Real estate investment trusts (REITS) represent the shares of an individual real estate company, while REIT ETFs passively track indexes for the larger real estate market. These REIT indexes include a number of different types of REITs as components. The individual performance of REITs can vary widely. Many REITs are traded on major stock exchanges, but there are also a number of private and non-publicly traded REITs.
REIT ETFs that track indexes are passively managed and often have low expense ratios. By tracking an index, an investor can gain exposure to the larger real estate sector without having to risk capital on one individual company. On the other hand, more sophisticated real estate investors may wish to invest in a single REIT. The investor may want to focus on a REIT with good management, a strong business plan or a focus on a certain portion of the real estate sector. Still, for the investor who does not want to perform due diligence on a number of different REITs, REIT ETFs may provide an easy way to gain diversified exposure to real estate in one trade.
Types of REITs
There are three main types of REITs. Equity REITs invest directly in real estate properties. They generate revenue based upon the rent received from those properties. Generally, equity REITs specialize in owning certain types of property. They may focus on commercial office space, properties for health care and storage spaces among others. Equity REITs comprise nearly 90% of all REITs.
Mortgage REITs invest in property mortgages. These REITs may buy mortgage-backed securities (MBS) or even offer mortgages directly to property owners. These REITs make money from the interest received on the mortgages or from price appreciation in the value of the MBS.
Hybrid REITs are a combination of the other two types. They invest directly in properties as well as in real estate mortgages. They comprise the smallest percentage of the REIT sector.
Tax Advantages of REITS
REITs do not have to pay income taxes if they comply with certain federal regulations. REITs must distribute at least 90% of their taxable income annually to shareholders as dividends and distributions. At least 75% of the REITs’ assets must be in real estate, cash or U.S. Treasurys, with at least 75% of the income coming from rents, mortgages or other real estate investments. Finally, REIT shares must be held by a minimum of 100 stockholders.
Popular REIT ETFs
The Vanguard REIT ETF (VNQ) is the largest REIT in the sector and began trading in 2004. It invests in stocks issued by REITs and seeks to track the MSCI U.S. REIT index, the most prominent REIT index.
VNQ had over $46 billion in assets under management as of 2015, with a very low expense ratio of 0.12%. It pays an attractive dividend of over 4%. The fund has 145 stocks in its holdings. The top 10 largest comprised 36% of the fund’s net assets. Retail REITs had the largest allocation of holdings at 24.8%, with 17% of the fund's holdings in residential REITs and 16.7% in office REITs. VNQ returned 8.67% for the three years prior to 2015 and was up 8.84% since its inception.
The iShares U.S. Real Estate ETF (IYR) is the second-largest REIT ETF. IYR tracks the Dow Jones U.S. Real Estate Index. It began trading in 2000 and had $5 billion in management as of 2015. IYR has an expense ratio of 0.43%, which is higher than that of VNQ. The fund had 115 components and paid a dividend yield of 3.45% in 2014. Shares of IYR returned 7.6% over the three years prior to 2015 and returned 9.9% since inception. IYR's shares trade on the New York Stock Exchange.