REITs
Introduction
A pooled investment is an investment where many investors combine their money to pursue a shared objective. The products discussed in the investment companies chapter are pooled investments. The investments in this chapter fall outside the legal definition of an investment company, but they often work in similar ways.
Specifically, you’ll cover the following in this unit:
- Real estate investment trusts (REITs)
- Hedge funds
- Direct participation programs (DPPs)
- Business development companies (BDCs)
Alternative pooled investments can provide returns from non-traditional sources. REITs offer real estate exposure without the practical challenges of owning property directly. Hedge funds may provide access to specialized strategies managed by professional investment managers. DPPs let investors participate more directly in the gains and losses of specific ventures. BDCs provide access to investments in smaller businesses.
You’ll learn more about each investment throughout this unit. We’ll start with REITs.
Real estate investment trusts (REITs)
Real estate investment trusts (REITs) are similar to mutual funds in that they pool investor money, but they invest specifically in real estate (and they are not technically mutual funds). REITs are typically structured as trusts*, and a typical REIT portfolio holds commercial properties, commercial mortgages, or both. Most REIT shares are sold by the issuer in an initial public offering (IPO) and then trade in the secondary market. Some REITs, however, 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
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 generate significant income by renting space and collecting lease payments.
- Property 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
Mortgage REITs buy and offer mortgages on commercial properties. Rather than owning properties directly, mortgage REITs seek income from the mortgages they own or originate. When a REIT purchases or offers a mortgage, the property owners make monthly mortgage payments to the REIT. In that sense, mortgage REITs function similarly to a bank for many corporations.
Hybrid REITs
Hybrid REITs invest in a combination of real estate properties and mortgages. Investors may receive returns through capital appreciation, plus income from leases and mortgage payments.
Utilizing REITs as a hedge
REITs can be 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 like stocks.
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 offset losses elsewhere in a portfolio.
How REITs are traded and regulated
There are three general types of REITs available to investors:
- Public listed REITs
- Public non-listed REITs
- Private REITs (unregistered, non-listed)
Two types of REITs are non-listed (public non-listed REITs and private non-listed REITs). This means they are not 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. 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.
Pricing works differently for these REITs, too. A listed REIT’s share price updates continuously as it trades on an exchange, but a non-listed REIT’s value isn’t set by continuous market trading. Instead, the REIT (or an independent valuation firm) periodically calculates a net asset value (NAV), or estimated value, per share. There’s no single required schedule for these updates - the frequency depends on the REIT’s structure and valuation model. Some non-listed REITs recalculate NAV monthly or quarterly, while others (particularly lifecycle-style public non-listed REITs) may update their estimated per-share value on a different, less frequent schedule. The key point to remember is that valuation frequency varies by REIT rather than following one universal rule.
Private REITs are offered only to select investors and are therefore exempt from Securities and Exchange Commission (SEC) registration. Securities can be exempt from many regulations and government oversight (primarily SEC oversight) when they aren’t offered publicly. If you remember Regulation D (the private placement rule) from the SIE exam, this is a common way to sell securities 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.
Because private REITs aren’t publicly available, it can be difficult for investors to sell them. Investors generally can’t liquidate private REITs in public markets. Instead, sales typically occur through private transactions between willing participants (often sophisticated investors or institutions).
Subchapter M & REITs
Like mutual funds, REITs are subject to Subchapter M, also called the conduit rule. If a REIT distributes at least 90% of its net investment income to investors, the REIT can avoid paying taxes on that income (investors pay the taxes instead). To qualify, REITs must also meet asset and income tests: at least 75% of assets must be invested in real estate, and at least 75% of income must come from real estate investments.
REITs are often used by investors who want diversification and exposure to real estate. As discussed, real estate has typically 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 a practical alternative.
That said, 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 generally involve 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 the liquidity constraints.