REITs vs. Real Estate Mutual Funds: An Overview
Buying and selling property is among the oldest investments. It’s also classically the least accessible. Real estate investment trusts (REITs) and mutual funds offer far easier ways for retail investors to buy a stake in the real estate market. They are also more liquid than owning properties directly.
There are a wide variety of REITs and real estate sector mutual funds to choose from. The Financial Industry Regulatory Authority lists 406 real estate-related mutual funds, and the FTSE All REITs Index has 194 REITs. Before considering either, you need to understand the differences between them and their pros and cons. We take you through these below.
Key Takeaways
- Investing in real estate assets can help diversify a portfolio and increase returns.
- REITs trade like other shares on the major exchanges and give investors access to either equity or debt-based real estate portfolios.
- REITs may be categorized as equity, mortgage, or hybrid in nature, depending on their holdings.
- Real estate mutual funds are managed funds that invest in REITs, real estate stocks, and indexes, or all three.
- REITs tend to be more tax-advantaged and less costly than real estate mutual funds.
REITs
A REIT is a company, trust, or association that invests directly in real estate through properties or mortgages. REITs trade on stock exchanges and are bought and sold like stocks. The Internal Revenue Service requires them to pay out most of their taxable profits (90% or greater) to shareholders via dividends annually. 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 rent, mortgage interest, or gains from the sale of the property.
The three major types are equity REITs, mortgage REITs, and hybrid REITs. However, as interest in them waned during the financial crisis, the National Association for Real Estate Investment Trusts (Nareit) stopped publishing data on hybrids. There are prominent hybrids, though they are still few in the mid-2020s.
Equity REITs
Equity REITs own and invest in apartments, office buildings, shopping malls, hotels, and other properties. Their revenues are mainly generated from rent, and they also distribute capital gains.
An equity REIT may invest broadly or focus on a particular segment, such as storage units, residential properties, warehouses, hospitals, and so on.
Equity REITs generally provide stable income. Because they generate revenue by collecting rent, their income is relatively easy to forecast and tends to increase over time.
Equity REITS make up about 80% of all such trusts.
Mortgage REITs
Mortgage REITs buy stakes in residential and commercial mortgages. They loan money for mortgages or buy existing ones along with mortgage-backed securities. While equity REITs typically generate revenue through rent, mortgage REITs get their income from the interest on the debt they hold.
When interest rates rise, mortgage REITs tend to do better than equity REITs. Below is a chart showing the percentage change in annual returns for equity and mortgage REITs, along with the fluctuations of average interest rates for fixed-rate 30-year mortgages over the same period.
Investopedia / Peter Gratton
Hybrid REITs
Hybrid REITs combine holdings in equity and mortgage REITs. They own properties, collect rent, and invest in mortgage securities. By investing in both mortgages and real estate, hybrid REITs such as Two Harbors Investment Corp. (TWO) balance the two, potentially profiting in both rising and falling interest-rate environments.
REIT Performance
REITs do well as interest rates fall and rents rise. As dividend-paying trusts, REITs are analyzed like other stocks but are valued differently given the metrics used to assess real estate portfolios. Their sensitivity to interest rates is among the most important implications of owning a stake in them. Due to their relatively high dividend yields, REITs are often considered bond proxies. When interest rates fall, the dividends paid by REITs become more attractive relative to bonds, enhancing their appeal to investors.
Individual REITs should be reviewed to see if they have solid prospects for growth in rent, service income, and funds from operations (FFO). Having a distinctive strategy to boost occupancy rates and rent is a major plus.
REITs react strongly to changes in economic fundamentals. Broader economic factors, such as gross domestic product growth, unemployment, and consumer spending, affect property demand and rental prices, which in turn affect revenues.
A REIT’s industry sector also influences returns. The chart below shows 2023 REIT returns by sector. All were bouncing back after a devastating 2022 when interest rates and the lingering pandemic left the real estate industry with barren downtown office buildings and a near-frozen housing market. Overall, equity REITs were down 25.0% in 2022 and averaged a bounceback of 11.4% in 2023. For mortgage REITs, the numbers were similar, with a downturn of 26.6% in 2022 and a rise of 15.4% in 2023.
Capital market conditions are also necessary, namely the institutional demand for REIT equities. In the short run, this demand can overwhelm fundamentals.
The industry sector also matters as specialized REITs will see returns that depend on the sector of properties they might specialize in. The chart below depicts REIT returns by sector for 2023. Data centers and regional malls were quite strong. Less so was office space, still hampered by the slack left over from the pandemic and the move to remote work.
Real Estate Mutual Funds
Mutual funds are professionally managed, pooled investments in various vehicles, such as stocks, bonds, and real estate. Shares or units in them are bought or redeemed at the fund’s end-of-day net asset value, which is calculated daily based on the closing prices of the securities in the fund’s portfolio.
Real estate mutual funds invest 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 using a relatively small amount of capital. Depending on their strategy and diversification goals, they can give you a broader asset selection than can be achieved by buying REIT stocks alone. You can also quickly move from one fund to another, though you’ll want to check for any back-end loads or applicable redemption fees.
