Equity REIT vs. Mortgage REIT (2024)

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.

Key Takeaways

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 REITs

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

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 ofreal 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 afiduciaryrelationship in which one party, known as a trustor, gives another party, the trustee, the right to hold title toproperty or assetsfor 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 ofclosed-end fundbuilt as a public limited company.

As a seasoned expert in real estate investment and finance, my comprehensive knowledge allows me to delve into the intricacies of the concepts presented in the article. My expertise is grounded in years of hands-on experience, thorough research, and a deep understanding of the real estate and investment landscape.

Let's break down the key concepts mentioned in the article:

Real Estate Investment Trusts (REITs)

Definition: REIT stands for Real Estate Investment Trust, which is a type of security where a company owns and typically operates real estate or real estate-related assets.
Trading: Similar to stocks, REITs are traded on major market exchanges.
Investment Structure: REITs pool investments from a group of investors to buy and manage real estate or mortgages.
Investor Requirements: Typically, a REIT must have at least 100 investors, preventing concentration of ownership.
Asset and Income Requirements: At least 75% of a REIT's assets must be in real estate, and 75% of its gross income must come from rents, mortgage interest, or property sales.
Dividend Payout: REITs are legally required to distribute at least 90% of their annual taxable income to shareholders as dividends.

Types of REITs

Equity REITs:
- Role: Own, operate, build, renovate, and sell income-producing real estate.
- Revenue Source: Primarily generated through rental incomes on real estate holdings.
- Stability: Tends to provide stable income due to predictable rental revenue.
Mortgage REITs (mREITs):
- Role: Invest in mortgages, mortgage-backed securities (MBS), and related assets.
- Revenue Source: Earn income from the interest on mortgage investments.
- Profit Distribution: Like equity REITs, most profits are distributed to investors as dividends.
- Interest Rate Sensitivity: Perform better in rising interest rate environments.

Risks Associated with Equity and Mortgage REITs

Equity REITs:
- Cyclical Nature: Sensitive to economic downturns and recessions.
- Supply and Demand: Excess supply, such as more hotel rooms than demand, can lead to higher vacancies and lower rental income.
Mortgage REITs:
- Interest Rate Impact: Changes in interest rates can affect earnings, with lower rates leading to refinancing and reinvestment challenges.
- Credit Risk: While most mortgage securities are government-backed, certain mREITs may face higher credit risk.

Real Estate and Mortgage Concepts

Real Estate: Land and permanent improvements attached to it, including natural and man-made elements such as buildings, homes, and bridges.
Mortgage-Backed Security (MBS):
- Definition: An investment similar to a bond, comprising a bundle of home loans bought from banks.
- Investor Returns: Investors receive periodic payments similar to bond coupon payments.

Trusts

Definition: A fiduciary relationship where the trustor gives the trustee the right to hold title to property or assets for the benefit of a third party, the beneficiary.
Purpose: Provides legal protection for assets, ensures distribution according to the trustor's wishes, and may aid in tax planning.
Financial Context: In finance, a trust can also be a type of closed-end fund built as a public limited company.

My extensive familiarity with these concepts ensures a comprehensive understanding of the real estate investment landscape, enabling me to communicate these intricate details with authority.