The Vanguard REIT ETF: Growth and Income With Lower Risk Than Individual REITs

The Vanguard REIT ETF (VNQ 0.89%) is an index fund that invests in real estate investment trusts, or REITs, that own various types of properties. With a generous dividend yield and a history of strong returns and dividend growth, this ETF can be a great way to own all of the best REITs at the same time.

About the Vanguard REIT ETF

With more than $67 billion in net assets, the Vanguard REIT ETF is a massive fund that seeks to match the performance of the MSCI US REIT Index, a gauge of how REITs are doing as a whole. As of the end of July 2016, the fund owned 150 different REITs, weighted by size.

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Here's a look at the 10 largest REIT holdings of the ETF, which collectively make up about 35% of the fund's assets.

Data source: Vanguard.

The ETF's portfolio is diverse in terms of the type of real estate the underlying REITs invest in. Retail is the largest, contributing about 25% of the ETF's current assets, and no other property type makes up more than 16% of the fund's assets.

Finally, the fund's 0.12% expense ratio is about the best you'll find, and is 91% lower than that of similar ETFs. This means that for every $10,000 you have invested with the fund, your annual fee expense will be just $12 per year, allowing you to keep most of the index's returns. Because of the low expense ratio, the fund has done an excellent job of mirroring the index's performance over time.

Data source: Vanguard.

Why invest in REITs?

There are a few good reasons to keep REITs in your portfolio. For starters, the dividends they pay tend to be better than other sectors, thanks to REITs' favorable tax treatment. It's not uncommon for property-owning REITs to pay dividends in excess of 6%, and as of this writing, the Vanguard REIT ETF pays an impressive 3.92%.

In addition to the high yields, REITs -- especially the big ones -- tend to increase their dividends consistently each year. Since their income comes from renting out property, and rent tends to go up over time, these companies have a naturally increasing income stream.

REITs can also add diversity to your investment portfolio, without the work and risk that come with buying individual investment properties. This can help for several reasons -- for example, when markets get volatile, many REITs tend to go up as investors flock to safer, more predictable investments.

Finally, as property values increase, so do the values of the REITs that own them. And, with smart debt usage, this can really result in some impressive long-term returns. Just to name a couple of examples, consider that freestanding retail giant Realty Income has generated 18.2% average total returns since its 1994 IPO, and healthcare REIT Welltower has averaged 15.6% over its impressive 45-year history.

What could go wrong?

Obviously, if another real estate collapse were to come, it could cause REIT values to fall. However, many tend to make it through the tough times better than you may think. Aside from apartment REITs, most of these companies' tenants sign long-term leases, meaning that occupancy stays high and income keeps rolling in no matter what the economy is doing.

Another big risk is interest-rate spikes. Low rates are generally good for REITs, and are a big reason for the excellent performance of REITs over the past year or so. They make borrowing cheaper, which leads to better profit margins on acquired properties. And they make high-dividend REITs appealing to investors, creating upward pressure on their stocks. Conversely, high interest rates can have the opposite effect. If interest rates rise faster than the market expects, it could cause the REIT sector to take a hit.

The bottom line

I'm a big fan of REITs and believe they belong in every long-term stock portfolio, whether the primary goal is income, growth, or both. The Vanguard REIT ETF can give you exposure to this high-reward potential sector without the homework assignment of researching individual companies, and without the risk of relying too much on any one type of property. The bottom line is that if you'd like to own real estate the easy way, the Vanguard REIT ETF could be a good choice for you.