important factors affecting mREITs is fluctuations in the short term and long-term interest rates. Changes in interest rates can affect the net interest margin, which is mREITs’ fundamental source of earnings, but also may affect the value of their mortgage assets which affects corporate net worth.
2. Credit Risk: Commercial mREITs may be exposed to credit risk through their private-label RMBS and CMBS. The degree of credit risk for a particular security depends on the credit performance of the underlying loans, the structure of the security (that is, which classes of security are paid first, and which are paid later), and by the degree of over-collateralization (in which the face amount of the mortgage loans held as collateral exceeds the face amount of the RMBS or CMBS issued).
3. Prepayment: Changes in interest rates or borrower home sales affect the probability that some borrowers will refinance or repay their mortgages. When such a refinancing or repayment occurs, the investor holding the mortgage or MBS must reinvest the proceeds into the prevailing interest rate environment, which may be lower or higher. mREITs seek to hedge prepayment risk using similar tools and techniques as those they use to hedge against interest rate risks.
4. Rollover: mREIT assets are mainly longer-term MBS and mortgages, while their liabilities may include a significant amount of short-term debt, especially among residential mREITs. This term mismatch requires that they roll over their short-term debt before the maturity of their assets. Their ability to do so depends on the liquidity and smooth functioning of the short-term debt markets, including the repo market.
Akshat Bhargava contributed to this report.
 Nareit, Guide to Equity REITs NAREIT, https://www.reit.com/what-reit/types-reits/guide-equity-reits (last visited Oct 5, 2018).
 Reit, Guide to Mortgage REITs NAREIT, https://www.reit.com/what-reit/types-reits/guide-mortgage-reits (last visited Oct 5, 2018).
 Steven Nickolas, What is the Difference Between an Equity REIT and a Mortgage REIT? INVESTOPEDIA(2015), https://www.investopedia.com/ask/answers/052815/what-difference-between-equity-reit-and-mortgage-reit.asp (last visited Oct 5, 2018).