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7 Differences Between Real Estate Funds and REITs

Ellen Chang

Are you ready to invest in real estate?

Real estate funds and real estate investment trusts invest in office buildings, shopping centers, cell tower and data centers and provide both diversification and income through their dividend yields. They have many similarities since investors combine their funds to purchase shares of commercial real estate and earn income. One of the key differences is that REITs are traded like an exchange-traded fund or stock, while a real estate fund is a mutual fund that invests in securities offered by public real estate companies. Here are seven important differences between real estate funds and REITs.

REITs mimic stocks and ETFs.

A REIT is a corporation that invests directly in income producing real estate and a REIT is traded like a stock. A REIT's taxable income is paid out as dividends to shareholders who pay taxes on the dividends. Some REIT ETFs are broad in scope and invest in real estate companies with assets in the U.S., globally or in emerging markets. Others focus on a specific sectors such as data centers, cell phone towers, self-storage and manufactured housing communities. These alternative property types now make up a substantial part of the REIT universe and require special knowledge of these asset classes, says Michael Underhill, chief investment officer of Capital Innovations.

Real estate funds mirror traditional mutual funds.

Real estate funds offer the same benefits for investors who choose a mutual fund. The majority of real estate funds invest in commercial and corporate properties, but also may include investments in land and apartments, says Stuart Michelson, a finance professor at Stetson University in DeLand, Florida. "Real estate funds generally increase in value through appreciation and generally do not provide short-term income to investors as do REITs," he says. "Real estate funds gain value mostly through an increase in value of the assets." These funds provide diversification across multiple property sectors and geographies compared to a single REIT holding that may not provide that degree of diversification, Underhill says.

REITs invest directly into real estate.

Revenue from REITs is mostly derived from leases, rents or mortgages. A REIT is managed by a corporation or trust that owns a portfolio of properties or mortgages, says Mike Loewengart, chief investment officer at E-Trade Financial. "REITs are traditionally considered alternative investments since they have a low correlation to stocks and bonds, yet can be traded like a security," he says. Since REITs are required to distribute at least 90% of their taxable income, investors gravitate toward them because they provide a steady cash flow. The catch is that dividends are taxed as ordinary income, Loewengart says.

Real estate funds have higher expense ratios.

While real estate mutual funds provide diversification to an investor's portfolio and often generate excellent returns, the costs are generally higher than many other mutual funds, Michelson says. For example, the Pimco Real Estate Real Return Strategy Fund (ticker: PRRSX) has a 10-year return of 16.9% and 2.09% expense ratio, while the Vanguard Real Estate Index Admiral Shares (VGSLX) is much lower cost with a 10-year 15.4% return and 0.12% expense ratio. Investors pay higher fees in REIT mutual funds compared to ETFs because the funds provide access to active management by specialists with dedicated real estate securities analyst teams, Underhill says.

REITs now have a lower tax on income.

The new lower tax rate on income for REITs can be an advantage to investors. The IRS announced in January that effective for the 2018 tax year, income distributions from REITs held in mutual funds will be eligible for a new 20% pass-through deduction called Qualified Business Income (QBI). Instead of being taxed at the top tax rate of 37%, the tax on REIT ordinary distributions will now top out at 29.6%, Underhill says. The QBI deduction is available regardless of an individual's level of income or whether they itemize or take the standard deduction and will be provided to shareholders on form 1099.

Health care REITs are growing.

Health care REITs own and manage a variety of health care-related real estate and collect rent from tenants. The property types include senior living facilities, hospitals, medical office buildings and skilled nursing facilities. The largest health care REITs include Alexandria Real Estate Equities (ARE), Welltower (WELL) and Ventas (VTR).

Real estate funds are more attractive for buy-and-hold investors.

A real estate fund invests in real-estate focused securities but can also invest in REITs. These funds are more diversified and less likely to focus on one sector such as data centers. The funds are focused on capital appreciation and are intended for long-term investment strategies, Loewengart says. On the other hand, REITs are often used as an income generator. Both REITs and real estate funds can have significant expenses, so check out the management fees, he says. Real estate funds are an alternative to REITs if "your goal is for your principal investment to continue to grow because the IRS requires REITs to give 90% of profits back to investors annually, which are subject to federal tax," Michelson says. The profits from mutual funds remain in the fund unless you sell.

Know the differences between real estate funds and REITs.

-- REITs mimic stocks and ETFs.

-- Real estate funds mirror traditional mutual funds.

-- REITs invest directly into real estate.

-- Real estate funds have higher expense ratios.

-- REITs now have a lower tax on income.

-- Health care REITs are growing.

-- Real estate funds are more attractive for buy-and-hold investors.



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