REIT stands for real estate investment trust. It's a type of company that lets investors pool their money to invest in a collection of properties or other real estate assets.

REITs have a special tax status, which requires them to pay out at least 90% of their income as dividends. If they do so, they aren't taxed at the corporate level like most other types of businesses. To qualify as a REIT, the following conditions must be met:

  • There must be at least 100 shareholders.
  • No five shareholders can own more than 50% of the shares.
  • At least 75% of assets must be invested in real estate, cash, or Treasuries.
  • 75% of gross income must be derived from real estate.

Two types of REITs
The majority of REITs are equity REITs, which own and manage properties. Most equity REITs are specialized -- meaning that there are REITs that invest in (just to name a few):

  • Apartment buildings.
  • Single-family homes.
  • Shopping malls.
  • Freestanding retail.
  • Healthcare properties.
  • Office buildings.
  • Industrial buildings.
  • Self-storage facilities.
  • Data centers.

There is also another class of REITs that invest in mortgage-backed securities, known as mortgage REITs. These companies may invest in agency mortgages (those guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae), non-agency mortgages, or commercial mortgages.

How equity REITs make money
The business model of equity REITs is quite simple -- buy properties and lease those properties to tenants. This creates a stream of income, most of which is passed through to shareholders as dividends.

In addition, as property values tend to appreciate over time, the value of shareholders' investments can grow. And as property values increase, commercial properties' ability to generate income rises. So the idea behind an equity REIT is to create a growing dividend stream and to increase shareholder value through rental income and property appreciation.

How mortgage REITs make money
Mortgage REITs borrow money at low short-term interest rates and buy mortgages that pay higher long-term interest rates. The spread between the two rates is the REIT's profit.

To boost returns, mortgage REITs tend to use high leverage -- often 5-to-1 or more. For example, let's say that a mortgage REIT raises $10 million from investors and borrows an additional $50 million at 2% interest -- or $1 million in annual interest expense. It then uses this $60 million to purchase mortgages paying 4% interest, which translates to $2.4 million in interest income. The difference between the interest income and interest expense -- $1.4 million -- is the profit, and represents a 14% annual return on invested capital.

Of course, this is a simplified example, but this is the basic idea of a mortgage REIT.

Mortgage REITs can be incredibly volatile, while equity REITs can be stable long-term investments
Investors should be aware that equity REITs and mortgage REITs are completely different investments, not only in terms of their business models, but in terms of investment risk as well.

Because of their high leverage, mortgage REITs are rather risky investments, as they are extremely susceptible to interest rate fluctuations. Let's say that a mortgage REIT can buy mortgages that pay 4% for 30 years, and can borrow money for just 2% interest, creating a healthy 2% spread. Well, if the short-term cost of borrowing spikes to 3%, the REIT's mortgage investments will still pay 4% and the spread gets cut in half. If short-term rates spike to 4%, the profit margin disappears completely. Because of this, mortgage REITs can be volatile investments and their dividends can be unpredictable.

On the other hand, many equity REITs have proven throughout the years to be stable income investments, to the point where many investors think of them more like bonds than stocks. Many equity REITs have averaged total returns well into the double digits for several decades now, and have produced consistent dividend growth.

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