What is the difference between a REIT and a real estate fund?

Investing, Real Estate
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May 2018

Both real estate funds and real estate investment trusts (REITs) are used when diversifying a long-term investment portfolio. A real estate fund is a type of mutual fund that primarily focuses on investing in securities offered by public real estate companies. The majority of real estate funds are invested in commercial and corporate properties, although they also may include investments in raw land, apartments complexes and agricultural space. This type of fund can invest in properties directly or indirectly through REITs.

How REITs Work

A REIT is a corporation, trust or association that owns or finances income-producing real estate. Their mode of operation is similar to that of a mutual fund where investors combine their capital to buy a share of commercial real estate and then earn income from their shares. REITs’ taxable income is paid out as dividends to their shareholders, who then pay income tax on the dividends.

Types of REITs

There are three main types or REITs, equity REITs, mortgage REITs and hybrid REITs. Equity REITs own, operate and trade hard real estate assets. Mortgage REITs trade commercial and residential mortgages. Hybrid REITs are a combination of equity and mortgage REITs. The majority of revenue associated with equity REITs comes from real estate property rent, while the revenue associated with mortgage REITs is generated from interest through mortgage loans.

Pros and Cons

Investments in both REITs and real estate funds have their benefits and drawbacks. The benefits of investing in REITs include their lower investment entry costs in that investors can invest as little as $500 or the price of one share. Secondly, REITs offer a highly liquid method of investing in real estate. Thirdly, REITs are highly flexible, allowing investors to invest in a range of real estate from commercial properties to shopping malls.

Real estate funds that invest in mortgage REITs provide higher yields than real estate funds that invest in equity REITs. Conversely, as equity REITs trade on assets and not on mortgage loans, capital gains are instead far more attainable for equity REITs.

Mortgage REITs don’t offer as much capital gains as equity REITs because an earned capital profit cannot be attained on a loan. Mortgage REITs’ potential for capital gains are correlated against interest rates, as the higher the interest rate, the greater the gain. Conversely, the opposite also applies. If mortgage rates fall, the REIT receives diminished interest payments and thus suffers a loss of expected income.

As REITs generally deliver more of an income, neither provides long-term capital appreciation. On the other hand, real estate funds that are not invested in REITs can offer capital appreciation and fund value appreciation.

Real estate fund investments allow investors to reap the same benefits they would if they were investing in a mutual fund, as they receive the same professional and portfolio management support. Real estate fund investments with direct real estate investments invest in assets, while real estate funds invest indirectly invest in REITs. An investor is, however, able to choose whether to invest in a real estate fund (that may or may not invest in REITs) or invest in REITs directly.

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