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The 2 Main Types of REITs and Their Risks and Rewards

REITs are a key consideration when contemplating diversifying your portfolio. REIT, which stands for real estate investment trusts, offers the ability to invest in real estate with more liquidity and diversification, and best of all, there are multiple types of REITs to buy, such as retail, office, or specialized, to name a few.

Another benefit REITs offer potentially higher overall returns and lower overall risk, plus they are a great counterbalance to bonds, stocks, and cash. And lastly, they offer an offset to the potential danger of inflation; as REITs lag the economy, they are generally the last asset class to feel the sting of rising inflation.

“I would give a thousand furlongs of sea for an acre of barren ground.”

Shakespeare

When considering investing in real estate, remember that some of the world’s wealthiest people and organizations are landowners. People such as Queen Elizabeth, John Malone, and Ted Turner are among the world’s richest people and some of the largest landowners in the world. The Catholic Church is one of the largest landowners globally and one of the wealthiest organizations as well.

Throughout history, those who owned land controlled the wealth; think about the Romans, Byzantines, Mongols, and Chinese Empires and their power and wealth generated from those lands’ ownership.

With the ability to invest in REITs, we have the opportunity to participate in that wealth without the stress of actual ownership, such as maintenance, collecting rents, and liquidity.

In today’s post, we will learn:

  • What are the Two Types of REITs?
  • What are Equity REITs?
  • REIT Sectors: Risks and Rewards

Ok, let’s dive in and learn more about the types of REITs.

What are the Two Types of REITs?

We can break the types of REITs into four categories:

  • Equity REITs
  • Mortgage REITs
  • Private REITs
  • Public non-listed REITs

The two main types that are traded on public exchanges are both equity and mortgage REITs.

Equity REITs generate the majority of its income through rent, and we are going to discuss them in more depth in the next section.

Mortgage REITs, also known as mREITs, invest in mortgages or mortgage securities tied to commercial and residential properties.

Mortgage REITs main goal is to provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities (MBS). The mREITs earn income from the interest earned on those investments.

Mortgage REITs trade on the public stock exchanges, as do equity REITs, and shares are available for purchase through mutual funds or ETFs. One of the benefits that mREITs offer is the high dividend yields they offer, one of these REITs’ main attractions.

mREITs play an essential role in the economy by facilitating new housing with the purchase of mortgage-backed securities, which help fuel the market’s growth. As of 2020, mREITs have helped finance over 1.8 million homes in the U.S.

mREITs also play an important role in the commercial world, as they invest in commercial mortgages which help buy or sell income-producing real estate.

The biggest advantage of mREITs offers the ability to invest in real estate with the bonus of liquidity and flexibility that comes with investing in the stock market.

mREITs hold the mortgages and MBS on their balance sheets and fund their operations with equity, selling company shares, and from debt offerings, selling corporate bonds.

The mortgage REITs’ main goal is to make money on the spread between the interest rates they borrow money and the interest rates of the money they lend out, also known as the net interest margin.

Mortgage REITs depend on a variety of funding sources:

  • Common equity
  • Preferred equity
  • Repurchase agreements
  • Structured financing
  • Convertible debt
  • Long-term debt
  • Credit facilities

However, mREITs typically utilize more equity financing than debt financing, which is preferred by more large mortgage investors.

Despite the advantages that mREITs offer, they are not perfect and do come with risks.

The business risk most associated with mREITs is interest rate risk, similar to those in the financial sector.

How an mREIT manages the effects in short and long-term interest rates is critical to the success of any mREIT.

Any changes in the interest rates will affect the net interest margin, the main aspect of candy for any mREIT, and as the rates rise, the margins get pinched and profits affected.

Mortgage REITs attack these risks by combining interest rate hedges and adjusting the length and terms of its debt offerings to help manage cash flow.

Another risk to consider is credit risk; the bulk of mortgage-backed securities is backed by the U.S. government’s full faith, which helps ease the pain on those securities. But other debt offers are dependent on the credit performance of the underlying security, and as those companies struggle, those credit risks grow.

