Real estate investment trusts (REITs) are similar to mutual funds in the sense that they pool investor money to buy a portfolio of assets. The key difference is that REITs invest specifically in real estate-related assets (even though they aren’t technically mutual funds). Legally structured as trusts*, a typical REIT portfolio holds commercial properties, commercial mortgages, or both. Most REIT units are sold by the issuer during an initial public offering (IPO) and 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 in real estate properties. They typically focus on commercial real estate, with common holdings such as strip malls, condominiums, and office buildings.
Equity REITs generally earn returns in two ways:
Mortgage REITs buy and offer mortgages on commercial properties. Instead of owning real estate directly, mortgage REITs earn income from the mortgages they own or originate. When a REIT purchases or offers a mortgage, the property owners make their monthly mortgage payments to the REIT. In this way, mortgage REITs function much like a bank for many corporations.
There are also hybrid REITs, which invest in a combination of real estate properties and mortgages. Investors may receive returns through capital appreciation, plus income from leases and mortgage payments.
REITs offer a straightforward way to invest in real estate and diversify a portfolio. Unlike direct real estate transactions - which often involve brokers, inspections, and negotiations - most REITs can be bought and sold in the secondary market much like stock.
With the exception of the Great Recession from 2007-2009, real estate has typically acted as a hedge against market downturns. When stock market values fall, real estate has often held its value better and can help counterbalance losses.
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 aren’t listed on national exchanges (like the NYSE). Public non-listed REITs still trade in the secondary market, but they may involve more liquidity risk than listed REITs (many of the most widely traded REITs are exchange-listed).
When a security doesn’t trade on an exchange, it trades in the over the counter (OTC) markets. OTC markets are generally less active than exchanges, which can increase 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 aren’t offered publicly. Later, we’ll cover Regulation D, the private placement rule. In practice, Regulation D is a common way to sell a security to a limited group of wealthy individuals and institutions without registration (which can be costly and time-consuming). Private REITs are often purchased through private placements.
When a security isn’t available to the public, it can be difficult for investors to sell their investment. Because private REITs aren’t registered with the SEC (as discussed above), investors generally can’t liquidate them in public markets. Instead, they’re typically sold through private transactions between willing participants (often sophisticated investors or institutions).
REITs can be suitable for investors who want to diversify and gain exposure to real estate. As discussed, real estate has often acted as a hedge against stock market declines. For investors who want real estate exposure without the operational challenges of owning property directly, REITs can be an alternative.
However, REITs still carry real estate market risk, which can lead to significant losses (for example, the collapse of the real estate market in 2008).
Unlisted and private REITs are generally subject to greater liquidity risk. Investors who may need quick access to their funds typically shouldn’t invest in these REIT types. These investments are generally appropriate only for wealthy (sophisticated) retail investors or institutional investors who can tolerate these risks.
Sign up for free to take 6 quiz questions on this topic