For many securities-oriented investors, real estate provides an ideal way to diversify their overall portfolios (and indeed, real estate comprises one of only two asset classes that have outperformed inflation over the long term). However, owners of individual properties face the same risk as owners of individual stocks: If the value of the asset declines, then they can lose big.

Fortunately, investors have an alternative method of participating in the real estate market through real estate sector funds (see An Introduction To Sector Mutual Funds). This article examines the risks and rewards inherent in real estate funds, as well as some of the winners and losers in this category.

What Is a Real Estate Fund?

A real estate fund is a professionally managed portfolio of diversified holdings. Most real estate funds invest in commercial or corporate rental properties, although they do occasionally dabble in residential investments. This type of fund can invest in properties directly or indirectly through real estate investment trusts (REITs). Like stock funds, real estate funds can invest domestically, internationally or both.

Real estate funds allow small investors to participate in the profits from large-scale commercial real estate enterprises, such as corporate office parks and skyscrapers. They also provide the usual benefits of mutual funds, such as professional management and diversification. This last characteristic is key for these funds, as most investors do not have a sufficient asset base to participate in commercial real estate in any direct sense, unlike stocks, which may be purchased as individual shares at a much more reasonable cost.

Real Estate Funds' Historical Performance

Real estate funds generally follow the mainstream economy in terms of performance; during periods of inflation and economic growth, real estate will usually post strong returns, while it usually fizzles in periods of recession. Since the late '60s and early '70s, real estate funds have outperformed the stock market in some periods and underperformed it in others. The real estate sector goes through periods of expansion and contraction, just like all other sectors of the economy.

As with all other sector funds, real estate funds tend to be more volatile than broader-based growth funds or income funds. Investors can generally expect to be hit hard in these funds when the real estate market collapses, as they were in the subprime meltdown of 2008 that triggered the Great Recession. A long term view is definitely required.

Real Estate Funds: The Pros and Cons

Although real estate funds are usually either growth- or income-oriented, investors can generally expect to receive both dividend income and capital gains from the sale of appreciated properties within the portfolio. Real estate funds can defer capital gains through special rules, and funds that invest in REITs can  benefit from certain tax advantages. For this reason, tax-conscious investors may be pleasantly surprised when they receive their annual capital gains distributions.

While they offer more protection than individual holdings, real estate funds face several kinds of risk that are inherent in this sector of the market. Liquidity risk, market risk and interest rate risk are just some of the factors that can influence the gain or loss that is passed on to the investor. Liquidity and market risk will tend to have a greater effect on funds that are more growth-oriented, as the sale of appreciated properties depends upon market demand. Conversely, interest rate risk impacts the amount of dividend income that is paid by income-oriented funds.

The Bottom Line

The real estate market offers opportunities for both growth and income investors seeking long-term returns outside of the stock market. Real estate sector funds allow the small investor to participate in large-scale enterprises that would normally be far out of reach. Investors should understand the specific risks and rewards presented by real estate sector funds, but those who are willing to stay in for the long haul have historically reaped superior returns and competitive dividend income over time.

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