What Are the Two Types of Real Estate Investment Trusts?
Explore the fundamental differences in how Real Estate Investment Trusts generate returns and what assets they hold.
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate across a range of property sectors. These entities allow individuals to invest in large-scale real estate portfolios without the need to directly purchase or manage properties. REITs function similarly to mutual funds, pooling capital from many investors to acquire, manage, and develop diverse types of properties. This structure provides a way for investors to participate in the real estate market, gaining access to dividend income and potential capital appreciation. To maintain their special tax status, REITs are required by law to distribute at least 90% of their taxable income to shareholders annually in the form of dividends. This distribution requirement helps REITs avoid corporate income tax, as the income is taxed at the shareholder level.
Equity REITs
Equity REITs represent the most common type of Real Estate Investment Trust, directly owning and operating income-producing real estate. These companies generate their primary revenue through the collection of rent from tenants who lease space in their properties. Their business model involves acquiring, developing, managing, and sometimes selling physical real estate assets. The value and income of Equity REITs are directly tied to the performance of these underlying physical properties and the rental markets they operate within.
Equity REITs invest in a wide array of property types across various sectors. Common examples include apartment complexes, shopping malls, office buildings, and industrial warehouses. They also specialize in niche areas such as data centers, self-storage facilities, hotels, and healthcare facilities. This income stream is generally considered stable due to long-term leases and predictable rental rates.
Mortgage REITs
Mortgage REITs, often referred to as mREITs, operate differently by providing financing for income-producing real estate rather than owning physical properties. Their primary source of revenue is the interest earned on mortgage loans and mortgage-backed securities (MBS). This allows them to participate in the real estate market through financial instruments.
Mortgage REITs invest in various types of debt instruments, including residential mortgages, commercial mortgages, and mortgage-backed securities. These MBS can be agency-backed, meaning they are guaranteed by government-sponsored enterprises, or non-agency backed. The core of their business model involves borrowing money at short-term interest rates and lending it out at higher long-term rates, profiting from the spread between these rates. This leverage can amplify their earnings, but it also increases their sensitivity to fluctuations in interest rates.
Distinguishing Between Equity and Mortgage REITs
The fundamental distinction between Equity REITs and Mortgage REITs lies in their primary business models and the assets they hold. Equity REITs own and manage physical properties, earning rent. Mortgage REITs finance real estate by investing in mortgages and mortgage-backed securities, earning interest.
Their underlying assets also differ significantly. Equity REITs hold tangible real estate assets like apartment buildings or office spaces. Mortgage REITs invest in debt instruments and securities, including mortgage loans. This means Equity REITs are exposed to risks associated with property values, occupancy rates, and rental market conditions. Conversely, Mortgage REITs are highly susceptible to changes in interest rates, as these fluctuations directly impact their borrowing costs and the interest income they earn.
The source of income further highlights their differences: Equity REITs rely on rental income, while Mortgage REITs generate income from the interest spread on their loan portfolios. This leads to different market drivers influencing their performance. Equity REITs are more sensitive to economic factors affecting property values and rental demand. Mortgage REITs, on the other hand, are more directly impacted by interest rate movements, as their profitability depends on maintaining a favorable spread between their borrowing and lending rates.