A Real Estate Investment Trust (REIT) is a form of corporation that allows investors to pool their money to invest in real estate. REITs can be public or private corporations.
REITs are created in part for their tax advantages. An REIT is not subject to corporate federal income tax if it fulfills numerous conditions, including: It is not a financial institution or insurance company; it is jointly owned by at least one hundred people; no more than 50% of its shares are held by five or fewer people during the last half of the taxable year; at least 75% of its total investment assets are in real estate; at least 95% of its income is derived from dividends, interest, and property income; and at least 90% of its income is distributed as dividends to shareholders each year.
If these conditions are fulfilled, the REIT is not subject to corporate tax, however, the recipients of the distributed dividends themselves must pay tax on that income.
There are two main types of REITs, or really three counting hybrids of the first two. Equity REITs invest in real property. They purchase, hold, and manage rental and commercial property.
Mortgage REITs instead invest in mortgages on real property. They may originate or underwrite these mortgages, or purchase existing ones. They do not directly own property, though property serves as collateral on the mortgages they do own. The money for investing in these mortgages can come from shareholder equity or more often debt borrowed from other lenders.
Mortgage REITs make money primarily by the interest earned on the mortgage loans. Basically, their potential for profit is the difference between the short term interest rates they pay to borrow money to obtain the mortgages, and the long term interest rates of the mortgages themselves.
Mortgage REITs tend to be more volatile than equity REITs. Their value is largely dependent on interest rate fluctuations, and they are vulnerable to borrowers defaulting on their mortgages.
Mortgage REITs have existed since the 1960s, when they were formed by major banks for construction loans. Some of those early REITs went bankrupt, and mortgage REITs have had a controversial and bumpy history ever since. Certainly they have returned substantial profits for some investors, but many of them have failed spectacularly, and they are considered a significant element in bringing about the financial crisis of recent years.
Despite their troubles, mortgage REITs are still very much around, and in fact have experienced a resurgence recently. Given their history, investors are certainly cautioned to tread lightly.