The term “pooled investment” refers to investors combining their money together towards a common goal. The products covered in the investment companies unit are considered pooled investments. The investments discussed in this unit fall outside the definition of an investment company but work similarly.
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. The issuer sells most REIT units during their initial public offering (IPO); after, the units 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.
*While most REITs are composed of commercial properties or mortgages associated with those properties, REIT investments in single-family home and associated mortgages have dramatically increased recently. These investment vehicles are known as residential REITs.
Equity REITs invest directly into real estate properties. Usually focusing on commercial real estate, typical 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 return from lease payments.
Additionally, money can be made through property values rising. When this occurs, the REIT increases in value. These gains can stay unrealized (unsold), or the REIT can lock in profits 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 in real estate, mortgage REITs make income from the mortgages they own or offer (similar to a bank). 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 make interest from the mortgages they own and pass on their income to investors.
There are also hybrid REITs, which invest in a combination of real estate properties and mortgages. Investors obtain returns from 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.
Except for 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.
Some REITs are non-listed, meaning they are not listed on national exchanges (like the NYSE). 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.
Some REITs are offered only to private audiences and are therefore exempt from Securities and Exchange Commission (SEC) registration. You’ll learn more about this in the primary market chapter, but securities are exempt from many regulations and government oversight (primarily from the SEC) when they are not offered publicly.
When a security is unavailable to the public, it can be challenging for investors to liquidate (sell) their investment, leading to significant liquidity risk. Investors cannot simply go to the general markets to sell their investments (remember, it’s not available to the public). Because of this dynamic, investors in private REITs are typically wealthy individuals and institutions (and other investors that can withstand liquidity risk).
Similar to mutual funds, REITs are also subject to Subchapter M, also known as the conduit rule. If REITs pass through at least 90% of the net investment income to their investors, the fund can avoid paying taxes on that income (taxes are paid by the investor instead). Additionally, REITs must have 75% of their assets invested in real estate and 75% of their income come from real estate investments to qualify.
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