Real estate investment trusts (REITs) are similar to mutual funds in the sense that they pool investor money, but they invest specifically in real estate (and 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 the initial public offering (IPO) and then trade in the secondary market. However, some REITs are never publicly offered. We’ll cover that in the next section.
*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. Common holdings include strip malls, condominiums, and office buildings.
Equity REITs generally earn returns in two ways:
Lease income: If a REIT owns dozens or hundreds of properties, it can rent space to tenants and collect lease payments.
Property sales (capital appreciation): If property values rise, the REIT’s value may rise as well. These gains can remain unrealized (the property isn’t sold), or the REIT can sell properties to realize capital appreciation (buy low, sell high) for investors.
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 commercial 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 mortgages.
REITs offer a straightforward way to invest in real estate and diversify a portfolio. Unlike buying property directly - which often involves 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 often holds 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 may still trade in the secondary market, but they can involve more liquidity risk than listed REITs.
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 can be exempt from many regulations and government oversight (primarily from the SEC) when they aren’t offered publicly. We’ll cover Regulation D, the private placement rule, later in this material. In practice, Regulation D is a common way to sell a security to a limited group of wealthy investors 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 it. Because private REITs aren’t registered with the SEC, 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 option. 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 recommended only for wealthy (sophisticated) retail investors or institutional investors that can withstand these risks.
Sign up for free to take 6 quiz questions on this topic