REITs vs. Real Estate Mutual Funds: An Overview
Real estate investment trusts (REITs) and real estate mutual funds both offer diversification and an easy, affordable way for individual investors to invest in various segments of the real estate market. Theyalso represent a more liquid vehicle forinvestment in this sector than owning or investing in real estate directly.
There exists a wide variety of REITs and real estate sector mutual funds to choose from. Before considering either type of instrument, you need to understand the key differences between the two, as well as their pros and cons.
Key Takeaways
- Investing in real estate assets can help diversify a portfolio and increase returns.
- REITs are share-like securities that give investors access to either equity or debt-based real estate portfolios. REITs typically invest directly in properties or mortgages.
- REITs may be categorized as equity, mortgage, or hybrid in nature.
- Real estate mutual funds are managed funds that invest in REITs, real-estate stocks and indices, or both.
- REITs tend to be more tax-advantaged and less costly than real estate mutual funds.
REITs
A real estate investment trust (REIT) is a corporation, trust, or association that invests directly in real estate through properties or mortgages. They trade on a stock exchange and are bought and sold like stocks. REITs pay out dividends as part of their structure. They are required by the Internal Revenue Service (IRS) to pay out most of their taxable profits (90% or greater) to shareholders via dividends. REIT companies, however, do not pay corporate income tax.
At least 75% of a REIT’s assets must be in real estate, and at least 75% of its gross income must be derived from rents, mortgage interest, or gains from the sale of the property.
The three major types are equity REITs, mortgage REITs, and hybrid REITs.
Equity REITs
Equity REITs own and invest in properties such as apartments, office buildings, shopping malls, and hotels. Revenues are generated mainly from the rents of properties they own or have a share in.
An equity REIT may invest broadly, or it may focus on a particular segment such as hotels, residential properties, warehouses, hospitals, and so on.
In general, equity REITs provide stable income. And, because these REITs generate revenue by collecting rents, their income is relatively easy to forecast and tends to increase over time.
The majority of REITs are of the equity type.
Mortgage REITs
Mortgage REITs (or mREITs) invest in residential and commercial mortgages. These REITs loan money for mortgages, or purchase existing mortgages or mortgage-backed securities (MBS). While equity REITs typically generate revenue through rents, mortgage REITs earn income from the interest on their debt investments.
Mortgage REITs tend to do better than equity REITs when interest rates are rising.
Hybrid REITs
Hybrid REITs are a combination of equity and mortgage REITs. They both own properties and collect rents and also invest in mortgage securities. By investing in both mortgages and hard assets, hybrids REITs like Two Harbors take a more balanced approach and may be able to profit in both rising and falling interest-rate environments where traditional equity only or mortgage only REITs can struggle.
Note that there are only a few hybrid REITs listed.
REIT Performance
REITs tend to perform best when interest rates are falling and when rents are rising. As dividend-paying stocks, REITs are analyzed much like other stocks. But there are some big differences due to the accounting treatment of the property. Since REITs buy real estate, for instance, you may see higher levels of debt than for other types of companies.
Capital market conditions are also important, namely the institutional demand for REIT equities. In theshort run, this demand can overwhelm fundamentals. For example, REIT stocks did quite well in 2001 and the first half of 2002 despite lackluster fundamentals, because money was flowing into the entireasset class.
At the individual REIT level, you want to see strong prospects for growth in revenue, such as rental income, related service income, and FFO. You want to see if the REIT has a unique strategy for improving occupancy and raising its rents.
The industry sector also matters as specialized REITs will see returns that vary depending on what type of properties are owned. For example, the chart below depicts REIT returns by sector in 2023 (YTD). Data centers and timber are performing best while infrastructure and diversified properties are languishing.
Real Estate Mutual Funds
Mutual funds are professionally managed pooled investments that invest in a variety of vehicles, such as stock and bonds. Investors purchase mutual fund shares, or units, which are bought or redeemed at the fund's current net asset value (NAV). NAVs are calculated once a day and are based on the closing prices of the securities in the fund's portfolio.
Real estate mutual fundsinvest primarily in REITs and real estate operating companies using professional portfolio managers and expert research. They provide the ability to gain diversified exposure to real estate usinga relatively small amount of capital. Depending on their strategy and diversification goals, they provide investors with a much broader asset selection than can be achieved by buying REIT stocks alone, and they also provide the flexibility of easily moving from one fund to another.
One advantage to retail investors is the analytical and research information provided by the fund. This can include details on acquired assets and management’s perspective on the viability and performance of specific real estate investments and as an asset class. More speculative investors can invest in a family of real estate mutual funds, tactically overweighting certain property types or regions to maximize return.
