Real estate investment trusts (REITs) are like mutual funds that solely invest in real estate (although they are not technically mutual funds). Legally structured as trusts*, a typical REIT portfolio is comprised of commercial properties, commercial mortgages, or both. Most REIT units are sold by the issuer during their initial public offering (IPO) but then trade in the secondary market. However, some REITs are never publicly offered (discussed further below).
*A trust is a specific type of account created to hold and manage assets for a beneficiary. REITs hold and manage assets for their investors (the beneficiaries of the REIT). We’ll learn more about trusts later in the Achievable materials.
Equity REITs invest directly into real estate properties. Typically focusing on commercial real estate, common investments in equity REITs include strip malls, condominiums, and office buildings. There are two general ways equity REITs make money: leases and selling property. If a REIT owns dozens or hundreds of properties, it can rent out commercial space and make a considerable amount of money from lease payments.
Additionally, money can be made through property values rising. When this occurs, the REIT rises in value. These gains can stay unrealized (unsold), or the REIT can lock in gains by selling the property and obtaining realized capital appreciation (buy low, sell high) for their investors.
Mortgage REITs buy and offer mortgages on commercial properties. Instead of investing directly into real estate, mortgage REITs make income from the mortgages they own or offer. When a REIT purchases or offers a mortgage, the owners of the commercial properties make their monthly mortgage payments to the REIT. Essentially, mortgage REITs act like a bank for many corporations.
There are also hybrid REITs, which invest in a combination of real estate properties and mortgages. Investors obtain returns in the form of capital appreciation, plus income from leases and mortgages.
REITs provide an easy way to invest in real estate and diversify portfolios. Unlike typical real estate transactions that involve real estate brokers, property inspections, and negotiations, most REITs can be bought and sold in the secondary market just like stock.
With the exception of the Great Recession from 2007-2009, real estate typically acts as a hedge against market downturns. When the stock market values fall, real estate usually maintains its value and acts as a counterbalance.
There are three general types of REITs available to investors:
Two types of REITs are non-listed (public non-listed REITs and private non-listed REITs), meaning they are not listed on national exchanges (like the NYSE). Public non-listed REITs still trade in the secondary market but may be subject to more liquidity risk than a listed REIT (the most popular REITs are listed on exchanges). When a security does not trade on an exchange, it solely trades in the over the counter (OTC) markets. The OTC markets are less active than the exchanges, which can lead to liquidity risk.
Private REITs are offered only to private audiences, and are therefore exempt from Securities and Exchange Commission (SEC) registration. Securities are exempt from many regulations and government oversight (primarily from the SEC) when they are not offered publicly. We’ll learn about Regulation D, known as the private placement rule, later in this material. In a nutshell, this is a popular method of selling a security to a small group of millionaires, billionaires, and institutions without registration (which is costly and time-consuming). Private REITs are often obtained through private placements.
When a security is not available to the public, it can be very difficult for investors to sell their investment. Because of their lack of registration with the SEC (discussed in the next paragraph), investors cannot attempt to liquidate private REITs in public markets. Typically, they can only be sold in private transactions between two willing participants (usually sophisticated or institutions).
REITs are suitable for investors seeking to diversify their portfolio and gain access to the real estate market. As we discussed, real estate typically acts as a hedge against the stock market. For an investor seeking a real estate investment without the headaches and problems of making direct investments in real estate, REITs are a good option. Regardless, there are still risks related to the real estate market, which may cause significant losses (for example, the collapse of the real estate market in 2008).
Unlisted and private REITs are subject to more liquidity risk, so investors needing quick access to their funds should not invest in these REIT types. These investments should only be recommended to wealthy (sophisticated) retail investors or institutional investors that can withstand these risks.
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