The term pooled investment refers to investors combining their money toward 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 they work in a similar way.
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 legally structured as trusts*, and a typical REIT portfolio holds commercial** properties, commercial mortgages, or both.
Most REIT units are sold during the issuer’s initial public offering (IPO). After the IPO, 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 in real estate properties. They usually focus on commercial real estate. Typical equity REIT holdings include 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 investing directly in real estate, mortgage REITs earn income from the mortgages they own or originate (similar to a bank).
When a REIT purchases or offers a mortgage, the commercial property owners make their monthly mortgage payments to the REIT. In other words, mortgage REITs earn interest from the mortgages they hold and pass that income on to investors.
Hybrid REITs invest in a combination of real estate properties and mortgages. Investors can receive returns from capital appreciation, plus income from leases and mortgages.
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 like stock.
Except for the Great Recession from 2007-2009, real estate typically acts as a hedge against market downturns. When stock market values fall, real estate often maintains its value and can help counterbalance losses.
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 they may have more liquidity risk than listed REITs (many of the most widely traded REITs are exchange-listed).
When a security does not 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.
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 the key idea is that securities can be 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 difficult for investors to liquidate (sell) the investment, creating significant liquidity risk. Investors can’t simply sell in the general markets because the security isn’t publicly available. For this reason, investors in private REITs are typically wealthy individuals and institutions (and other investors that can withstand liquidity risk).
Like mutual funds, REITs are subject to Subchapter M, also called the conduit rule. If a REIT passes through at least 90% of its net investment income to investors, the REIT can avoid paying taxes on that income (taxes are paid by the investor instead).
To qualify, REITs must also meet these requirements:
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