Ok, let’s move onto the next type of REIT, the equity REIT.

What are Equity REITs?

Most REITs fall into the equity REIT camp, of which these types of REITs earn the majority of their income from rental income.

Equity REITs are real estate businesses that own or manage income-producing properties, think:

  • Shopping centers
  • Malls
  • Office buildings
  • Health care
  • Many more

Although these REITs own and manage the buildings, the companies that operate out of the properties lease the REITs space. Equity REITs pay out the majority of is annual income to shareholders as a dividend, or distribution, after all the expenses of managing the properties.

Equity REITs also generate revenue from the sale of their properties, but generally, the bulk comes from rental income.

As most REITs are of the equity flavor, they refer to equity REITs when mentioned in the market.

Equity REITs total the majority of the REIT market, and they own over $2 trillion of assets in the U.S., which includes over 200,000 properties in 50 states and D.C.

A few more numbers for you, over the last 25 years, the Nareit FTSE returned over 10.9%, which comprises all of the REIT markets, with the REIT market averaging a 4.0% dividend yield.

The primary incentive for investing in equity REITs is the dividend income; with the higher dividend yields, the equity REIT is perfectly suited for income investors or those looking to grow their wealth from dividends’ benefits.

Equity REITs also offer additional portfolio diversification because of their relatively low correlation to other sectors in the market. Equity REITs tend to move less with other stocks, or when the market goes up or down.

Lastly, equity REITs offer inflation hedging as a benefit. Equity REITs offer a natural hedge against inflation in the form of rental income since rents tend to rise along with inflation, which leads to increased revenue for the REITs and potential increases in dividend distributions.

And as we have mentioned in other posts concerning REITs, the liquidity offered by equity REITs is a major bonus to investors looking for exposure to the real estate market. Because REITs trade like stocks and don’t have to tie up your capital in physical real estate, you have more flexibility when investing in REITs. Besides those benefits, you also don’t have the stress of building maintenance, finding tenants, collecting rents, and the headaches associated with the loan process.

There are, of course, risks associated with investing in equity REITs, but we will uncover those in the next section.

Next, let’s look at the REIT sectors and their risks and rewards.

REIT Sectors: Risk and Rewards

In this section, I would like to look at each sector of the equity REITs and dissect both the risk and rewards of each sector. There are many different flavors of equity REITs, any to suit any kind of real estate you are trying to find.

Office REITs

Office REITs manage and own office real estate and rent those spaces to tenants. The types of properties can range from skyscrapers to office parks. Some office REITs that niche down into specific types of markets, such as central business districts or the suburbs. Others focus on specific tenants, such as government agencies and biotech firms, for example.

Office buildings are also classified based on many factors:

  • Building quality – construction and materials
  • Conditions of their mechanical systems
  • In-building amenities such as gyms or restaurant
  • Location, of course

With newer buildings rated Class-A properties, older buildings with lesser mechanical or electrical systems rated Class-B or Class C. Although these ratings are somewhat subjective from market to market, they help determine what kind of rents you can expect from these properties.

Office leases are typically full-service leases with an initial term of five to seven years, plus additional renewal options. Remember, the longer the lease, the more stable the rental income.

Risks and Rewards

  • Office REITs are the most cyclical of any of the equity REITs due to periodic overbuilding. Because of the longer cycle to build office buildings, there tends to be overbuilding to keep up with demand.
  • The work from home trend underway before COVID has only intensified since the outbreak and threatens to continue long after the virus recedes, which will put a lot of pressure on the overabundance of office space, thus reducing rental income.
  • When the demand is there, office REITs are fantastic properties to own.

Numbers for office REITs:

  • 21 office REITs operating currently
  • 4.11% sector dividend yield
  • The occupancy rate as of September 2020 is 93.24%
  • Rental growth year over year – 2.90%

Top REITs in the sector:

  • Boston Properties, Inc. – BXP
  • SL Green Realty Corp – SLG
  • Paramount Group, Inc. – PGRE
  • Alexandria Real Estate Equities – ARE

Industrial REITs

There are currently 14 industrial REITs in the sector, with the industrial REIT leasing to businesses for various reasons, such as distribution warehousing, light manufacturing, and R&D.

