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What is the Difference Between Equity and Mortgage REITs?

by | May 11, 2022 | REITs

With trillions of dollars in assets, including hundreds of thousands of properties in the United States alone, real estate investment trusts (REITs) are a common feature of the investing landscape. 

Yet for many investors, REITs remain something of a mystery. For instance, they may be unaware of the different types of REITs, what they do, and how they operate. In this post, we will provide a brief overview of the two most common types of REITs—equity and mortgage—and the differences between them.

What Is a REIT?

First, however, it may be helpful to answer the question: What is a REIT? Real estate investment trusts usually own and operate income-producing or other assets, such as mortgages, that are related to real estate. Unlike other real estate companies, REITs are required to own and operate their portfolio properties after they are acquired or developed. And in return for meeting several IRS requirements, they may receive significant federal tax benefits. 

Qualifications for a Real Estate Investment Trust

To qualify as a REIT, the entity must be:

  • Investing 75% or more of its total assets in real estate.
  • Earning 75% or more of its gross income from rents collected on real property, property sales, or interest from mortgages on real property.
  • Distributing 90% or more of its annual taxable income to shareholders in the form of dividends.
  • Taxable as a corporation.
  • Managed by a board of directors or trustees.
  • Operating with 100 or more shareholders after its first year, with no more than half of its shares held by five or fewer individuals.
  • Offering shares that are fully transferable.

Established by Congress in 1960, REITs are designed to give individual investors the opportunity to invest in larger, income-producing properties that may be out of their reach otherwise. A significant number of REITs are publicly traded and registered with the Securities and Exchange Commission. Others—known as public non-listed REITs—are registered with the SEC, but do not trade on the national stock exchanges. Private REITs are exempted from registration with the SEC and do not trade shares on the national exchanges.

What are Equity REITs?

According to the National Association of Real Estate Investment Trusts (NAREIT), most REITs operate as equity REITs. Equity REITs manage and own income-producing properties and may lease space in those properties to tenants. Income may be earned from rents or from the sale of properties in the REIT’s portfolio.

By NAREIT’s estimate, more than 145 million Americans are invested in equity REITs listed on the major stock exchanges, either through individual investments or through mutual funds or retirement plans. “Because most REITs operate as equity REITs when the market refers to REITs it is typically discussing listed equity REITs,” NAREIT says.

Equity REITs typically concentrate on a particular type of commercial real estate, such as office buildings, healthcare facilities, hotels, multi-family apartment complexes, shopping centers, and industrial sites, among others. Once they have paid operating expenses, equity REITs distribute 90 percent—and often 100 percent—of their income to shareholders as dividends. 

What are Mortgage REITs?

Unlike equity REITs, mortgage REITs are not in the business of acquiring, owning and operate real estate. Instead, they provide direct money to residential and commercial real estate owners in the form of mortgages and other loans, or they invest in mortgages indirectly via residential or commercial mortgage-backed securities.

Most mortgage REITs, also known as “mREITs,” are publicly traded and registered with the SEC. Like equity REITs they often specialize. This may mean focusing on particular class of borrower, such as real estate developers, or a specific category of debt, such as loans to distressed properties or mezzanine financing.

Mortgage REITs typically follow one of three investment strategies:

  • earning an arbitrage spread on high-quality mortgage securities.
  • originating and acquiring mortgages and other real estate loans on residential or commercial properties.
  • investing in distressed mortgages.    

Investors should be aware that REITs offering loans or mortgages are subject to an array of federal regulatory requirements governing mortgage lending. And mortgage REITs often require more borrowed capital to operate than equity REITs and use derivatives and other techniques to hedge against interest rate and credit risks.

Other Types of REITs

A third type of REIT—the hybrid REIT—deploys the investment strategies of both equity and mortgage real estate investment trusts. However, the number of REITs that focus on owning and operating property and acquiring or issuing real estate debt is relatively small. More commonly, equity REITs may hold a few debt-related investments that are secured by properties similar to those it owns and operates. 

No matter the type of REIT, experienced legal counsel should be consulted to navigate the myriad compliance and tax issues, as well as the transactional and operational issues that may arise. KVCF PLC has extensive experience representing clients on a full-range of REIT-related issues, including qualifications and IRS requirements, classifications and structures, property management, investor evaluation, compliance, and regulatory matters. Contact us to learn more.