When building a diversified buy-and-hold portfolio, many investors utilize a well-balanced combination of fixed income and equity securities. Historically, investors have also embraced a material allocation to real estate; however, since the housing crisis, investors are still quite hesitant to jump back into this corner.
As the real estate market continues to grow, an allocation to this unique asset class should certainly not be overlooked.
Real Estate Investment Trusts (REITs) are securities that trade like common stocks on major exchange and invest in real estate directly, either via properties or mortgages. REITs have long been harolded as an attractive investment because these securities receive special tax considerations.
REITs must distribute 90% of their earnings to shareholders through dividends; furthermore, REITs are exempt from paying income taxes on the profits paid to their shareholders, meaning shareholders are responsible for paying taxes on earned dividends.
In general, there are two main kinds of REITs: equity and mortgage, which are separated by the type of investments they make. Equity REITs make their money by acquiring and managing residential and commercial properties. In contrast, mortgage REITs do not own any actual real estate; instead, these companies use leverage to buy mortgage-backed securities that yield a higher rate than the money borrowed.
Further delving into the space, investors can also fine tune their exposure to specific sub-sectors of the real estate space including residential and retail real estate.
See also Real Estate ETFs: 3 Things to Consider.
Thanks to the rapid development of exchange traded funds, there are now several options for investors looking to add real estate to their portfolios, including both equity and mortgage REIT options.
The most popular real estate ETFs are those that offer exposure to a variety of different types of REITs, including industrial and office, retail, residential, hotels and lodging, and real estate holding and development.
While there is some overlap between these broad funds, investors should note that some of these ETFs are quite different in terms of expenses, portfolio sizes, and yield. Below we highlight the top five broad U.S.-focused real estate funds:
|(VNQ )||Vanguard REIT ETF||0.10%||143||3.50%|
|(RWR )||SPDR Jow Jones REIT ETF||0.25%||92||3.42%|
|(IYR )||Dow Jones U.S. Real Estate Index Fund||0.43%||111||3.38%|
|(ICF )||Cohen & Steers Majors Index Fund||0.35%||31||2.84%|
|(SCHH )||U.S. REIT ETF||0.07%||93||2.03%|
|*All data as of 3/31/2015|
Industrial & Office REITs
The performance of industrial & office REITs greatly relies on rental rates. Rental rates are in turn dependent on demand for office space, which is influenced by numerous factors, including unemployment rates and anticipated commercial growth. For investors looking to tilt their real estate holdings towards this sub-sector, keeping a close eye on rental and vacancy rates is key.
Currently, there is only one ETF that offers targeted exposure to industrial REITs: iShares’ FTSE NAREIT Industrial/Office Index Fund (FNIO ). The ETF invests in roughly 35 individual holdings and is a bit top-heavy: the top two holdings account for more than one-third of FNIO’s total assets. FNIO charges an expense ratio of 0.48%.
Residential REITs focus on rental apartment buildings and manufactured housing. The biggest residential REITs tend to own properties in high cost regions such as New York or Los Angeles where they are able to charge higher rent.
Investors in residential REITs should keep a close eye on rental prices throughout the country. Other reports to track are building permits, housing starts, and new home sales, as all of these metrics help paint the overall picture of the health of the residential real estate market [see 10 of the Best ETF Trades of all Time].
iShares’ FTSE NAREIT Residential Index Fund (REZ ) is the only ETF that offers exposure to this targeted sub-sector. Its portfolio consists of approximately 35 holdings, the majority of which are large-cap REITs. REZ charges an expense ratio of 0.48%.
Retail REITs account for roughly a quarter of all REIT investments made in the U.S. These REITs make money from rent from their tenants, so it is important that the retailers are doing well in their businesses so that they able to pay their rent, and provide regular cash flow for the company.
Great indicators for the health of the retail sector are consumer confidence reports and consumer spending habits. Popular reports include the University of Michigan’s and the Conference Board’s Consumer Confidence monthly figures; monthly retail sales, reported by the U.S. Census Bureau, are also key to keep an eye on.
There is only one ETF that targets retail REITs – iShares’ Retail Real Estate Capped ETF (RTL ), which charges 0.48%. The fund holds nearly 35 individual REITs, including the popular Simon Property Group (SPG), which alone accounts for more than 20% of total assets.
As mentioned earlier, mortgage REITs differ from equity REITs in that these securities do not own actual property. Because these REITs invest directly in mortgages instead, they are considered to be riskier than their equity counterparts, and can often exhibit volatility.
Interest rates are crucial for investors of mortgage REITs to follow, as changes in interest rates are the biggest influence on mortgages. Other important reports to follow include foreclosure rates (the rate of default on the underlying assets) and mortgage delinquencies figures.
See also 101 ETF Lessons Every Financial Advisor Should Learn.
There are currently three ETFs that offer exposure to mortgage REITs, one of which is a leveraged fund:
|(MORL )||ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN||0.40%||25||17.22%|
|(REM )||FTSE NAREIT Mortgage REITs Index Fund||0.48%||38||14.57%|
|(MORT )||Market Vectors Mortgage REIT Income ETF||0.41%||25||7.97%|
|*All data as of 3/31/2015|
These funds are by far some of the highest yielding ETFs in the Real Estate ETF Database Category. Like the other targeted ETFs we’ve mentioned, Mortgage REIT ETFs have relatively small, top-heavy portfolios.
For those wanting to expand beyond the U.S., there are several international real estate options available. Investing in international REITs can add a great layer of diversification to investors’ portfolios, or may be more appropriate for those who are bearish on the prospects for the U.S. real estate market.
Below we highlight the top five global real estate funds. It should be noted, however, that some of these funds maintain exposure to U.S. markets.
|(RWX )||SPDR DJ Wilshire Intl Real Estate||0.59%||137||3.64%|
|(VNQI )||Global ex-U.S. Real Estate Index Fund||0.24%||628||3.92%|
|(RWO )||SPDR DJ Wilshire Global Real Estate ETF||0.50%||228||3.36%|
|(IFGL )||FTSE EPRA/NAREIT Global Real Estate ex-U.S. Index Fund||0.48%||200||3.41%|
|(WPS )||International Developed Property ETF||0.48%||390||3.78%|
|*All data as of 3/31/2015|
The Bottom Line
For investors, the appeal of adding real estate to a portfolio is simple: this asset class can provide stable, high, and inflation-fighting income, all the while providing diversification benefits. Investors should remember, however, that not all REITs are the same, and that each type of REIT is affected by different factors and can exhibit significantly different yields and performances.
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