Unless you’re dreaming of becoming a landlord or trying your hand at flipping houses, real estate funds might be just the investment you’ve been looking for. There are a number of reasons why real estate holdings make attractive additions to a portfolio. If you’re interested in venturing into real estate funds, here’s what you need to know.
Real Estate Funds, Explained
To understand what a real estate fund is, you first have to know how a mutual fund works. Simply put, a mutual fund is a single collection of several different investments. For example, a fund may own a mix of stocks and bonds, or track the stocks in a particular index, such as the S&P 500 or the Dow Jones industrial average.
A real estate fund works similarly, except it only invests in real estate (either directly or indirectly). A real estate fund may own individual commercial properties, for instance, or invest in a collection of properties (think shopping centers and hotels). A real estate fund can also invest in real estate investment trusts, or REITs.
Real estate funds can be open-end or closed-end. An open-end fund allows you to enter or leave the fund as long as it remains active. A closed-end fund typically has one entry point and one exit point; you have to invest within a certain window and, once invested, cannot leave the fund until it’s run through its natural life cycle.
Like any other mutual fund, real estate funds can be passively or actively managed. Passive investment strategies typically try to mimic the performance of an underlying index. Take, for example, the Vanguard Real Estate Index Fund. The VGSIX, as its known, tracks the performance of the MSCI US REIT Index, which in its own right tracks domestic equity REITs.
With an actively managed investment strategy, the fund manager oversees the buying and selling of the underlying assets within the fund. Instead of trying to match the performance of an underlying index, actively managed funds attempt to beat it. The Cohen & Steers Global Realty Shares Fund (CSFAX) is one example of a real estate fund that relies on an active management strategy to drive investor returns.
Real Estate Funds vs. REITs: What’s the Difference?
Yes, real estate funds and REITs both invest in real estate. But no, they are not the same thing.
As noted above, a real estate fund operates just like any other mutual fund, in that you’re pooling your money with other investors and sharing in the fund returns. You can invest in a real estate fund through an online brokerage, paying a flat expense ratio to own the fund each year.
An REIT is different — it’s a corporation that invests directly in income-generating real estate and is traded like a stock. These trusts can take either a broad or narrow approach to their holdings. For example, Boston Properties (BXP) invests primarily in office space in major markets like San Francisco and New York. Realty Income (O), on the other hand, invests in commercially leased properties that span different industries.
The way returns are delivered to investors differ, too. With a mutual fund, investors can realize profits from price fluctuations, assuming they buy the REIT at one price and sell it at a higher price. Some real estate funds can also pay out dividends to investors periodically.
REITs, in comparison, are required to pay 90% of their taxable incomes as dividends to investors. In that respect, REITs can offer income to investors more quickly than a real estate fund, since dividends are paid out regularly, usually on a monthly or quarterly basis. REITs also pass on some of the benefits of direct ownership to investors, such as depreciation, without requiring them to actually own property.
Should You Invest in Real Estate Funds?
Real estate investments in general are considered solid additions to any portfolio. But real estate funds specifically offer several unique advantages. Here are some of the top reasons to consider real estate funds over REITs or direct ownership of rental property.
- Diversification: Stocks and bonds may be the obvious go-to choices for a portfolio, but real estate adds a new dimension of diversification. Because real estate has a low correlation to stocks in general, it allows you to balance out the risk. Real estate funds themselves can also be highly diversified — a fund like U.S. Diversified Real Estate ETF (PPTY), for example, invests in real estate in a number of locations and across a variety of property types.
- Volatility hedge: When the stock market becomes volatile, real estate funds can act as a stabilizer in your portfolio. Since real estate performance and returns aren’t necessarily dictated by the direction stock prices move, real estate funds can continue to do well even when stocks falter.
- Inflation hedge: Inflation and rising prices for consumer goods can be problematic for investors, since stock prices may drop. But if demand for real estate remains high during inflationary periods — and consumers aren’t in a position to buy — real estate investors can benefit from rising rents.
- Professional management: Whether a real estate fund is actively or passively managed, there’s a fund manager behind the scenes directing the investment strategy for you.
- No landlord duties: Owning a rental property can be a headache if you have to chase down rent, not to mention having to keep up with required maintenance. Owning a real estate fund, on the hand, comes with none of those stressors.
- Low costs: Your primary investment cost in a real estate fund is its expense ratio. Some of the top real estate funds have low expense ratios, allowing you to keep more of your returns. The iShares Core US REIT ETF (USRT), which invests in U.S.-based REITs, has an expense ratio of just 0.08%, for example.
- Performance: Real estate funds deliver stable returns to investors that may match or even surpass what you’d get with other real estate investments or mutual funds. The T. Rowe Price Real Estate Fund (TRREX), for instance, notched a 10-year return of 12.69% as of October 31, 2019. VGSIX boasted a 10-year return of 13.39% through the close of November 2019. The average 10-year return for the S&P 500 is 13.60%, suggesting that real estate funds are capable of holding their own against stocks.
The Bottom Line
While there are plenty of reasons to consider real estate funds, remember that some risk is still involved. Real estate, though historically a strong performer, does experience the occasional rough patch, as it did during and immediately after the 2008 financial crisis. And as with all investments, diversity is key to balancing potential risks: Think of real estate funds as just one slice of the pie, not the whole pie itself.
Tips for Investing in Real Estate Funds
- When considering a real estate fund, research the fund’s past performance, its underlying assets, whether it’s diversified or non-diversified, and how actively or passively it’s managed. Also pay attention to the expense ratio. Remember, the lower the expense ratio, the more of your returns you get to keep. Finally, look at the age of the fund and the fund manager’s track record before investing.
- Consider talking to a financial advisor to get detailed insight into investing in real estate funds and how they can figure into your overall retirement savings plan. Not only can an advisor help you determine if real estate is a crucial missing piece in your portfolio, but they can also point you to which funds best suit your goals.
- If you don’t have an advisor yet, finding one who fits your needs doesn’t have to be difficult. SmartAsset’s free tool matches you with financial advisors in your area in just 5 minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
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