Millions of Americans own real estate, and even though most investors think of stocks and bonds when they're looking to invest, real property can make a good choice for those seeking good returns on their capital. Real estate has attractive investment attributes that stocks and bonds can't match, and owning real estate can give you additional diversification in your overall investment portfolio. In some cases, investing in real estate can help offset losses in other investment holdings, preserving the total value of your total investments. Moreover, there's only a finite amount of real estate in the world, and especially in certain locations, scarcity has led to impressive long-term returns for real estate investors.
Investing directly in real estate can be lucrative, but it's also challenging. Doing research on particular individual properties is time-intensive, and transactions can take a long time to complete. For those who like how quickly they can buy and sell stocks, one alternative is to invest in real estate investment trusts. As you'll learn in more detail below, real estate investment trusts, or REITs for short, put together portfolios that have dozens or even hundreds of properties, offering their shareholders the ability to share in the income and appreciation that the REIT's real estate holdings produce. With hundreds of different REITs to choose from, many real estate investors prefer to use exchange-traded funds that in turn let them own stakes in dozens of REITs in a single investment. Low costs and the ability to invest more efficiently in real estate make ETFs an attractive option for those seeking to add real estate investments to their portfolios.
Below, you'll learn more about ETFs and REITs, and then we'll reveal some of the top REIT ETFs in the business along with detailed information about how they work and what their pros and cons are. That way, you'll be able to figure out whether REIT ETFs are worth a closer look in your portfolio.
REITs let you invest in real estate beyond simply owning your primary residence. Image source: Getty Images.
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, 401(k) 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.
Four top REIT ETFs
Assets Under Management
5-Year Total Return
Vanguard Real Estate (NYSEMKT: VNQ)
Schwab US REIT (NYSEMKT: SCHH)
iShares Mortgage Real Estate (NYSEMKT: REM)
iShares Residential Real Estate (NYSEMKT: REZ)
Data sources: Fund providers and ETFdb.com. Data as of Dec. 31, 2018.
Two all-purpose choices for REIT investors
If you want broad-based REIT coverage, then the Vanguard Real Estate ETF and the Schwab US REIT ETF are both solid choices. The Vanguard offering is the older and larger of the two, commanding the industry with a huge investor base. The ETF holds almost 200 different stocks, with substantial allocations to retail, residential, office, healthcare, industrial, and hotel REITs, as well as more specialized real estate investment trusts. The ETF also has some exposure to real estate operating companies that aren't REITs, but those holdings add up to less than 5% of the fund's total assets.
The Schwab ETF has a similar focus, but the index that it tracks has focused solely on REITs. Among its top 10 holdings, you'll see REITs specializing in shopping malls, industrial properties, self-storage facilities, healthcare property, residential, office, and digital communications. The fund holds about 115 stocks -- somewhat less than the Vanguard ETF, but it still has plenty of diversification.
Either of these two ETFs can do a good job of giving you broad-based coverage of the REIT sector. Vanguard's larger fund offers a bit more trading liquidity, but Schwab's expense ratio is lower. Investors can get commission-free trades by opening brokerage accounts with the two respective fund managers.
Two smaller, more specialized plays
Meanwhile, ETF giant iShares offers a couple of ways to play the two subsets in the REIT universe. iShares Mortgage Real Estate owns primarily mortgage REITs, giving investors focused exposure to these mortgage-related investments. The biggest feature for investors from mortgage REITs is that they tend to have extremely high dividend yields, and that explains why the ETF's SEC yield currently exceeds 10%. Dividends contribute a huge portion of iShares Mortgage Real Estate's overall returns, but investors need to understand that the fund can be extremely volatile -- especially during periods when interest rates are moving higher.
In particular, mortgage REITs take on a type of risk that most other REITs avoid. In order to generate more income, mortgage REITs routinely borrow substantial amounts of money, which they then turn around and reinvest in additional mortgage-backed securities. It's not uncommon to see mortgage REITs borrow several times as much money as they raise from shareholders, but as long as the mortgage REIT can earn a greater return on those securities than it pays in interest on its loans, the strategy results in greater profit for shareholders. However, if the value of the mortgage REIT's investments drops, then the high leverage involved can cause much greater losses than traditional REITs would experience in a similar real estate environment.
The iShares Residential Real Estate ETF lets investors drill down on the real estate market that's directly related to residential living. This includes not just REITs that own apartment buildings and other multifamily properties but also senior living and assisted living facilities. You'll also find self-storage operations within the ETF's portfolio. By concentrating on the residential side of the business, iShares Residential Real Estate avoids exposure to commercial real estate, letting investors manage their risk in whatever manner they see fit.
Do REIT ETFs belong in your portfolio?
If you're looking for the income and growth potential that real estate offers but don't want to deal with the hassles involved in investing in and owning individual pieces of property, then REITs can be an attractive way to add real estate exposure to your portfolio. With REIT ETFs like the ones listed above, you'll be able to get maximum diversification while still tailoring your holdings to the specific objectives you have for your investments.
Not all investors own real estate investments, and you can earn solid returns without bothering to go beyond traditional stocks and bonds. But if the idea of real estate investing appeals to you, or if the diversification has value in your investment strategy, then consider these top REIT ETFs as an option for a portion of your investment assets.
More From The Motley Fool
- 10 Best Stocks to Buy Today
- 3 Stocks That Are Absurdly Cheap Right Now
- 5 Warren Buffett Principles to Remember in a Volatile Stock Market
- The $16,728 Social Security Bonus You Cannot Afford to Miss
- The Must-Read Trump Quote on Social Security
- 10 Reasons Why I'm Selling All of My Apple Stock