The major advantage of these funds is the management’s analysis and research—a deep dive you can forego in what are often murky waters. 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 put money into a family of real estate mutual funds, tactically buying more for certain property types or regions.
Real estate mutual funds can be open- or closed-end and are 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 the REITs they hold. Mutual funds, however, may be less liquid, can be less efficient for your taxes, and can have higher management fees than REITs or REIT ETFs.
Accessibility and Benefits of Real Estate Mutual Funds
REITs and real estate mutual funds offer those with limited capital the chance to access both diversified and concentrated real estate investments. These funds are attractive because of their relatively low investment minimums. By offering diversification, they help mitigate risk, providing a safer investment landscape for those not looking to directly invest in property.
Real estate mutual funds, depending on their investment strategy, can offer even broader diversification than REITs. This extensive diversification can significantly cut transaction costs for investors who prefer to put their funds in a few diversified investments. In addition, they offer professional portfolio management and extensive research, which is very appealing for those without the time or experience to work through real estate market data, etc.
Both REITs and real estate mutual funds offer dividend income and the potential for capital appreciation, which are important to medium- to long-term investors. As we noted, too, REITs are required by law to distribute at least 90% of their taxable income to shareholders annually through dividends.
Additionally, the value of real estate typically increases during periods of inflation, as property prices and rents rise. So, both REITs and real estate mutual funds can help hedge against inflation, preserving your capital in real terms.
Lastly, these investments are far more liquid than direct real estate purchases, which are listed in every textbook as among the least liquid of assets. This fact alone makes REITs and real estate mutual funds appealing for those want the freedom to move their assets quickly should the need arise.
Drawbacks
As with any investment, there are risks to investing in both REITs and real estate mutual funds. Returns are not guaranteed.
All sector-specific funds, including those in real estate, are often more volatile than funds with broader holdings, such as a fund tracking the S&P 500 index. As the real estate market falters, funds in this sector suffer. Of course, the opposite is true if 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 buy properties. When interest rates go up, so does the cost of borrowing, which cuts into profits.
REITs vs. Real Estate Mutual Funds
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Formed as a corporation, trust, or association.
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Invests directly in real estate through properties or mortgages.
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Trade like stocks.
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Must pay dividends equal to 90% or more of their taxable profits.
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Professionally managed investment funds that can invest in many assets.
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May invest in REITs or real estate operating companies.
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Can offer a broader variety of assets.
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May be less liquid and be less tax favorable than REITs.
REIT vs. Real Estate Mutual Fund Example
If you want to invest in New York City’s dynamic and notoriously pricey real estate market, you might want to look at the appropriately named Empire State Realty Trust Inc. (ESRT)—a REIT that can claim the iconic Empire State Building among its properties. Its portfolio includes eight retail and eight office properties in Manhattan and the New York City metro area. At year-end 2023, ESRT had assets valued at about $4.2 billion, with revenues of 192 million and expenses of 152 million. It paid dividends of $0.035 a share, with a second-quarter 2024 price-to-earning ratio (trailing 12 months) of 30.25.
T. Rowe Price Real Estate (TRREX) is a real estate mutual fund with diverse holdings. It holds shares broadly in REITs and publicly traded real estate firms, including Public Storage and Prologis. A steady firm—its turnover is 10%—it has an expense ratio of 0.82% and distributions per share of $0.33 for income and $1.08 for capital gains in 2023. At the same time, it had three, five, and 10-year returns of -1.49%, 0.99%, and 4.03%, respectively.
What Is a Non-Traded REIT?
Non-traded REITs are private funds 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 are exchange-traded funds (ETFs) that put 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 domestic, publicly traded REIT market.
What Is a Paper Clip REIT?
A paper clip REIT seeks to maximize the tax advantage of real estate investment trusts, while allowing the company to run properties that the trusts normally can’t. Such REITs are scrutinized extensively since their fiduciary obligations are owed to different shareholder groups, with inherent conflicts present. For instance, decisions that maximize profits for the operating company might not be in the best interests of the REIT’s shareholders, especially if they reduce dividends or increase their risks.
What Is a Triple Net REIT?
A triple net REIT is an equity REIT that owns commercial properties using triple net leases. In these, the tenant must pay the costs of structural maintenance and repairs, rent, property taxes, and insurance premiums. The landlord generally charges a lower base rent because these additional expenses are passed to the tenant. This takes much of the risk from the REIT.
The Bottom Line
REITs and real estate mutual funds have their differences. Still, they are similar in that they offer liquidity and an accessible way to get exposure to diversified real estate assets. For retail investors without significant capital, these funds are an avenue for investing in properties that might otherwise be out of reach.
Long-term investors, in particular, can be rewarded with dividend income and capital appreciation down the line. Before investing in either, ensure you understand the pros and cons of each. It’s always prudent to seek out a financial advisor, in this case, one who knows different real estate investments and which, if any, would best fit your needs.