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 property assets. REITs have a particular tax status, which requires them to spend at least 90% of their income as dividends.

If they actually so, they aren’t taxed at the corporate level like most other types of businesses. There must be at least 100 shareholders. No five shareholders can own more than 50% of the shares. At least 75% of possessions must be invested in real estate, cash, or Treasuries. 75% of gross income must be derived from real property.

The most 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 invest in agency mortgage loans (those guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae), non-agency home loans, or commercial home loans.

The business design of collateral REITs is fairly simple — buy properties and rent those properties to tenants. This creates a stream of income, the majority of which are handed down through to shareholders as dividends. In addition, as property beliefs tend to appreciate over time, the value of shareholders’ investments can develop.

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

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

Because of their high leverage, home loan REITs are rather risky investments, because they are susceptible to interest rate fluctuations extremely. Let’s say that a mortgage REIT can purchase mortgages that pay 4% for 30 years and can borrow money for just 2% interest, creating a wholesome 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 disappears completely.

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