Investing in real estate can be an effective way to generate passive income. For investors interested in real estate who want the benefits of investment without the responsibilities of managing properties, real estate investment trusts (REITs) are a potential option. These alternative investment vehicles enable investments in income-producing properties that the REIT manages, owns, and operates, freeing investors of those duties. By purchasing and owning shares in a REIT, investors may collect dividends from the money that the real estate properties generate within the portfolio.
Investors considering REIT investments can benefit from understanding how to invest in a REIT and what types are available. Learn about how to develop a REIT investment strategy that aligns with your investment goals.
What Is the Difference Between Publicly Traded REITs, Public Non-Listed REITs (PNLRs), and Private REITs?
REITs generally come in three types, each with its own characteristics and potential benefits. These REIT classifications are publicly traded REITs, public non-listed REITs (PNLRs), and private REITs.
According to IRS requirements, all REITs must distribute at least 90% of their net income to investors as dividends. REITs also use professional REIT managers whose objective is to increase income for investors. The REIT manager can adjust the REIT’s portfolio as they wish, so investors may not have much say in how their funds are invested.
Despite these similarities, each REIT class is regulated differently and has different requirements for investment:
1. Publicly Traded REITs
Investors can invest in publicly traded REITs through national securities exchanges, including the New York Stock Exchange, using a similar process as investing in shares of company stock. The Securities and Exchange Commission (SEC) regulates publicly traded REITs and requires them to adhere to regulations, including registration and filing compliance reports promptly.
Publicly traded REITs don’t require investors to be accredited, which means investors in these REITs don’t have to meet requirements like having an earned income exceeding $200,000 over the past two years or a net worth of over $1 million.
Publicly traded REITs may carry a few cons. Since publicly traded REITs are traded on stock exchanges, stock market volatility can influence their value. These REITs are also sensitive to interest rate fluctuations and the risks associated with the types of properties they hold.
Investors can buy shares of PNLRs, also known as non-traded REITs, through a broker or financial advisor rather than on national securities exchanges. PNLRs are available to nonaccredited investors. The SEC regulates PNLRs as it does publicly traded REITs.
Because PNLRs are not listed on national securities exchanges, their valuation may be less influenced by changes in the stock market. Instead, the value of the trust’s properties determines the price of a share in a PNLR.
However, investors typically cannot sell shares in a PNLR until the REIT lists its shares on an exchange. Even early redemption programs, which are often offered in non-traded REITs, come with limitations and may significantly restrict the liquidity of shares. As with publicly traded REITs, PNLRs are also subject to interest rate risk and risks associated with their property types.
3. Private REITs
Shares in private REITs are primarily sold to accredited investors through a broker, making it critical for investors to perform their due diligence on these investments. These REITs are not regulated by the SEC or traded on national securities exchanges, though they must meet the requirements of Regulation D of the Securities Act. Because these REITs aren’t traded on an exchange, they are less liquid than publicly traded REITs.
Private REITs may reduce overall portfolio volatility compared to public REITs since they are valued monthly or quarterly rather than daily on the securities exchange. Private REITs also generally pay higher dividend yields than public REITs.
A potential disadvantage of investing in private REITs is that investors may have a more difficult time determining exactly what their share is worth. Because private REITs are not regulated by the SEC, they don’t have to publicly disclose the value of their assets. However, these REITs can give regular updates on their Net Asset Value (NAV) based on appraisals. Private REITs may also borrow to pay distributions, which can increase the risk of investing in this type of REIT.
Types of REITs and How to Invest in Them
Investors have several options when selecting a REIT for their investment portfolio. Understanding the types of REITs available and their characteristics before investing is vital. Besides the three classifications of REITs, there are three main types of REITs in which investors can invest. Each type has its own purpose and may provide unique benefits. The different types of REITs are:
- Mortgage REITs
- Equity REITs
- Hybrid REITs
1. Mortgage REIT (mREIT)
A mortgage REIT, or mREIT, provides financing for real estate investments through one of two methods. Some mREITs offer financing directly through mortgages or other real estate loans. Others purchase or originate mortgage-backed securities (MBSs), which are asset-backed securities that pool bundles of home loans. Banks package loans as MBSs and sell them to mREITs or other investors. mREITs can use various funding sources to originate or purchase their mortgages or mortgage securities, including repurchase agreements and structured financing.