Real estate mutual fundscan beopen- or closed-endand either actively or passively managed.
Real Estate Mutual Fund Performance
Since they mainly invest in REITs, real estate mutual fund performance is closely correlated with that of the REITs they hold. Mutual funds, however, may be less liquid, be less tax-favorable, and carry higher management fees than REITs or REIT ETFs. Although real estate mutual funds bring liquidity to a traditionally illiquid asset class,critics believe they cannot compare to direct investment in real estate.
Special Considerations
REITs and real estate mutual funds give individual investors with limited capital access to either diversified or concentrated real estate investments because they have relatively low investment minimums. When it is diversification they provide, the two types of fundshelpmitigate risk.
Depending on their investment strategy, real estate mutual fundscan be a morediversified investment vehiclethan areREITs. This can cut down on transaction costs for those looking for greater diversification concentrated in one or a few funds. They also have the benefit of professional portfolio management and research.
Real estate funds provide dividend income andthe potential for capital appreciation for medium- to long-term investors. Remember, REITs must distribute at least 90% of taxable income to shareholders each year in the form of dividends.
The value of real estate tends to increase during times of inflation, as property prices and rents go up. Therefore,REITs and real estate mutual funds can serve as a potential hedge against inflation.
Finally, both types of real estate funds provide liquidity in what is typically an illiquid asset class.
Drawbacks
As with any investment, there are risks to investing in both REITs and real estate mutual funds. Returns are not guaranteed.
Also, as with all sector-specific funds, those that focus on real estate can be more volatile than funds with broader investment horizons, such as a fund tracking the S&P 500 index. In short, when the real estate market falters, funds in this sector suffer. Of course, the opposite is true when the real estate market is booming.
Rising interest rates can also affect the returns of real estate funds. For example,REITs rely on debt or borrowed money to acquire properties. When interest rates rise, so does the cost of borrowing, which can cut into profits.
REIT vs. Real Estate Mutual Fund Example
If you want to invest in New York City’s dynamic and notoriously pricey real estate market, for instance, consider the appropriately named Empire State Realty Trust Inc. (ESRT)—a REIT that can claim the iconic Empire State Building as one of its portfolio properties. Its portfolio totals eight retail and eight office properties in Manhattan and the New York City metropolitan area.
T. Rowe Price Real Estate (TRREX) is an example of a (real estate)sector mutual fund with diverse holdings. Boasting 41 holdings, it invests primarily in REITs as well as publicly-traded real estate-related companies.
What Is a Non-Traded REIT?
Non-traded REITs are private real estate investment funds that are professionally managed and invest directly in real estate properties and are not listed on stock exchanges. These are available only to accredited, high-net-worth investors and typically require a large minimum investment.
What Is a REIT ETF?
REIT ETFs areexchange-traded funds(ETFs) that invest the majority of their assets in equity REIT securities and related derivatives. REIT ETFs are passively managed around an index of publicly traded real estate owners.
What Is a REIT Index Fund?
Like a REIT ETF, a REIT index fund is a mutual fund that passively invests in a benchmark real estate index, such as the MSCI U.S. REIT Index or the Dow Jones U.S. REIT Index, which together cover about two-thirds of the aggregate value of the domestic, publicly-traded REIT market.
What Is a Paper Clip REIT?
A paper clip REIT is a structure that seeks to maximize the tax advantages inherent in real estate investment trusts, while allowing the company to operate properties that such trusts normally cannot run. Such REITs are given intense regulatory scrutiny since in the paper clip structure fiduciary obligations are owed to different shareholder groups and inherent conflicts may be present. It is similar but more flexible in structure to the stapled REIT.
What Is a Triple Net REIT?
A triple net REIT is an equity REIT that owns commercial properties utilized triple net (NNN) leases. Thetriple netlease means that the costs of structural maintenance and repairs must be paid by the tenant—in addition to rent, property taxes, and insurance premiums. Because these additional expenses are passed on to the tenant, the landlord generally charges a lower base rent. This absolves the REIT of the most risk of any net lease.
The Bottom Line
REITs and real estate mutual funds have their differences, but they are similar in that they both offer liquidity and an accessible way to get exposure to diversified real estate assets. For retail investors without significant capital, these real estate funds create an avenue for investing in a wide range of properties that might otherwise be out of reach. Long-term investors, in particular, have the potential to reap the rewards of dividend income and capital appreciation down the line. Before investing in either, make sure you understand the differences between the two, as well as the attendantrisks and rewards.