Industrial REITs are among the most stable of the equity REITs. With the demand for industrial property closely aligned with consumer spending and growth in the GDP, the more demand for consumer goods, the greater the need for warehousing.

Industrial properties are simple to build and maintain, and because of ease of construction, the risk of overbuilding is less than office REITs, for example.

Industrial leases tend to employ triple-net or modified-gross leases, with the length of leases one-to-three years for smaller spaces and larger spaces commanding longer terms such as five, seven, or ten years.

Risk and Rewards:

  • The tradeoff for all the stability is the lack of rapid price appreciation available from other equity REITs.
  • Because of industrial property’s importance, this REIT sector tends to be stable throughout the economic cycle, which means industrial REITs won’t dazzle, but steady Eddie’s are always welcome.

Industrial REIT numbers:

  • 14 REITs in the sector
  • Dividend yield – 2.46%
  • Occupancy rate – 96.27%
  • Year over year rent growth – 5%

Top industrial REITs:

  • Prologis, Inc. – PLD
  • Duke Realty Corporation – DRE
  • Liberty Property Trust – LPT

Retail REITs

Retail REITs are probably the most famous of REITs because of the exposure to malls. Retail REITs focus on large regional malls, outlet centers, grocery-shopping anchors, and power centers that feature many big-box retailers such as Home Depot. Included in this sector are freestanding properties.

Risk and Rewards:

  • With the continuing trend towards online retail sales, this sector has come under extreme pressure to maintain their incomes.
  • Along with the move towards online retail, many of the mall anchors have declared bankruptcy, such as JC Penney, Nordstrum, Sears, and Dillards. Also, anchors such as Macy’s are on the struggle bus, hurting mall foot traffic as well.
  • Retail REITs that have done well have utilized the market strategy of positioning their centers in geographically desirable areas with good population density.

Retail REIT numbers:

  • 40 total retail REITs
  • Dividend yield – 6.61%
  • Occupancy rate – 94.60%
  • Year over year rental growth – 2.10%

Top Retail REITs:

  • Realty Income – O
  • STORE Capital Corp – STOR
  • Simon Property Group, Inc. – SPG
  • Kimco Realty Corporation – KIM
  • Federal Realty Investment Trust – FRT

Lodging REITs

Lodging REITs are connected with the hotel industry closely; the majority of hotels are affiliated with REITs. Many are with the most popular brands such as Marriott Internation, including Courtyard, Residence Inn, Hilton, Hampton Inn, and Holiday Inns. The tier classifies most lodging REITs they are in, for example, luxury, upscale, or economy.

Hotel revenues are inconsistent and depend on a strong economy and travel, and location plays a large part in many hotels’ success or failure.

Risks and Rewards:

  • Hotels are more like operating a company where you have to perform every day to lease their rooms and maintain a high occupancy rate.
  • When the economy is strong, lodging REITs do extremely well, but the REITs struggle when the economy struggles.

Lodging REITs numbers:

  • 17 total REITs
  • Dividend yield – 8.49%

Top lodging REITs:

  • Host Hotels & Resources, Inc – HST
  • Hospitality Properties, Trust – HPT
  • Ashford Hospitality Trust, Inc. – AHT

Residential REITs

Residential REITs consist of three subcategories of this sector:

  • Apartment REITs
  • Manufactured Housing REITs
  • Single-Family-Home REITs

All residential REITs specialize in apartment buildings, student housing, manufactured homes, and single-family homes. Traditional apartment buildings are classified as garden-style or high-rise buildings with both formats coming in Class A, B, or C properties. With Class B and C buildings tending to be older and less desirable locations.

Rental leases tend to be twelve months, and the landlord is responsible for maintaining the buildings.