The mREIT doesn’t own physical real estate assets in either of these arrangements. Instead, it earns income from the interest its investments generate. mREITs earn income from homeowners’ mortgages and through loans so others can acquire, develop, and own income-producing commercial property.
After the mREIT pays for its funding costs and operating expenses, investors earn a proportionate share of the income in the mREIT.
mREITs can also invest in several types of real estate assets, including:
- Residential mortgages
- Commercial mortgages
- Residential mortgage-backed securities (RMBSs)
- Commercial mortgage-backed securities (CMBSs)
Most mREITs invest in residential or commercial mortgage offerings, though some also invest in RMBSs and CMBSs. By charging interest on the money they lend to borrowers financing their purchase of residential or commercial real estate properties, mREITs produce income while supporting the real estate sector. When mREITs originate mortgages, they might sell them to banks, other investors, or the government.
How to Invest in a Mortgage REIT
Investors considering mREITs should be aware of several factors that could affect their investment:
- Interest rate risk: Interest rate fluctuations can affect an mREIT’s net interest margin, which is the spread between the income generated from interest on their mortgage assets and their funding costs. Rising interest rates can particularly devalue the holdings in mREITs if their holdings include fixed-rate mortgages. Some mREITs use hedging techniques like interest rate swaps, caps, or floors to manage their interest rate and credit risks. These strategies can reduce the risk of investing in mREITs.
- Volatility: mREITs may be more volatile than other types of REITs. Changes in the mREIT’s net interest margin can contribute to this volatility. However, mREITs can have a high yield potential when the spread is wide.
mREITs can be publicly traded, public non-listed, or private REITs. Investors can also purchase shares of mREITs through a mutual fund or exchange-traded fund (ETF). Here’s how investors might invest in mREITs through each of these avenues:
- Stock exchange: Real estate investors can find publicly traded mREITs on major U.S. stock exchanges. These REITs are registered with the SEC and must publish regular financial statements so investors can analyze their yields and overall performance.
- Broker or financial advisor: Investors interested in public non-listed mREITs can buy them through a broker or financial advisor who participates in the REIT’s offering. Some brokers sell private mREITs to accredited investors.
- Mutual fund or ETF: Investors can also purchase shares of an mREIT through an mREIT mutual fund or ETF.
2. Equity REIT (eREIT)
An equity REIT, or eREIT, invests in real estate properties and generates income through rental payments from tenants. eREITs can invest in residential or commercial real estate. eREITs perform various functions as part of their operations, including repairing, developing, and managing their real estate properties. eREITs typically employ property managers who manage these physical assets for the investors. This arrangement makes eREITs a passive investment that can generate significant returns through rental income.
eREITs use income from rental payments to pay their properties’ operating expenses and their property managers. Investors then receive dividends from the eREIT’s net income. As with mREITs, eREITs must pay investors at least 90% of their net income. eREITs may also earn income from the sale of properties. If the eREIT can sell a property at a gain, it distributes the income to investors through capital gain distributions. The IRS taxes capital gains at 0%, 15%, or 20%, depending on the investor’s income bracket, which are favorable rates compared to ordinary income rates.
eREITs may be what many potential real estate investors think of when they think of a REIT. These REITs help fund projects that create jobs, enable essential services, build infrastructure, and help boost the economy. Because these REITs depend on rental payments to make income, they may be well-suited for a long-term investment strategy, such as one focused on investing for retirement.
eREITs invest in several types of real estate properties, including:
- Shopping malls
- Office buildings
- Hotels and resorts
- Senior living facilities
- Self-storage facilities
- Apartment complexes
- Manufacturing facilities
How to Invest in an Equity REIT
Real estate investors interested in eREITs might find it helpful to consider some factors unique to this type of REIT that could affect their investment strategy:
- Ongoing operating costs: The costs associated with leasing and managing residential and commercial properties could reduce the eREIT’s income.
- Opportunity for real estate appreciation: These properties may also have the opportunity for long-term growth due to real estate appreciation. Although market fluctuations affect property value to some degree, investors may be able to realize a steady appreciation of an eREIT’s properties over time. However, eREITs must sell a property to realize appreciation. Since the manager of the eREIT oversees that process, investors don’t have much input for realizing real estate appreciation on the properties.
