Real estate investment trusts (REITs) and real estate mutual funds offer exposure to property investments, but in different ways. A REIT is a legal entity that owns and operates income-producing real estate and is required to pay dividends, while a real estate mutual fund is a pooled investment vehicle.
What Is a REIT?
A REIT is a trust that invests in real estate, typically through direct ownership. Those properties generate rental income, which is paid out to REIT shareholders in the form of dividends. The types of properties REITs may own can include:
• Hotels and resorts
• Self-storage facilities
• Warehouses
• Commercial office space
• Retail space
• Apartment buildings
• Strip malls
Some REITs take a different approach in how they generate returns for investors. Rather than owning income-producing property, they may invest in mortgage loans and mortgage-backed securities. A third category of REITs employs a hybrid strategy, investing in both properties and mortgages.
REITs may be publicly traded on an exchange, similar to a stock, or they may be registered with the SEC but not publicly traded. This second category of REITs can also be referred to as non-traded REITs. Regardless of how they’re classified, REITs are considered alternative investments.
💡 Quick Tip: While investing directly in alternative assets often requires high minimum amounts, investing in alternative assets through a mutual fund or ETF generally involves a low minimum requirement, making them accessible to retail investors.
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What Is a Real Estate Mutual Fund?
A real estate fund is a type of mutual fund that’s focused on the real estate sector. Mutual funds are pooled investment vehicles that allow multiple investors to buy shares and gain access to underlying investments. What a real estate mutual fund invests in can depend on its objective.
Real estate fund investments may include:
• REITs
• Individual properties
• Mortgages and mortgage-backed securities
A fund manager determines which investments to hold inside the fund. The frequency with which fund assets turn over can depend on whether it uses an active or passive management strategy.
Real estate funds can pay out dividends to investors, though not all of them do. Some real estate funds are exchange-traded funds (ETFs), meaning they have the structure of a mutual fund but trade on an exchange like a stock.
Like most funds, real estate mutual funds have annual fees in the form of expense ratios.
What Are Key Differences Between REITs and Real Estate Mutual Funds
The most significant differences between REITs and real estate funds lie in how they operate, how they generate returns for investors, and how they’re taxed. While both have the same overall goal of leveraging real estate for returns, they don’t approach that goal the same way.
How They’re Structured
REITs are companies that either own and operate income-producing real estate, invest in mortgages and mortgage-backed securities, or a mix of both. To qualify as a REIT, the company must pay out at least 90% of its taxable income annually to investors as dividends.
A real estate fund is structured as a pooled investment vehicle that can hold dozens of different investments. Many real estate funds concentrate holdings on REITs, with some focusing on a specific niche, such as commercial office buildings or shopping centers. Other real estate funds may hold real estate stocks.
Both REITs and real estate funds may be actively or passively managed. With an active management strategy, the fund manager’s goal is to beat the market. Passive management, on the other hand, aims to track the performance of an underlying benchmark. Real estate index funds, for example, may try to match the returns of the Dow Jones U.S. Real Estate Index (DJUSRE).
How They’re Taxed
How a REIT generates its income can determine how dividends paid to investors are treated for tax purposes. In most instances, dividends that result from the collection of rent payments are treated as ordinary income for the investor. If a REIT sells a property at a profit, however, those dividends would be treated as capital gains.
Investors who own REIT shares should receive a Form 1099-DIV each year that breaks down:
• Dividends from ordinary income
• Qualified dividends
• Capital gains
• Payments for return of capital
Qualified dividends are taxed at the long-term capital gains tax rate. This rate is lower than ordinary income tax rates for certain taxpayers.
Real estate mutual funds can also generate a Form 1099-DIV for investors when there are taxable distributions to report. Investors have to pay tax on income and/or capital gains they receive from the fund, including:
• Dividends
• Interest payments
• Capital gains from the sale of underlying assets
Ordinary dividends are taxed as ordinary income, while qualified dividends qualify for the long-term capital gains tax rate. Interest is also taxed as ordinary income in most cases, while capital gains are subject to the short- or long-term capital gains tax rate, depending on how long the assets were held.
