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REITs vs. Real Estate Mutual Funds: Which Is the Best Way for You to Invest?


Jun 15, 2020 by Matt Frankel, CFP

There are several ways you could invest in real estate. Most obviously, you could buy a rental property or attempt to fix and flip a house, but these can be very time consuming. You could invest in a crowdfunded commercial real estate project, but this is generally limited to high-net-worth investors and is a highly illiquid way to invest.

Alternatively, you could choose to invest in real estate in a way that is passive, easy to understand, and can be sold whenever you want. Two of the main ways to do this are through real estate investment trusts, or REITs, and real estate mutual funds or ETFs. Here's a quick overview of how these two types of real estate investments work, the pros and cons of each, and how to decide which might be best for you.

What is a REIT?

A real estate investment trust, or REIT (pronounced "reet"), is a special type of corporation whose primary business involves owning real estate assets. Technically there are two main types of REITs:

  • Equity REITs (which own properties).
  • Mortgage REITs (which own mortgages and other financial instruments).

However, when you hear the terms "REIT" or "real estate stocks," they are generally referring to equity REITs. In fact, mortgage REITs are such a different type of investment that they are a part of the financial sector -- not real estate.

In order to be considered a REIT, a company can't just buy a bunch of properties and call itself a REIT. There are some specific criteria that must be met. The two most important to know are:

  • REITs must invest at least 75% of their assets in real estate investments and must derive at least 75% of their income from real estate investments.
  • REITs must distribute at least 90% of their taxable income to shareholders. Because of this rule, REITs don't pay any corporate tax -- they are considered "pass through" companies. This is also why REIT dividends tend to be higher than those paid by the average S&P 500 stock.

Some REITs simply buy existing properties and use them to generate rental income. Others develop properties from the ground up to try and create value for investors as well as income. Some operate their properties themselves, and some hire third-party management companies. The point is that there are several variations to the REIT business model.

Most REITs specialize in one type of commercial property. Just to name a few examples, there are apartment REITs, office REITs, mall REITs, and industrial REITs. However, there are some REITs that have more than one type of underlying asset.

There are publicly traded REITs, which are the most well-known type and trade on major stock exchanges. Then there are public REITs that aren't traded on exchanges but that anyone can invest in. And then there are private REITs that aren't open to the public for investment.

What is a real estate mutual fund or ETF?

In a nutshell, a real estate mutual fund or ETF allows you to get exposure to real estate investment trusts in your portfolio, but without having to research and select individual REITs to invest in.

If you aren't familiar with mutual funds and ETFs, they are very similar types of investments. Both types of real estate funds pool investors' money and buy a diverse portfolio of stocks -- in this case, REITs. Mutual funds are priced daily and aren't traded on stock exchanges, while exchange-traded funds, or ETFs, trade just like individual stocks, and therefore their prices can fluctuate constantly while the stock market is open.

One of the best examples is the Vanguard Real Estate Index Fund (NASDAQMUTFUND: VGSLX), which is available in both mutual fund and ETF form. The Vanguard Real Estate Index Fund mutual fund has a minimum initial investment of $3,000 and charges a 0.12% expense ratio, which means that for every $1,000 you have invested in the real estate fund, your annual fees and other investment expenses are just $1.20.

On the other hand, the Vanguard Real Estate ETF (NYSEMKT: VNQ) trades directly on the New York Stock Exchange, and you can invest for as little as the price of one share (about $80 as of June 2020). The ETF has the same 0.12% expense ratio.

Both versions invest in an index of REITs that is weighted by market capitalization, meaning that larger REITs make up more of the fund's assets. The funds own a total of 183 different REITs and will give you exposure to all types of commercial real estate assets, such as apartments, self-storage facilities, office buildings, data centers, and much more.

There are several other excellent REIT mutual funds and ETFs, so do your homework if you decide this is the way to go. It's also worth mentioning that while the Vanguard funds are broad REIT index funds, there are others that are actively managed, meaning that the fund aims to beat the real estate sector, not just match its performance as an index fund does. And some REIT mutual funds and ETFs are more specialized. For example, you can find REIT mutual funds that invest in international REITs and others that might incorporate non-REIT real estate stocks (homebuilders, for example) into the investment strategy.

Pros and cons to consider

REITs were created to allow everyday investors to put their money to work in an asset class (commercial real estate) that has historically only been accessible to the wealthy. REITs have higher-than-average dividends, have excellent long-term growth potential since the value of real estate tends to rise over time, and can help diversify your portfolio if you own mainly stock and bond investments.

The downside of investing in individual REITs is that not only will you have to spend time researching and evaluating individual REITs but your investment performance will be dependent on a single company and probably one single type of commercial real estate.

Just take a look at how some types of REITs fared in the COVID-19 pandemic. As a whole, the real estate sector has dropped by about 15% in 2020 through mid-June, but if you had been invested in certain hotel or retail REITs, you'd be down by 50% or more. Choosing REIT mutual funds or ETFs to invest in gives you a more diverse approach, so if one REIT or type of real estate is suffering, the impact on you will be minimized.

On the other hand, investing in REIT mutual funds or ETFs has downsides as well. For one thing, all REIT mutual funds and ETFs have expense ratios, meaning that there are ongoing fees associated with them. Now, in many cases the fees are small (like with our Vanguard examples) and can be worth it for the diversification and simplicity, but they are certainly worth considering.

Which is the best way for you to invest in real estate?

The bottom line is that the decision comes down to how much homework you want to do as well as your individual investment goals. If you want to essentially put your real estate investment strategy on auto pilot, a REIT mutual fund or ETF could be the smartest move for you. On the other hand, if you have the time and desire to research and evaluate individual REITs, it can certainly be an excellent way to invest for growth and income over the long term.

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Matthew Frankel, CFP has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Vanguard REIT ETF. The Motley Fool has a disclosure policy.

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