One of the best ways to invest in real estate without actually buying a property is through real estate investment trusts, or REITs, but which ones are right for you? There are two main types of REITs, with some investing in actual properties (equity REITs) and some buying mortgages and similar assets (mortgage REITs). Here is a quick guide to the differences between the two and the pros and cons of each.
Equity REITs for growth and income
This a very broad category, as there are equity REITs specializing in all different types of properties. You can find REITs that own apartment buildings, offices, malls and other retail stores, hotels, health care facilities, and storage units, just to name a few.
For example, Boston Properties (NYSE:BXP) is one of the largest, specializing in office buildings. The company currently owns about 160 properties, which consist of more than 44 million rentable square feet. The company's shareholders make their money in two ways: through quarterly distributions of income as well as through appreciation in the properties owned by the trust.
General Growth Properties (NYSE:GGP) owns, develops, and operates regional shopping malls throughout the U.S. The trust's main goal is to maximize the income from its 144 malls through active property management and operating cost reduction. Currently, General Growth Properties pays a 2.7% annual yield, which has increased significantly in recent years.
Two ways to win with equity REITs
The best reason to invest in REITs that own property is not just for the income stream, but for the growth potential as the underlying properties appreciate in value over time. As far as income is concerned, the dividends are generally in the 2-5% range, and here is a sampling of what can be expected from some of the larger equity REITs:
If you are bullish on real estate prices in the United States, an equity REIT may be the way to go, as many of the equity REITs have doubled in value (or more) since the end of the recession as real estate has rebounded.
Equity REITs tend to move up when the real estate market is "healthy", meaning that the level of defaults is relatively low. So, if you think the worst of the foreclosures are behind us, history tells us real estate values will go up and will subsequently take the equity REITs with them.
Mortgage REITs for income
Mortgage REITs buy mortgage securities and make their money from the difference in the interest rate they pay to borrow and the rate they collect on the mortgages they buy. Now, these spreads are usually not wide enough to produce the type of income their investors want, so mortgage REITs employ a great deal of leverage in order to produce high returns, which can reach double-digits.
The largest and oldest of the mortgage REITs, Annaly Capital Management (NYSE:NLY) is an excellent place to get started, because they are one of the more "conservative" of the mREITs. The company has greatly reduced its leverage ratio in anticipation of volatile interest rates during the Federal Reserve's tapering process, and as a result will have more available capital left to jump on lucrative opportunities as they come up.
As I wrote in another recent article, Annaly's leverage is currently around five to one, and if the company wanted to bring is up to seven-to-one (still pretty low for the sector), they could purchase about $24 billion in additional assets.
American Capital Agency (NASDAQ:AGNC) is also a very popular mortgage REIT, but management's strategy is a bit different from Annaly's. Both companies are trading for substantial discounts to book value, but American Capital's strategy has been to aggressively buy back its own shares. This seems like a no-brainer: if you can buy shares of your own business for less than the underlying assets are worth, why not?
Annaly, on the other hand, feels that with new money spreads on the rise, their shareholders will be better served by adding assets to the portfolio, increasing the company's leverage and profit potential.
American Capital Agency has a higher use of leverage (around seven-to-one), and rewards investors with a slightly higher yield of 11.8%, compared with about 10.8% for Annaly.
Which is best for you?
The best way for you to play real estate depends on several factors, such as your specific risk tolerance, income requirements, and the timeframe of your investments. However, since these are two very different types of investments, some combination of the two should be right for just about everyone.
As long as you choose REITs with a large, diverse asset pool and good management at the helm, both equity and mortgage REITs should produce excellent income and growth in your portfolio for years to come.
Matthew Frankel owns shares of Annaly Capital Management. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.