The two main types of REITs - Equity & Mortgage REITs
Before we go any further, let’s take a minute to discuss the two different classifications of REITs. As we’ll see later, there are REITs that specialize in a wide variety of asset types, but all REITs can be dropped into one of two buckets.
First, equity REITs are the type of real estate investment trusts that own properties as their primary business. For example, a shopping mall REIT or a senior housing REIT would be considered an equity REIT. Going forward, you can assume the term REIT refers to equity REITs unless specified otherwise.
Second, mortgage REITs invest in mortgages, mortgage-backed securities, and other mortgage-related assets. Generally speaking, these companies borrow large amounts of money at lower, short-term interest rates, and use this money to purchase 15- or 30-year mortgages that pay higher rates. The difference between the borrowing costs and the interest income paid by the mortgages is the profit margin. These are very different investments than equity REITs -- in fact, they aren’t even classified as being in the real estate sector. Mortgage REITs are considered to be financial stocks, just like banks and insurance companies.
There are a few REITs that own both property and mortgage assets, and these are known as hybrid REITs. However, the overwhelming majority of REITs invest in either one type of real estate asset or the other.
Types of REITs to invest in
There are REITs that allow you to invest in just about any type of commercial property you can imagine. Here’s a rundown of the different specializations of REITs you could invest in:
- Mortgage REITs -- As discussed above, mortgage REITs invest in mortgages, mortgage-backed securities, as well as other mortgage-related assets such as mortgage servicing rights (MSRs).
- Residential REITs -- Residential REITs generally specialize in apartment properties, but there are some that invest in single-family rental properties. Some choose to specialize even further -- for example, there are residential REITs that exclusively invest in urban apartment buildings, student housing communities, and more.
- Office REITs -- Some office REITs invest in a wide variety of office properties, while others choose to specialize. There are office REITs that only invest in top-tier urban high-rise offices, for example, while others specialize geographically, concentrating on a specific market.
- Industrial REITs -- Some industrial REITs also refer to themselves as "logistics" REITs. They own properties such as distribution centers, factories, and warehouses. For example, many of the massive distribution centers used by e-commerce giants like Amazon are owned by industrial REITs.
- Healthcare REITs -- There is a variety of subspecialties that healthcare REITs can invest in. Healthcare real estate can be broken down into categories such as hospitals, medical offices, senior housing, skilled nursing, life science, wellness centers, and more. Some invest in just one of these, while others invest in several different types.
- Self-storage REITs -- This category is pretty self-explanatory. Self-storage REITs invest in properties that rent storage units to individuals and corporations.
- Retail REITs -- There are three main subcategories of retail REITs -- malls, shopping centers, and net lease (also known as freestanding). Most retail REITs choose one of these three types, but there are a few that have a broad retail property portfolio.
- Infrastructure REITs -- These companies invest in properties like communications towers, fiber optic networks, pipelines, and other infrastructure assets that need real estate (land or buildings) to operate. For example, in order to build a communications tower, you need to own or lease the land it’s going to be installed on. In fact, the largest REIT in the world is an infrastructure REIT with communications towers located all over the world.
- Timberland REITs -- Timberland REITs own forest land and make their money selling the wood their lands produce, as well as its related products.
- Hospitality REITs -- Most hospitality REITs primarily own hotels, but some get revenue from additional hospitality-related sources as well. For example, a hospitality REIT might own resort hotels, but may also earn substantial revenue from the restaurants and retail outlets in its properties, in addition to the revenue generated by its hotel rooms.
- Data-center REITs -- Data centers are facilities designed to provide secure and reliable space for companies to house servers and other computing equipment.
- Diversified REITs -- Simply put, a diversified REIT is any real estate investment trust that owns a combination of two or more of these types of properties. For example, a diversified REIT might own hotels and shopping centers.
- Specialty REITs -- Obviously, there are more types of commercial real estate than the 12 discussed here, so any of those other types would belong in this category. Just to name a few examples, a specialty REIT might invest in education properties, entertainment properties, farmland, or prisons.
Two very important metrics for real estate investors to know
To be perfectly clear, there are certainly more than two metrics that REIT investors should use, and you can read our more thorough list of important REIT metrics if you plan to analyze and evaluate individual REITs.
However, the two most important metrics to know are funds from operations (FFO) and company-specific varieties of that same metric.
Funds from operations, or FFO, expresses a company’s profits in a way that makes more sense for REITs than traditional metrics like “net income" or "earnings per share." Without getting too deep into a discussion of how depreciation works, let’s just say that when you invest in real estate, you can write off (deduct) a certain portion of the purchase price each year. Although this decreases taxable income, it also distorts a REIT’s profits -- after all, depreciation doesn’t actually cost the REIT anything. FFO adds back in this depreciation expense, makes a few other adjustments, and creates a real-estate-friendly expression of a company’s profits.
To take it a step further, most REITs report one or more company-specific FFO metrics. These may be called normalized FFO, core FFO, or adjusted FFO. The point of these is to adjust for one-time items or market conditions that distorted earnings for that particular REIT. These metrics are typically very close to FFO. However, the key thing to remember is that despite offering the most accurate picture of a particular REIT’s profits, they don’t necessarily make for good apples-to-apples comparisons between REITs. Unlike FFO, they just aren’t standardized metrics.
Publicly Traded REITs and nontraded REITs
The most popular and largest REITs are generally publicly traded, but it’s important to mention that a REIT doesn’t have to be a publicly-traded company. There are actually three classifications of REITs when it comes to how they accept investments:
- Publicly traded REITs can be readily bought and sold on major stock exchanges like the NYSE and Nasdaq.
- Public nonlisted REITs are available to all investors, but don’t trade on major exchanges.
- Private REITs aren’t listed on major stock exchanges, and are generally restricted to accredited investors, which typically means high-income or high-net-worth individuals, or institutional investors.
There are some advantages and disadvantages to each type. One major consideration is that the latter two types generally aren’t liquid investments, meaning that they can be very difficult to sell and cash out of. Private REITs also don’t have to follow most SEC regulations that apply to the other two types, so there’s a lack of transparency.
Tax implications of investing in REITs
Although the lack of corporate taxation is certainly a benefit for REITs and their investors, the caveat is that the tax structure of REITs can be quite complex.
First off, most REIT dividends don’t meet the IRS definition of "qualified dividends," which would entitle them to lower tax rates. For example, someone in the 22% tax bracket typically pays 15% on qualified dividends, but REIT dividends generally don’t qualify for this favorable treatment.
However, because REITs are pass-through businesses, REIT dividends that aren’t considered qualified dividends typically qualify for the 20% qualified business income (QBI) deduction. In other words, if you receive $1,000 in ordinary dividends from an investment in a REIT , as little as $800 of that amount could be taxable.
Plus, REIT dividends often have several different components. The majority of each distribution you receive from a REIT is typically considered to be ordinary income, but some portion might meet the qualified dividend definition. And, some portion of REIT distributions can also be considered a return of capital, which isn’t taxable at all, but reduces your cost basis in the REIT, and can have future tax implications.
Confused yet? The good news is that you don’t have to keep track of any of this. When you receive your year-end tax forms from your brokerage, the dividend classification will be broken down for you automatically.