Equity REIT vs. Mortgage REIT

There are two distinct types of real estate investment trust (REIT) that individual investors can consider if they want to invest in this sector:

• An equity REIT, the most common type, is an investment in a company that buys, builds, renovates, manages, and sells income-producing real estate. The company’s income is derived primarily from rents paid by its tenants.
• A mortgage REIT purchases or originates mortgages and mortgage-backed securities (MBS). The income from a mortgage REIT is derived from the interest payments made on the mortgages.

Key Takeaways

• Real estate investment trusts (REITs) may own and operate or finance income-producing properties.
• Shares in REITs are listed on the major stock exchanges and can be bought and sold through brokers.
• Equity REITs directly own and operate rental properties.
• Mortgage REITs originate or buy mortgages and mortgage-backed securities.

What Is a REIT?

Real estate investment trusts are a type of security that can be bought and sold, like stocks, on the major stock exchanges. Both are investments in real estate but their approaches are very different.

Equity REITs directly own and operate rental properties, making their money from rents paid by their tenants. Mortgage REITs buy or originate mortgages, making money from the interest payments.

REITs sell shares to investors to raise money to expand their businesses, whether the focus is on buying real estate or buying mortgages. Investors buy the shares to make money in this major business sector without the far greater commitment of time and money that is required of direct participants in real estate.

REIT Regulation

REITs are generally required to have at least 100 investors. Additional regulations prevent a small number of investors from owning and controlling a majority 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 property.

REITs are required by law to pay out at least 90% of the company’s annual taxable income (excluding capital gains) to their shareholders as dividends. This restriction insures investors get a fair share of the profits but limits a REIT’s ability to reinvest cash flow for growth purposes.

Equity REITs

Equity real estate investment trusts are the best-known type of REIT. Their revenues are mainly generated through rental payments on their real estate holdings. The companies acquire, manage, build, renovate, and sell income-producing real estate.

An equity REIT may invest broadly or may focus on a particular segment such as shopping centers, residential complexes, or healthcare facilities.

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

Mortgage REITs—also called mREITs—invest in mortgages, mortgage-backed securities (MBS), and related assets. While equity REITs generate revenue through rents, mortgage REITs earn income from the interest payments on mortgages.

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 the property and collects monthly rents from its tenants. Company ABC is thus considered an equity REIT.

Company XYZ also qualifies as a REIT. It lends money to a real estate developer. Unlike company ABC, company XYZ generates income from the interest earned on the loan. 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 risks. Here are a few that investors should be aware of:

• Equity REITs tend to be cyclical, making them sensitive to recessions and periods of economic decline.
• Too much supply—for example, more hotel rooms than a market can support—can lead to higher vacancies and lower rental income for equity REITs.
• Mortgage REITs are vulnerable to changes in interest rates. Lower interest rates lead more borrowers to refinance or repay their mortgages, forcing the REIT 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.

What Is Real Estate?

Real estate is land and any permanent improvements attached to that land, whether natural or man-made. It thus includes streams, trees, and minerals as well as buildings, fences, and bridges.

Real estate is a form of real property. Real property is permanently attached to land, unlike personal property such as vehicles, boats, jewelry, furniture, and farm equipment.

What Is a Mortgage-Backed Security (MBS)?

A mortgage-backed security (MBS) is a bundle of home loans bought from the banks that issued them and repackaged as an investment. Investors who purchase MBS receive periodic payments. These payments represent their share of the interest payments made on the mortgages.

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 and to make sure those assets are distributed according to the wishes of the trustor. A trust also can save time, reduce paperwork and, in some cases, avoid or reduce inheritance or estate taxes.

In investing, a trust can be a type of closed-end fund built as a public limited company.

The Bottom Line

REITs give investors a way to tap into the real estate market the substantial investment in time and money required to own, operate, and finance properties themselves.

Both equity and mortgage REITs are required to pay out 90% of their income to shareholders in the form of dividends.

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.

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