Equity vs Debt REITs
Equity vs Debt REITs: What You Need To Know
REITs is an acronym for “Real Estate Investment Trusts.” These trusts are companies that own, operate, and/or finance large scale real estate investments that produce income. At the core, REITs are revenue-generating real estate projects.
As a trust, investors are a part of a larger pool and do not take on the full risk of a development project on their own. Instead, that risk is shared. This is a main reason why REITs have become such an attractive, popular investment vehicle over the last few years. Many people compare REITs to mutual funds, but the investment with REITs is with income-producing real estate assets only.
As a real estate investor or company, there are two main types of REITs to understand: equity REITs and mortgage REITs.
Here, we’ll cover the specific details of each, as well as discuss the essential information you should know if you’re deciding on equity REIT vs mortgage REIT as your next investment.
What is an Equity REIT?
What are equity REITs? An equity REIT generates money primarily through rent paid on real estate. Because the amount of revenue is connected to rent, income generation potential is fairly consistent and typically pretty easy to predict. Rent is generally paid month-to-month, so investors can track their earnings month-to-month as well.
The risks associated with equity REIT investments are connected to the market though, so fluctuations in rent prices should be monitored and taken into consideration.
What is a Mortgage REIT?
A debt or mortgage REIT is where a trust gives out loans to property investors. These REITs make their money through interest made on a loan (or loans). If interest rates increase, the potential for income through a mortgage REIT increases. However, if those interest rates decrease, the income potential also decreases.
Equity & Debt REIT Similarities
Mortgage REITs vs equity REITs is as much about similarities as differences. There’s a level of risk in any investment, and there are similarities between equity REITs and mortgage REITs.
Both options are required to pay out a large percent of the income to the shareholders: at least 90% of taxable annual income must be distributed to shareholders. In both situations, these profits are paid in the form of dividends.
There are a few other key similarities worth mentioning, such as:
- Investments focus solely on real estate
- Real estate trusts allow investment diversity away from commodities
- Profits from both types of REITs are taxed the same way
Equity & Debt REIT Differences
It's also important to look at differences when comparing a mortgage REIT vs equity REIT. The biggest difference between mortgage and equity REITs is how the income is generated and the risks associated.
Equity REITs make their money on rent.
Mortgage REITs make their money on interest.
Most other specific differences come back to rent vs interest:
- Dips in renting markets lower equity REIT returns and values
- Changes in interest rates directly affect debt REIT returns
- Equity REITs are explicitly tied to real estate markets, while debt REITs can better-weather real estate fluctuations when interest rates are consistent
Despite these differences, equity REITs will still be impacted by interest rates, and any REIT loan is tied to real estate markets. The directness of these relationships is inverted for the two types of REITs.
Risks of REITs
The equity vs mortgage REIT comparison also makes sense in terms of risk. With any investment, the risks are associated with the volatility of the market in question. This is true with both mortgage and equity REIT investment strategies. The housing market ebbs and flows drastically and there are other risks associated with any real estate investment, including:
- Vacancy issues
- Tenant problems
- Neighborhood or curb appeal fluctuations
- Structural integrity
Any disadvantage associated with real estate itself can have a direct impact on the investment potential.
Benefits of REITs
Although there’s always some risk associated with investing in real estate, there are a host of benefits as well. These benefits are a large reason why real estate remains such a popular investment:
- Potential for stable cash flow (often on a monthly basis)
- Predictable models
- Tax breaks
- Although it fluctuates, real estate is generally thought of as a comeback market
The current market in 2022 is showing some of the highest annual growth percentages on record.
It’s all about balance and weighing the risks vs. the benefits. The REITs game is also about doing your research and paying attention to market and location trends to make a sound investment in the first place.
REIT investments can often be considered a long-term investment strategy. With REIT loans, for example, mortgage loans are often set up on 5-year balloon, 15-year fixed, or 30-year fixed schedules. Investors can generate income throughout the lifetime of a property. This long-term approach to loans is also a long-term approach to the housing market. Most often, investors can “weather the storm.” In the case of a temporary market decrease, for example, investors just need to be patient and wait out the decrease, because, in the long run, there’s a good chance they’ll typically still come out positive with their investment.
Another huge benefit of REITs is the potential to increase profitability over time. Meaning, in addition to a predictable and steady dividend payment, if the market booms, an investment booms. For example, for equity REITs, if the monthly rental payments in a specific area increase over time, the amount of money generated from that rent will also increase.
There’s a ton of research that goes into the marketability of locations or neighborhoods connected to rental prices, so equity REIT investors can be on the lookout for the next up-and-coming neighborhood trends.
REITs are extremely popular these days, and many investors use them to strategically diversify their investment portfolios. The potential for income on the investment’s return is impressive, and both equity REITs and REIT debt are great options as long as risks are understood.
If you love the idea of investing in real estate, but aren’t sure how to get started, check out Connect Invest’s blog to learn more about how real estate can work for you.
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