What's a REIT?
REIT stands for real estate investment trust, and a REIT is a particular type of investment vehicle that's designed to allow multiple investors to put their money together into a common pool for use in investing in various types of real estate. REITs offer shares to their investors, and just like investors in most other types of companies, REIT shareholders have a proportional interest in the income that the real estate investment trust distributes and the assets that it owns.
There are several types of REITs, and they tend to fall into a few different categories. Among them are the following:
- Equity REITs own actual real property. Mortgage REITs, on the other hand, invest in securities that are related to mortgage financing of real estate, including not only mortgage loans but also mortgage-backed securities and similar derivative investments.
- REITs are also classified by the types of properties they own. Some of the categories include residential, retail, healthcare, self-storage, industrial, office, hotel, data center, and timber REITs. Because the underlying real estate holdings are so different, one category of REITs can have a different set of characteristics than another.
The biggest benefit of REITs is that they allow investors to make a real estate investment with relatively modest amounts of money. If you want to invest directly in real estate, then it requires a large amount of capital. Consider: Typical homes in the U.S. cost about $200,000, and among commercial properties, more than 300,000 sold for $1 million or more over the past two years. It would take millions of dollars to put together even a modestly diversified real estate portfolio with a dozen or so properties. By contrast, REITs let you invest in real estate for as little as the cost of a single share, which is usually less than $100.
The REIT advantage for income investors
The other primary draw of REITs applies to investors who value receiving income from their investments. REITs have tax advantages that most companies don't have in that their REIT status lets them avoid income taxation at the corporate level. Instead, the only income taxes get paid by shareholders when they receive distributions of income from the REIT. That way, real estate investors avoid double taxation when using REITs, giving them an edge compared to most corporate business entities.
There are things that a real estate business has to do in order to qualify as a REIT, and that's where things get exciting for shareholders. REITs must invest at least 75% of their assets in real estate, and at least 75% of their income has to come from rental or other real-estate-related sources. REITs must have a diversified shareholder base of at least 100 investors, with no five investors having more than a 50% stake in the REIT. Most importantly, REITs must pay 90% of their taxable income to their shareholders in the form of distributions. Because of this last characteristic, dividend yields on REITs are typically higher than what you'd find with stocks, giving income investors an alternative to stocks that still leaves them the potential for capital appreciation if the REIT's underlying holdings grow in value.
The basics of exchange-traded funds
Exchange-traded funds have become extremely popular across the investing universe, with trillions of dollars pouring into the thousands of ETFs you can choose from now. ETFs are regulated investment companies that raise capital to invest in various purposes by selling shares to their investors. ETFs typically have specific investment objectives that they then follow in investing the money they've raised.
Most ETFs invest passively by tracking indexes that third-party providers create. Instead of actively choosing which investments to buy or sell, these index ETFs just buy the investments included in the index in the proportions that the index dictates. Their ultimate goal is to match the performance of the index, understanding that in most cases, they'll end up trailing the index's return by whatever amount they have to pay to cover their operational expenses and other costs.
The growth of ETFs has stemmed from many favorable attributes. Like REITs, ETFs offer even small investors with little money to invest a chance to get exposure to a wide range of diversified investments. A single share of an ETF often costs less than $100, but that one share can give you access to dozens or even hundreds of investments held within the ETF's portfolio. Rather than having to choose individual investments, an ETF investor can just own the entire universe of available investments in a particular area, benefiting from the general trends favoring that niche while avoiding the risk of choosing a specific company that turns out not to keep up with its peers.
There are thousands of ETFs, and they cover just about every investment strategy imaginable. ETFs cover stocks, bonds, commodities, foreign currencies, and other more specialized investments. Some ETFs offer complete coverage of an entire asset class, while others look only at specific industry sectors, geographical areas, or other subsets of investments within that broader area. An investor can choose the right ETF to match precisely to the desired investment objective.
ETFs are also relatively inexpensive to own. Because the ETF just has to match the performance of an index, it doesn't have to spend money on expensive things like investment research. Most stock brokers will charge you a commission to buy or sell ETF shares, but with discount brokers having rock-bottom commission rates, that's rarely a big concern. Moreover, some brokers actually offer commission-free ETF trading, which reduces the costs even further.
The ETF format also makes it easy for investors to buy and sell shares. ETFs are listed on major stock exchanges such as the New York Stock Exchange and the Nasdaq Stock Market, so whenever the stock market is open, ETF trading is available. As a result, ETF investors can react quickly if they see a reason to do so.
Finally, ETFs offer some tax advantages of their own. Although they have to pass through the income they earn, they typically offer favorable treatment when it comes to the rising value of the investments they hold in their portfolios. You'll pay taxes on the dividends they pay and on any capital gains you realize when you sell your ETF shares -- unless you hold the ETF in a tax-favored account, such as an IRA, 401k retirement plan, or 529 college savings account -- but unlike some other similar pooled investments, the timing of those taxable events will largely remain in your control.
What are the pros and cons of REIT ETFs?
The biggest benefit of REIT ETFs is that they let you get diversified exposure to just about every different type of REIT there is. It's true that REITs are already diversified because of their extensive real estate holdings, but it's rare for REITs to invest in more than one or two different types of properties. Investors are used to REITs being tied to a specific property class, and so a REIT that sought to be a jack of all trades in the real estate market wouldn't get the positive reception that you might expect.
In addition, REIT ETFs save you from the complexity of having to put together your own portfolio of individual real estate investment trusts. Especially in a taxable account, the hassles of accounting for multiple REIT purchases can be extensive. An ETF lets you make just a single investment, and that makes subsequent tracking easier.
There are two main downsides to REIT ETFs. First, using an ETF won't give you as good returns as you'd get if you made a successful bet on a specific, particularly well-managed REIT. In other words, diversification can work against you if you accept average returns for the sector rather than concentrating on the best players in the industry. In addition, ETFs impose an extra layer of fees, and although those costs aren't generally very high, they still represent a reduction in the amount of income you'll receive from your REIT investment.
What makes a good REIT ETF?
Once you've decided that REIT ETFs are a good way for you to invest in real estate, you'll need to decide which REIT ETF is the best. The first decision you'll need to make is whether you want to go with an ETF that concentrates on a particular type of REIT. For instance, some ETFs own only mortgage REITs or only equity REITs, while others offer a combination of both. As you'll see below, these two categories of ETFs have very different investing characteristics, making them attractive to discrete groups of investors.
Any REIT ETF should also consider the following issues in picking the most appropriate investment:
- Top ETFs tend to have larger assets under management because greater asset levels typically mean lower costs. Not only do big ETFs usually have lower expense ratios -- which are the charges that mutual fund and ETF companies pass on to their shareholders to cover the costs of management and administration of the fund -- but the associated costs of trading shares are lower with a large, easily tradable ETF than with a small, illiquid ETF.
- Conversely, the more specific an investment objective a REIT ETF has, the higher its costs tend to be. The lowest-cost funds tend to use a big-picture approach to REIT investing. Those that drill down on smaller segments of the REIT universe often have higher fees.
- Because each REIT already has diversified portfolios of real estate assets, the diversification benefits of a REIT ETF aren't quite as large as they are with other types of ETFs. Even so, there's still some benefit, because owning multiple REITs gives you exposure to multiple management companies overseeing their real estate portfolios, taking away the risk that one particular property manager has done a poor job of picking real estate and operating its holdings.
There's no one perfect ETF for every REIT investor, but the following REIT ETFs are among the best in the business. Each has its own approach toward investing in the REIT universe, with advantages and disadvantages that various investors will weigh differently.