Faith Morrow
Real estate investment trusts (REITs) and exchange-traded funds (ETFs) are both popular investment options. They each have their own advantages and drawbacks, and investors must consider their own financial goals and risk tolerance before deciding which option is best for them.
REITs are companies that own or finance income-producing real estate, and they are required to distribute at least 90% of their taxable income to shareholders as dividends. They have been proven to be a strong income-generating investment, offering high dividend yields and steady cash flow over time. However, investing in REITs may not offer enough diversification for a portfolio as it focuses on one very narrow sector of the market.
On the other hand, ETFs are diversified baskets of assets that trade like stocks on an exchange. They can hold a variety of assets, including stocks, bonds, commodities, and real estate. ETFs offer investors a simple and accessible way to gain exposure to the real estate market without having to buy physical properties. While ETFs provide instant diversification and passive portfolio management, they may not offer as high of dividend yields as REITs.
Ultimately, both options can be good investments, and it is important for investors to carefully consider their own financial goals and risk tolerance before deciding which option is best for them.
What You'll Learn
How do REIT ETFs compare to individual REITs?
Real estate investment trusts (REITs) and REIT exchange-traded funds (ETFs) are both investment options for those seeking exposure to the real estate market. While they share a similar objective, there are some key differences between the two.
Assets
REITs purchase and operate properties directly, whereas REIT ETFs invest in shares of publicly traded REITs. In other words, REITs buy properties, while REIT ETFs buy shares in REITs.
Diversification
REITs diversify their portfolios by investing in many properties within the same sector. On the other hand, REIT ETFs diversify their portfolios by investing in multiple REITs across different property sectors, making them more diversified.
Asset Selection
REITs typically go through a rigorous due diligence process before purchasing a single property and repeat this process for each new investment opportunity. In contrast, the asset selection process for REIT ETFs may be much simpler, with many opting for a market-weight strategy, where they buy shares of REITs based on their market cap.
Fees
Both REITs and REIT ETFs charge fees to investors, and it is important to understand the fee structure before making an investment.
Benefits
Both REITs and REIT ETFs offer potential benefits such as diversification, income through dividend yields, the potential for price appreciation, liquidity, and an inflation hedge.
Risks
Some risks associated with investing in REITs or REIT ETFs include price volatility, interest rate sensitivity, and taxable income on dividends.
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What are the benefits of investing in REITs?
Real Estate Investment Trusts (REITs) have become an increasingly popular way of investing in the real estate market. They offer a range of benefits, including:
Portfolio Diversification
REITs allow investors to diversify their investment portfolio beyond the stock market. They provide access to a variety of income-producing properties, including residential and commercial real estate, such as medical offices, gas stations, movie theatres, and farmland. This diversification helps to mitigate the risk and volatility associated with investing.
Liquidity
REITs offer liquidity, which means investors can easily buy and sell shares by logging into their brokerage account and making a trade. This provides flexibility and quick access to cash if needed.
Regular Income
REIT investors receive regular dividends, which can be a great source of passive income. REITs are required to distribute at least 90% of their taxable income to shareholders, and many pay out 100% of their earnings due to tax benefits. This provides a steady stream of income for investors.
Tax Benefits
REITs can offer tax advantages for investors. Dividends from REITs are taxed differently from traditional stock dividends, and there is no state withholding tax on REIT dividends. Additionally, REITs may provide tax-efficient capital appreciation and cash flow opportunities, especially for investors in zero- or low-income tax states.
Access to Institutional-Quality Assets
REITs provide individual investors with access to institutional-quality, large-scale real estate properties. They leverage economies of scale to purchase, manage, and optimise these properties, which may be out of reach for a single investor. This allows investors to participate in diverse and far-reaching real estate portfolios.
Overall, investing in REITs offers benefits such as portfolio diversification, liquidity, regular income, tax advantages, and access to institutional-quality real estate assets. However, it is important to note that there are also risks and drawbacks associated with REITs, and investors should conduct thorough research before making any investment decisions.
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What are the drawbacks of investing in REITs?
REITs can be sensitive to interest rate fluctuations as they often rely on debt financing for their operations. When interest rates rise, the cost of borrowing increases, which can impact the profitability of REITs and lead to a decline in their share prices. This is because REITs typically have higher dividend yields than other stocks, and when interest rates rise, income-seeking investors may opt for less risky alternatives with similar yield potentials, such as bonds.
REITs are also subject to market risk and can be volatile, especially in the short term. The value of REIT shares can fluctuate due to various factors, including changes in the real estate market, economic conditions, and investor sentiment. While diversification within the REIT sector can help mitigate some of these risks, it's important to recognize that REIT prices can be volatile, and there is a potential for capital losses, especially if one invests during a market peak.