Recommended: How Are Mutual Funds Taxed?
Key Investment Considerations
When debating whether to invest in a REIT vs. mutual fund, it’s important to consider your objectives, risk tolerance, and time horizon. Specifically, you may want to ask yourself the following:
• Is it more important to collect dividends for passive income or realize gains through capital appreciation?
• What degree of risk are you comfortable taking?
• Which real estate sectors are you seeking exposure to?
• How much capital do you have available to invest in REITs or real estate funds?
• How long do you plan to hold real estate investments in your portfolio?
It’s also helpful to look at the specifics of individual investments. For instance, if you’re interested in a REIT, you’d want to consider its past performance and typical dividend payout, the types of properties it owns, how the REIT is structured, and the fees you might pay.
With a real estate fund, it’s also important to look at the underlying assets and the fund manager’s strategy. While past performance isn’t a guarantee of future returns, it can give you insight into how the fund has moved in prior years. It’s also wise to check the expense ratio to see what owning the fund might cost.
Are There Similarities Between REITs and Real Estate Mutual Funds?
REITs and real estate funds are similar in two key ways. They’re both pathways to diversifying with real estate and in most cases, they’re highly liquid investments.
If you’re interested in leveraging the benefits of real estate investments in a portfolio but don’t want to own property directly, a REIT or real estate fund can help you accomplish your goal. How wide or narrow the scope of those investments ends up being can depend on the REIT or fund’s overall strategy.
Publicly traded REITs and real estate funds are relatively easy to trade. You just need a brokerage account to buy and sell either one on an exchange. If you were to buy a fix-and-flip property or a rental property, on the other hand, it could be more challenging to unload the investment once you’re ready to exit.
💡 Quick Tip: When people talk about investment risk, they mean the risk of losing money. Some investments are higher risk, some are lower. Be sure to bear this in mind when investing online.
Risks and Role of Real Estate in Your Portfolio
Real estate investments in general can act as an inflationary hedge in a portfolio. When consumer prices rise, rents tend to move in tandem. Real estate also has a lower correlation overall with the stock market, providing some added insulation against volatility.
However, there are risks involved in real estate investing, either through a REIT or real estate fund. The biggest risk factors include:
• Declines in property values
• Fluctuations in interest rates
• Demand for properties
Liquidity risk can also become an issue for REITs or real estate funds that have low trading volume. Building a diversified portfolio that includes real estate as one small slice can help with managing those risks. Evaluating your risk tolerance can help you decide how much of your portfolio to commit to REITs or real estate funds.
The Takeaway
REITs and real estate funds can play an important role in an investment portfolio if you’re hoping to move beyond stocks and bonds. Familiarizing yourself with how each one works and the potential risks is a good place to start. Once you’ve decided whether to invest in REITs, real estate funds, or both you can take the next step and open a brokerage account to start trading.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
FAQ
Are REITs a good investment?
REITs can be a good investment if the underlying assets perform well and generate consistent dividend income for investors. But there are no guarantees, and the real estate market comes with its own risks. Thus it’s important to consider the tax implications and the potential risks of REIT investing before getting started.
Are real estate funds a good investment?
A real estate fund can be a way to invest in property (or properties) without direct ownership. It’s possible to diversify a portfolio with multiple property types or sectors using only a couple of funds. Investors can benefit from dividends, capital appreciation, or a mix of both. But the real estate market is subject to interest rate risk, fluctuating trends, and more.
What are the risks associated with REITs and real estate funds?
The real estate market may not be influenced by the stock or bond markets, but real estate values can also be volatile, and prices in certain property sectors — or geographic areas — can rise and fall just as suddenly as equities. When investing in real estate directly or indirectly through REITs or real estate funds, be sure to do your due diligence about relevant risk factors.
Can you lose money investing in a REIT or real estate fund?
Yes, it’s possible to lose money in any type of investment, including real estate-related instruments like REITs and real estate mutual funds and ETFs. The underlying properties are not guaranteed to provide investors with a profit, so it’s important to understand what you’re investing in before you do so.
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