REIT Investment Characteristics
With the structure, types, listing status, and tax treatment covered, you can now evaluate REITs as investments. The exam tests both the benefits and risks, and how they differ by REIT type.
Benefits of REIT Investing
- Diversification into real estate without directly owning, managing, or financing property
- Regular income through mandatory dividend distributions (90% rule)
- Professional management; REITs are run by experienced real estate professionals
- Accessibility; listed REITs can be purchased for the price of a single share (no large down payment)
Exam Tip: Gotchas
The mandatory 90% distribution rule is what makes REITs an income play. Expect a distractor claiming REITs can retain earnings like a typical corporation; they cannot, or they lose the pass-through tax treatment.
REIT Characteristics by Type
| Characteristic | Equity REITs | Mortgage REITs | Listed REITs | Non-Traded REITs |
|---|---|---|---|---|
| Income source | Rent | Interest | Varies | Varies |
| Inflation protection | Yes (rents/values rise) | No (fixed interest) | Yes (equity type) | Yes (equity type) |
| Interest rate sensitivity | Moderate | High | Moderate | Moderate |
| Liquidity | High (if listed) | High (if listed) | High | Very low |
| Fee transparency | Good | Good | Good | Poor |
Exam Tip: Gotchas
Non-traded REITs have very low liquidity and poor fee transparency; they are not a substitute for listed REITs. Expect a distractor equating the two on liquidity.
Key Risks
- Interest rate risk; all REITs are affected by rate changes, but mortgage REITs are especially sensitive
- Rising rates -> higher borrowing costs -> lower profitability
- Rising rates -> falling value of existing mortgage holdings
- Market risk; listed REITs trade like stocks and can be volatile
- Liquidity risk; non-traded and private REITs are difficult to sell
- Fee risk; non-traded REITs may have high upfront costs that erode returns
- Distribution risk; some non-traded REIT distributions come from borrowed funds or return of capital, not operating income
Exam Tip: Gotchas
Some non-traded REIT distributions are funded by return of capital or borrowed funds, not operating income. A steady yield is not always a sign of real underlying cash flow.
Investment Implications
- Equity REITs may serve as a partial inflation hedge because property values and rents tend to rise with inflation
- Mortgage REITs perform best in stable or declining rate environments
- Listed REITs offer the combination of real estate exposure with stock market liquidity
- Non-traded REITs are suitable only for investors with long time horizons who can tolerate illiquidity
Exam Tip: Gotchas
- Mortgage REITs are highly sensitive to interest rate changes. They earn the spread between short-term borrowing and long-term lending. When rates rise, borrowing costs increase and existing mortgage holdings lose value. Equity REITs, by contrast, can pass higher costs to tenants through rent increases.
- "Inflation protection" applies to equity REITs, NOT mortgage REITs. Equity REITs benefit from rising rents and property values; mortgage REITs hold fixed-rate assets that lose value when rates rise.
- Listing status determines liquidity, not REIT type. Listed REITs are liquid; non-traded REITs are illiquid regardless of whether they are equity or mortgage REITs.
Now let's move to the third alternative investment category: hedge funds.