Another drawback is the potential for low growth in the share price compared to other stocks. REITs are required by law to distribute at least 90% of their taxable income to shareholders as dividends. While this provides a steady income stream for investors, it also means that REITs may have less capital to reinvest in their business for growth initiatives. As a result, the share price appreciation of REITs may lag behind other sectors over the long term.
REITs also have limited diversification across industries and geographies. While there are different types of REITs specializing in various real estate sectors, the performance of REITs can still be closely tied to the overall health of the real estate market and the economy. A downturn in the real estate market or a specific geographic region can impact the performance of even well-diversified REIT portfolios.
Lastly, the tax implications of investing in REITs can be a drawback for some investors. The dividends received from REITs are typically treated as ordinary income, which is taxed at a higher rate than the qualified dividends received from stocks held for a certain period. Additionally, investors may also be subject to capital gains taxes when they sell their REIT shares for a profit. These tax considerations can impact the overall return on investment in REITs.
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How do I find the best REIT ETFs?
Real Estate Investment Trusts (REITs) are a special class of company that must deliver 90% of its taxable income back to shareholders in exchange for preferential tax treatment of its operations. This is because REITs require a lot of capital to own or maintain massive real estate holdings.
REITs are a great way to invest in real estate without the expenses and responsibilities of owning property. They are also more accessible than buying a rental property.
- Look for funds with $100 million or more in assets.
- Find ETFs with expense ratios of 0.40% or less.
- Seek out a yield of 2.5% or better.
- Vanguard Real Estate ETF (VNQ)
- Schwab U.S. REIT ETF (SCHH)
- Real Estate Select Sector SPDR Fund (XLRE)
- IShares U.S. Real Estate ETF (IYR)
- IShares Core U.S. REIT ETF (USRT)
REIT ETFs can be good investments as they provide investors with diversified exposure to the real estate sector, which has historically delivered attractive total returns.
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What are the largest REIT ETFs?
Vanguard Real Estate ETF (VNQ)
VNQ is the largest REIT ETF, with $27 billion in assets under management (AUM). The fund has a low fee structure and invests in approximately 165 companies, focusing on core-style equities in the mid-cap range. VNQ's yield is higher than its Morningstar category average, and it has a strong performance track record, outperforming its peers over the past three and five years.
Schwab US REIT ETF (SCHH)
SCHH is a sizeable REIT ETF with net assets of $7.3 billion. The fund is diversified across different types of real estate and has a low expense ratio of 0.07%. It is based on the Dow Jones Equity All REIT Capped Index and currently has Prologis Inc. as its largest holding, representing about 9% of the fund's assets.
IShares Core U.S. REIT ETF (USRT)
USRT is a broad-based REIT ETF with $2.8 billion in assets. The fund is based on the FTSE Nareit Equity REIT Index and has an internal expense ratio of 0.08%. USRT reported a one-year total return of 7.75% as of June 30, and it is expected to perform well in a falling rate environment.
The Real Estate Select Sector SPDR Fund (XLRE)
XLRE is a popular SPDR ETF with $7.7 billion in assets. The fund aims to replicate the performance of the S&P Real Estate Sector Index and has a low expense ratio of 0.09%. XLRE invests exclusively in equity REITs, with a focus on development and property management. It is ideal for investors familiar with the S&P 500 index.
IShares Residential and Multisector Real Estate ETF (REZ)
REZ is a REIT ETF focused on U.S. residential, healthcare, and self-storage real estate equities. These sectors have strong demographic tailwinds, such as the high demand for additional housing and the ageing baby boomer population. REZ has outperformed its Morningstar category over the past three, five, and ten years.
JPMorgan BetaBuilders MSCI U.S. REIT ETF (BBRE)
BBRE is a passively managed REIT ETF that tracks the MSCI US REIT Custom Capped Index, focusing on small- and mid-cap real estate firms. The fund has around 125 holdings, with its top 10 positions making up nearly 50% of its value. BBRE has outperformed its Morningstar category over the past one, three, and five years and has a low expense ratio.
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Frequently asked questions
A Real Estate Investment Trust (REIT) Exchange-Traded Fund (ETF) is a fund that invests in REITs, which are companies that own or finance income-producing real estate. REIT ETFs offer diversified exposure to various property sectors, reducing individual investment risk.
REIT ETFs provide investors with broad exposure to the real estate market and potential income through high dividend yields. They are also easily accessible, as they are traded on major stock exchanges, and can be purchased with relative ease through a broker or direct purchase program.
One drawback is that REIT ETFs may not offer enough diversification for your portfolio as they focus on a narrow sector of the market. Additionally, the dividend yields of REIT ETFs may be lower than those of individual REITs, and the fees associated with the fund can eat into the returns.
When looking for a REIT ETF to invest in, consider funds with a large asset tally and a low expense ratio. Look for funds with $100 million or more in assets and expense ratios of 0.40% or less. Also, seek out a yield of 2.5% or better to ensure regular payouts.
