Investors who seek income as a key component of their real estate portfolios have two primary options: Real Estate Investment Trusts (REITs) and Mortgage Investment Corporations (MICs)
While bond trading can be traced back to the Venetians of the 1300s, with publicly traded equities appearing three centuries later with the Dutch East India Company, the ability to invest in real estate via structured vehicles is a much more recent phenomenon.
REITs were first created in the U.S. via the Cigar Excise Tax Extension of 1960, a law signed by President Dwight D. Eisenhower to make it easy for investors to participate in large, diversified portfolios of real estate via the purchase of easily tradable securities.
A REIT can be a private or publicly traded company that can invest in a broad range of income-generating real estate assets. These assets can include apartment buildings, offices, retail shopping centers, medical facilities, hotels, data centers and a range of infrastructure such as cellular towers. Most REITs have a focused portfolio of property types, but they can also invest across multiple types.
MICs are a uniquely Canadian construct, introduced by Parliament in 1973 as part of the Residential Mortgage Financing Act. The government foresaw a looming housing crisis with a growing population generating the need for millions of new homes. Parliament estimated that $5 billion in mortgage financing would be required for new housing, a number that exceeded available mortgage financing by $2.3 billion.
Parliament created MICs to enable individual investors, registered retired savings plans (RRSPs) and pension funds to invest in pools of mortgages, thereby closing the impending deficit.
Most REITs are listed on major exchanges in 39 different countries, with those listed in the US having an equity market capitalization of $1.3 trillion.
REITs typically pay investors regular distributions from collected tenant rents, and they can also develop and renovate property. REIT investors may enjoy increased distributions after a property is renovated and repositioned or sold at a higher value. REITs must distribute 90% of their taxable income to investors each year.
Among the risks of a REIT are:
MICs enable individual investors to invest in pools of mortgages and leverage economies of scale that would otherwise be unavailable to individuals directly.
MICs may additionally borrow from banks to supplement shareholders’ capital. The combined pool is invested in a portfolio of mortgages backed by selected real estate properties. MICs receive streams of mortgage payments from borrowers, which are then distributed as income to investors on a monthly or quarterly basis.
The structure is comparable to a mutual fund that invests in mortgages, rather than stocks or bonds. Critically, as outlined in Canadian tax law, a MIC must distribute 100% of its income to investors as a flow-through dividend.
While this dividend is taxed as interest income, Section 130.1 of the Income Tax Act calls for the MIC itself to be considered as a tax-exempt corporation, providing further benefit to investors.
REITs and MICs both offer investors a means of participating in a pool of funds that invest in real estate, creating current income and portfolio diversification.
The structures are more different than they are the same, however, and it’s important for investors to understand these differences.
Perhaps the major difference is the MICs invest in mortgages (debt) secured by real estate assets while a REITs invest in physical properties (equity), and takes on the responsibility of ownership and maintenance.
REITs are therefore much more subject to market price fluctuations, with this heightened risk translating to returns that can be higher than those of MICs.
Conversely, MICs offer a higher level of security and stability as they invest in mortgage loans that borrowers must repay regardless of the state of the housing market. The mortgagor is still required to pay the interest and ultimately the principal of the loan whether or not any tenant in that property is paying rent and whether or not a property retains its value.
Further, since the loan to value ratio, or LTV, of a mortgage is generally a maximum of 80%, the value of a property is at least 20% more than the mortgage at the time of funding, a margin of safety for MICs that is unavailable in a REIT’s structure.
Therefore, returns on MICs, while they can be lower than those of REITs, are generally more predictable and stable. The typical range of returns is between 6% and 10%, with REITs tending to be at the higher end of the spectrum to reflect the increased inherent risk.
Which vehicle is right for you depends on your investment goals and risk appetite.