Should I Invest in Equity REITs or Mortgage REITs?

These are two very different kinds of investments.

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There are two main types of real estate investment trusts (REITs): Equity REITs and mortgage REITs. Equity REITs are what most investors think of when they hear the term "REIT." These companies invest in commercial properties like apartments and office buildings. Mortgage REITs invest in mortgages, mortgage-backed securities, and related assets.

There’s some overlap in the reasons to invest in them. For example, both types of REITs are required to pay out most of their income as dividends, and both types aren’t taxed at the corporate level.

But while both are classified as REITs, these are very different types of investments. Here’s a rundown of the reasons to invest in each one as well as some of the risks involved.

Reasons to invest in equity REITs

Equity REITs own, manage, develop, acquire, and sell commercial properties. Here are some of the key benefits for investors.

  • Equity REITs generally provide stable income. Their income comes from rent collected from properties, so it's easy to predict and tends to grow over time.
  • Equity REITs add diversification to an investment portfolio. While they’re technically stocks, real estate is a different asset class.
  • Equity REITs can produce fantastic total returns over time. They tend to pay above-average dividend yields. They also have lots of potential for capital appreciation as the values of their property portfolios grow. In fact, several long-established equity REITs have beaten the stock market for decades.

Risks of investing in equity REITs

No stock capable of market-beating returns is without risk and equity REITs are no exception. Here’s a quick rundown of some of the risks equity REIT investors should be aware of:

  • Interest rates are a big one. When risk-free interest rates rise, yields of other income-based investments tend to rise as well. Since yield and price have an inverse relationship, higher yields mean lower share prices. The 10-year Treasury is a good risk-free indicator for equity REITs.
  • Equity REITs can also be quite cyclical: They’re sensitive to recessions and other adverse economic conditions. This varies greatly depending on the type of property, but it’s a risk worth noting.
  • Oversupply concerns are also a risk factor with equity REITs, especially in strong economies. For example, if a particular market can support 1,000 hotel rooms and developers build 1,500, you can expect high vacancies and loss of pricing power.

Reasons to invest in mortgage REITs

Mortgage REITs are an entirely different type of investment than equity REITs. The obvious difference is the types of investments held. But the biggest difference is that mortgage REITs are built for income -- period.

Mortgage REITs borrow money at lower interest rates to buy mortgages that pay higher interest rates. The difference between the two interest rates, or the "spread," is the profit margin.

Mortgage REITs don’t buy mortgages or mortgage-backed securities because they think they’ll go up in value. They're designed to generate income for shareholders. This is why they tend to pay extremely high dividends -- 10% or more, in many cases.

The biggest reason to invest in mortgage REITs is to get income from your investments as possible.

Risks of investing in mortgage REITs

Like equity REITs, mortgage REITs can be sensitive to interest rates, but for different reasons and to a greater extent.

Mortgage REITs borrow money at short-term interest rates to buy mortgages. This can be an effective way to produce tons of income. Here's a simplified example:

  • a mortgage REIT with $2 billion in capital borrows $8 billion at 2% interest,
  • the REIT uses that money to buy $10 billion worth of mortgages paying 4% interest,
  • So the company earns $240 million in profit per year, a 12% return for investors.

The problem is that mortgage REITs need to renew their borrowing frequently -- after all, they use short-term financing. And when short-term interest rates rise, the mortgages they hold don’t pay any more.

Continuing the above example, if short-term interest rates spiked to 3%, the $240 million in annual profit would drop to $160 million. If rates spiked to 4%, the profit would plunge to $80 million.

To reiterate, this is a simplified example. In practice, mortgage REITs have ways to hedge against rising rates, but it’s still a big risk factor that can crush profitability.

The bottom line: Two very different investments

So who are equity REITs good for? Buy-and-hold investors of all levels of risk tolerance looking for a combination of income and growth.

Who should buy mortgage REITs? Risk-tolerant investors who want maximum income and aren’t too worried about capital appreciation.

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