It can be lucrative to invest in real estate, but it can also become a burden when you need to manage the property or if you want to buy or sell a property. If you are looking to broadly diversify your portfolio, to be more uncorrelated from the stock market, real estate is a good alternative. But how can you invest in real estate if you don’t have the cash at hand to purchase a full property? Or how would you invest if you don’t want to deal with the property itself? And how can you diversify by investing in different properties in different locations? This is what we will look at in this article.
What is a REIT ETF?
REITs pool money from investors to invest in a portfolio of income-generating real estate assets. ETFs track the performance of an underlying asset. A REIT ETF, therefore, tracks the performance of a REIT index.
If you want to learn more about REIT ETFs, read on.
What is a REIT in detail?
REIT stands for Real Estate Investment Trust. It is a particular type of investment intended to enable multiple investors to pool their money in different real estate areas. REITs offer stocks to their investors that lets them benefit by receiving a proportional share of the assets and the income the real estate fund distributes.
REITs can be divided into three main categories:
- Equity REITs: Own real estate directly.
- Mortgage REITs: Invest in securities associated with real estate mortgage financing, including mortgage loans and mortgage-backed securities, and similar derivatives.
- Hybrid REITs: As the name suggests, this type combines both of the variants mentioned above.
Equity REITs can further be classified based on the types of real estate they own:
- Residential real estate
- Retail real estate
- Healthcare real estate
- Energy storage real estate
- Industrial real estate
- Office real estate
- Hotel real estate
- Datacentre real estate
- Lumber real estate
The most significant advantage of REITs is that they allow investors to make a real estate investment with relatively moderate capital. Investing in real estate directly would require a considerably larger sum. A typical home in the U.S. costs around $200’000 – 300’000. Many commercial properties have sold for over $1 million in the past years. It would cost millions of dollars to put together a moderately diversified real estate portfolio. In contrast, REITs allow you to invest in real estate for as little as a single share, which can be as low as $100 per share.
What is an Exchange Traded Fund (ETF) in detail?
Exchange-traded funds have become hugely popular across the investment universe, with trillions of dollars pouring into thousands of ETFs. ETFs are regulated investment firms that raise capital to invest for various purposes by selling stocks to their investors. ETFs usually have specific investment goals that they pursue.
Most ETFs are tracking indexes and are therefore passively managed. They purchase the stocks contained in the Index, within the specified ratio. Their ultimate goal is to achieve the performance of the Index, minus the fund’s management cost, which is usually very low.
Like REITs, ETFs also offer small investors with little money the opportunity to invest in a wide range of diversified assets. A single share of an ETF will give you access to dozens or even hundreds of assets in your portfolio for the cost of less than $100.
Rather than choosing a single investment, an ETF investor can simply own the entire universe of investments available in a particular area and benefit from the general trends that favor that niche while avoiding the risk of choosing a particular one.
ETFs also make it easier for investors to buy and sell stocks. ETFs are listed on major exchanges like the New York Stock Exchange and the Nasdaq Stock Market, so ETF trading is available whenever the exchange is open. This enables ETF investors to buy or sell their ETFs at their convenience.
As ETFs only have to achieve an index’s performance, no research is required, which will cut down the costs of holding ETFs. Most stockbrokers charge you a commission for buying or selling ETF stocks, but discount brokers with the lowest commission rates will have low prices. Some brokers even offer commission-free ETF trading, which reduces the costs even further.
There are thousands of ETFs, and they cover almost every investment strategy imaginable. ETFs include stocks, bonds, commodities, foreign currencies, and other specialized investments. Some ETFs offer full coverage of an entire asset class, while others only map specific industries, geographic regions, or other sub-investment within this broader range. An investor can choose the right ETF that is precisely tailored to his desired investment objective.
Finally, ETFs offer some tax benefits too. Although they have to pass on the earned income to investors, they usually provide favorable tax treatment to increase the value of the assets. You pay taxes on the dividends and any capital gains you realize from selling your ETF stocks.
What are the advantages and disadvantages of REIT ETFs?
The most significant benefit of REIT ETFs is that they give you diversified exposure to almost all different types of REITs. REITs are already diversified due to their extensive real estate holdings, but they usually focus on only on up to 2 categories of real estate. Investors are used to REITs tied to a particular property class, so an all-rounder, REIT in the property market, would not get the positive response one might expect.
REIT ETFs save you the complexity of having to put together your portfolio from individual real estate funds. Especially with a taxable account, the problems of accounting for multiple REIT purchases can be demanding. An ETF allows you to make just one investment, which makes things much more manageable.
REIT ETFs have to pay 90% of the dividends to their shareholders.
Real Estate “enjoys” a certain protection against inflation and is, therefore, a relatively stable investment.
Using an ETF might not bring you the same returns that are possible from successfully betting on a single REIT under good management. In other words, focusing on the industry’s best players might be more lucrative than diversification.
ETFs are sensitive to market fluctuations. Therefore when prices fall, the impact on the ETF can be larger than when you invest in real estate directly.
ETFs have additional fees, and while these are generally low, they still represent a reduction in the returns you will get from your REIT investment.
The withholding tax is always due when the shares are sold. It doesn’t matter how long you’ve held the stock.
You might lose your shares if the company managing the ETF files for bankruptcy.
How high are the returns of REIT ETFs?
The returns of a REIT ETF will be similar to the returns of a stock. REIT ETFs tend to be less volatile than stock ETFs, but there isn’t any guarantee. As ETFs can be bought and sold at any time, there might be volatility during certain occasions. A good REIT ETF should be able to offer returns of at least 5%.
One of the significant benefits of REIT ETFs is that there is usually a good dividend paid through the rental income, and property appreciation can also be expected over time.
What to look out for when investing in REIT ETFs
If you’ve decided that REIT ETFs are the best way for you to invest in real estate, you need to decide which REIT ETF to purchase. For example, some ETFs only own mortgage REITs or only stock REITs, while others offer both. All these REIT ETFs have different characteristics suitable for specific types of real estate investors.
Top ETFs usually have more considerable assets under management. Larger assets mean generally lower costs. Not only do large ETFs tend to have lower expense ratios – that’s the cost that mutual funds and ETF companies pass on to their shareholders to cover the cost of managing the fund – but they can also be traded more quickly due to higher liquidity.
Conversely, the more specific the investment objective a REIT ETF has the higher its costs. Those who focus on smaller segments of the REIT universe often have higher fees.
Since every REIT already has a diversified portfolio of real estate investments, the diversification benefits of a REIT ETF are not quite as great as other types of ETFs. That said, owning multiple REITs will have the advantage of owning numerous management firms, eliminating the risk if one such firm goes bankrupt.
How do I buy REIT ETFs?
Check what REIT ETFs you want to purchase. Verify the holdings of the REIT ETF. Check if the REIT companies have the right strategic goals and invest in property, which is located in growing areas.
For example, in 2020, many companies noticed that productivity didn’t get impacted by letting people work from home during the pandemic. Due to this, many companies have adjusted their strategy and started to implement flexible and smart working. This means that real estate prices in office buildings might drop.
If this trend continues, people might get paid extra money to set up their home working environment, which could mean they search for properties that offer them an additional room that they can set up as office space.
It is advisable to choose an ETF that invests in various REITs. That spreads the risk particularly well.
Look at the prospectus, which will list out the details, risks, and fees. Make sure you understand everything that is in the prospectus.
You can then open an online brokerage account, or your bank might also have options, to invest in ETFs.