REIT stands for a real estate investment trust. It’s a kind of company that lets investors pool their money to purchase an accumulation of properties or other real estate property. REITs have a special tax position, which requires them to pay out at least 90% of their income as dividends.

If they do so, they aren’t taxed at the organization level like the majority of other styles of businesses. There must be at least 100 shareholders. No five shareholders can own more than 50% of the shares. At least 75% of assets must be invested in real property, cash, or Treasuries. 75% of gross income must be produced from real property.

The majority of REITs are equity REITs, which own and manage properties. There is also another course of REITs that invest in mortgage-backed securities, known as mortgage REITs. These businesses may spend money on agency mortgages (those assured by Fannie Mae, Freddie Mac, and Ginnie Mae), non-agency mortgage loans, or commercial mortgage loans.

The business model of collateral REITs is quite simple — buy properties and lease those properties to tenants. This creates a stream of income, the majority of which is passed to shareholders as dividends. In addition, as property beliefs tend to appreciate as time passes, the worthiness of shareholders’ investments can grow.

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And as property values increase, commercial properties’ capability to generate income rises. So the idea behind a collateral REIT is to create a growing dividend stream and to increase shareholder value through local rental income and property appreciation. Mortgage REITs borrow money at low short-term interest rates and buy mortgages that pay higher long-term interest rates. The spread between the two rates is the REIT’s revenue. To boost results, mortgage REITs have a tendency to use high leverage — often 5-to-1 or even more.

1 million in annual interest expenditure. 2.4 million in interest income. 1.4 million — is the profit, and symbolizes a 14% annual comeback on invested capital. Of course, this is a simplified example, but this is actually the basic notion of a mortgage REIT. Investors must be aware that equity REITs and mortgage REITs are completely different investments, not only in terms of their business models, however in terms of investment risk as well.

Because of their high leverage, mortgage REITs are rather dangerous investments, because they are susceptible to interest rate fluctuations extremely. Let’s say a mortgage REIT can buy mortgages that pay 4% for 30 years, and can borrow funds for just 2% interest, creating a healthy 2% spread. Well, if the short-term cost of borrowing spikes to 3%, the REIT’s home loan investments will still pay 4% and the pass on gets cut in two. If short-term rates spike to 4%, the profit margin completely disappears.

Because of the, mortgage REITs can be volatile investments and their dividends can be unpredictable. On the other hand, many equity REITs have proven throughout the years to be stable income investments, to the main point where many traders think of them similar to bonds than stocks and shares. Many equity REITs have averaged total returns well into the double digits for many decades now and have produced consistent dividend growth. This short article is part of The Motley Fool’s Knowledge Center, which was created based on the collected knowledge of a fantastic community of investors. We’d like to hear your questions, thoughts, and views on the data Center generally or this site in particular. Your insight can help us help the global world invest, better! Thanks — and Fool on!