- Potential for substantial income: Rental income from eREITs can be significant, depending on the market and investment strategy used.
- Potentially less volatile than mREITs: Because eREITs deal with physical real estate rather than mortgages and may be less affected by market and economic conditions, eREITs tend to be more popular than mREITs. eREITs can also provide portfolio diversification for investors because of their relatively low correlation with other assets like stocks and bonds.
eREITs can be publicly traded REITs, PNLRs, or private REITs. Some eREITs are specialized and focus solely on sector-specific assets, like self-storage facility eREITs or healthcare eREITs, while others are diversified. Some eREITs focus on specific investment strategies. For example, one method may be to acquire real estate properties that need development or renovations before they can be rented to tenants. Another approach might limit the properties an eREIT purchases to those already fully occupied and income-producing.
Here’s how investors might invest in an eREIT, depending on the type of eREIT they choose:
- Stock exchange: Investors can buy shares in a publicly traded eREIT through a national securities exchange as they would when purchasing shares of a publicly traded company’s stock. Investors can analyze the performance of these eREITs through the financial reports they publish with the SEC.
- Broker or financial advisor: Investors must go through a broker or financial advisor if they want to buy public non-listed or private eREITs.
- Mutual fund or ETF: Investors can also purchase eREIT shares through a mutual fund or ETF dedicated to eREITs listed on the stock exchange.
3. Hybrid REIT
Hybrid REITs are a combination of eREITs and mREITs. Hybrid REITs use the investment strategy of investing in mortgages and real estate properties. Hybrid REITs often invest more heavily in one type of investment than the other rather than being evenly split, but they still purchase both types. These types of REITs have more flexibility to change their portfolio allocation as economic conditions, interest rates, and property values change.
Hybrid REITs can help investors benefit from investing in eREITs or mREITs while mitigating the overall investment risk. For example, the primary risks associated with eREITs are rising interest rates and declining property values. Falling interest rates can also negatively impact the income mREITs earn. Investing in hybrid REITs where the REIT manager responds to these changing conditions by actively managing the portfolio’s diversification may help investors avoid some of the risks of each type of investment.
A hybrid REIT must pay operating expenses for its rental properties and funding costs for its investments in mortgages and MBSs. As with mREITs and eREITs, hybrid REITs must also distribute at least 90% of their net income to investors through dividends.
These REITs can invest in a combination of the following assets, depending on the REIT manager’s strategy:
- Residential or commercial mortgages
- Residential or commercial MBSs
- Manufacturing buildings
- Self-storage facilities
- Senior living facilities
- Apartment buildings
- Healthcare facilities
- Office buildings
- Shopping malls
How to Invest in a Hybrid REIT
Investors may choose to invest in hybrid REITs if they’re unsure which real estate assets they wish to invest in or if they want the REIT manager to actively manage the REIT’s portfolio as market conditions change. Some investors may also find hybrid REITs appealing because they can invest in real estate properties and mortgages. Ultimately, deciding whether to invest in a hybrid REIT depends on the individual investor’s investment goals and strategy.
An essential consideration for investors to keep in mind when deciding whether to invest in a hybrid REIT is the opportunity for sector-specific investing. Hybrid REITs can invest in specific real estate market sectors, like residential or commercial real estate assets. For example, a hybrid REIT might choose to invest in residential mortgages, residential MBSs, and residential real properties. Investors can decide what kind of hybrid REIT suits their interests.
Investing in a hybrid REIT is similar to investing in eREITs and mREITs:
- Stock exchange: Potential investors can find shares of publicly traded hybrid REITs on a national securities exchange.
- Broker or financial advisor: Public non-listed hybrid REITs are sold through brokers or financial advisors. Accredited investors can also access shares of hybrid REITs through this avenue.
Learn More With 1031 Crowdfunding
Equity, mortgage, and hybrid REITs bring their own benefits and risks. By understanding the types of REITs available, you can create a REIT investment strategy that aligns with your investment goals.
At 1031 Crowdfunding, we are an industry-leading real estate investment platform for alternative investment vehicles focused on tax deferral. We facilitate our clients’ real estate investment strategies by offering state-of-the-art resources and inspired solutions. With a combined 108 years of experience in the real estate investment sector, our team has the expertise needed to navigate these real estate offerings.
This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.