A hybrid REIT is a combination of two real estate investment trust (REIT) types:
- Equity REITs, which make equity investments in commercial real estate.
- Mortgage REITs, which invest in loans or mortgage-backed securities (MBS) backed by residential and commercial real estate.
By diversifying across both types of investments, hybrid REITs get the benefits of both REIT types with less risk.
What is it?
What is a hybrid REIT?
As mentioned, hybrid REITs invest in commercial real estate and mortgages, like mortgage-backed securities. REITs that only own properties are referred to as equity REITs, while those that only own mortgage loans are called mortgage REITs. Hybrid REITs are a combination of the two. In practice, most hybrid REITs are weighted more heavily toward one type of investment or the other, as we'll see later in the example.
Investments
Properties and mortgages as investments
Real estate-backed loans like mortgages are typically the safest real estate investments. They generate regular interest payments for the lender. Meanwhile, the loan value is usually significantly less than the property's value, giving the lender a cushion. If the borrower defaults, the lender can typically foreclose on the property and sell it to recoup their investment. However, while real estate mortgages have lower risk, they have lower rewards (the interest yield on the loan).
Equity investments are higher risk. If the value of the property declines, the equity holder can lose money, potentially their entire investment. However, they have the potential to yield higher returns. The investor owns equity in the real estate, which can generate passive rental income while the property can appreciate in value.
Given their lower returns, mortgage REITs use lots of leverage to generate high dividends for shareholders. While their business model is a bit complicated to explain in a paragraph or two, the general idea is simple.
The primary way mortgage REITs generate income is by borrowing money at low short-term rates and investing in longer-dated mortgages that pay higher interest rates. For instance, if a REIT can borrow money for short time periods at 1% interest and buy 15-year mortgages that pay 3% interest, the 2% difference, or "spread," is the profit. To generate double-digit yields, these companies use leverage ratios of 5-to-1 or more.
The main risk to mortgage REITs is interest rate fluctuations. Since these REITs borrow at short-term rates, an interest rate spike can erode profits quickly. In the example discussed in the last paragraph, if short-term rates spike from 1% to 2%, the company's profit margin gets cut in half.
On the other hand, equity REITs typically invest equity into a portfolio of commercial real estate. That entitles them to the rental income the property generates and its price appreciation potential. A high-quality property leased to a strong tenant can deliver steadily rising rental income and healthy price appreciation.
However, there are several risks to investing equity in real estate. The tenants might stop paying rent, the real estate market could experience an unexpected downturn that weighs on property values, or the investor might borrow too much money to help fund their investment. These issues could cause the equity investor to see their income decline or cease while their investment could go all the way to zero.
Hybrid REITs strive to capitalize on the benefits of both investment types to help reduce risk. They invest in real estate-backed loans to generate stable interest income. In addition, they invest equity in real estate to earn rental income and potentially realize capital gains from property price appreciation.
Related investing topics
An example
An example of a hybrid REIT
One good example of a hybrid REIT is VICI Properties (VICI -0.35%). VICI Properties' primary business is owning properties -- its portfolio consisted of almost 100 gaming and other experiential properties in late 2024. In addition, the company has a growing portfolio of financing partnerships. It will provide financing to companies building gaming, hospitality, and entertainment destinations to fund construction and expansion projects. Those loans provide additional income to the REIT from the interest payments. They also often offer the opportunity for VICI Properties to acquire the underlying real estate in the future.