Like office REITs, demand for apartment REITs is correlated to the strength of the economy.

Apartment REIT numbers:

  • 21 REITs in total
  • Dividend yield – 3.38%

Risk and Rewards:

  • The main risk associated with these REITs is the risk of oversupply. As demand rises, developers tend to produce more apartments, but the demand will fall as the region’s economy slows.

Top apartment REITs:

  • Equity Residential – EQR
  • Avalon Bay Communities, Inc. – AVD
  • Essex Property Trust, Inc. – ESS

Timberland REITs

These REITs specialize in harvesting and selling timber, duh. These REITs are specialized REITs and there are four REITs in this sector.

Timberland REITs have an annual dividend yield of 4.30%, and the top REIT in this specialized sector is:

  • Weyerhaeuser Company – WY

Health Care REITs

Health-care REITs usually receive the bulk of their income from leasing facilities to health-care providers. The property types include senior and assisted-living/rehab centers, medical clinics, medical office buildings, hospitals, and health-care labs.

Population growth and aging demographics have led to this industry’s growth, especially senior housing, and skilled nursing facilities.

Risk and Rewards:

  • With the growing elderly population, this sector has a long runway to growth.
  • One risk to be aware of is the possibility of overbuilding.
  • Government regulation does make up a large part of the payments for these types of REITs, and depending on the political environment, there is a risk in medicare payments reducing.

Health-care REIT numbers:

  • 17 REITs in total
  • Dividend yield – 5.19%

Top Health-care REITs

  • Welltower Inc. – HCN
  • Ventas, Inc. – VTR
  • HCP, Inc. – HCP
  • Omega Healthcare Investors, Inc. – OHI

Self-Storage REITs

The self-storage REITs fall into the specialty division, and the sector comprises of six REITs. The demand for the self-storage REITs is similar to apartment REITs and is driven by population growth.

The rental units for this REIT are month-to-month, creating volatility during weak demand or economic contraction periods.

The current dividend yield for the sector is 3.75%, and a few of the bigger names in this sector:

  • Public Storage – PSA
  • Extra Space Storage Inc. – EXR
  • CubeSmart – CUBE

Infrastructure REITs

Infrastructure REITs operate in the field specializing in fiber cables, wireless infrastructure, telecommunications towers, and energy pipelines.

There are currently six REITs in this sector, with a dividend yield of 1.99%.

Some of the bigger names in the sector:

  • American Tower Corp – AMT
  • Crown Castle International Corp – CCI

Data Center REITs

Another smaller REITs sector, data center REITs, offers products and services to house data, including providing uninterruptable power supplies with air-cooled chillers.

There are five REITs in the sector, with a dividend yield of 2.06%.

A few top names in the sector:

  • Digital Realty Trust, Inc. – DLR
  • Equinix – EQIX

Diversified REITs / Speciality REITs

Both of these REITs invest in properties that are either multiple use properties, or are a specialty REIT. Many of the speciality REITs are new to the market and focus on areas such as billboards, correctional facilities, or farmland.

Diversified REITs might contain both office and health-care properties in their portfolios.

There are 27 REITs in this sector, and the combined dividend yields are 5.78%.

A few big names in the space:

  • Vornado Realty Trust – VNO
  • VEREIT, Inc. – VER
  • W.P. Carey, Inc – WPC
  • Iron Mountain Incorporated – IRM
  • EPR Properties – EPR

Final Thoughts

Over the course of our series on REITs, we have discovered the benefits of this asset class. Many investors are not as familiar with REITs and how investing in real estate works.

The best part of analyzing REITs is the variety of options available to investors, with the wide range of options. The key is to understand the business and what the REITs do, plus any risks associated with buying any REIT.

One of the biggest benefits of investing in REITs is the ability to reduce the impact of inflation and how the sector can help weather any increases in inflation over the coming years.

With that, we are going to wrap up our discussion today.

As always, thank you for taking the time to read this post, and I hope you find something of value on your investing journey.

If I can be of any further assistance, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave