Add Some Real Estate to Your Portfolio

Diversify with REITs and real estate mutual funds

Reviewed by Erika Rasure

Due to the capital-intensive nature of real estate investing, its requirement for active management, and the rise in global real estate opportunities, institutions seeking efficient asset management utilize specialized real estate funds of funds.

The same is true for retail investors, who can benefit from access to real estate mutual funds, allowing for efficient capital allocation and diversification.

Like any other investment sector, real estate has its pros and cons. It should, however, be considered for most investment portfolios, with real estate investment trusts (REITs) and real estate mutual funds seen as possibly the best methods of filling that allocation.

Key Takeaways

• Retail and institutional investors alike should consider real estate investment trusts (REITs) and real estate mutual funds for a diversified investment portfolio.
• REITs typically own and operate real estate properties such as residential units, shopping centers, malls, commercial office space, and hotels.
• Real estate mutual funds, which themselves invest primarily in REITs and real estate operating companies, can provide diversified exposure to real estate with a relatively small amount of capital.
• Many retail investors do not realize that they already may be investing in real estate directly by owning a home.

Barriers to Real Estate Investing

Real estate investment has long been dominated by large players such as pension funds, insurance companies, and other big financial institutions. Thanks to the globalization of real estate investing and the emergence of offshore opportunities that allow for a greater degree of diversification, as well as return potential, real estate now has a permanent place in institutional portfolio allocations.

The permanent allocation of real estate capital comes with certain unique hurdles. First and foremost, it is highly capital-intensive. Unlike stocks that can be purchased in small increments, commercial real estate investments typically require substantial sums up front, and direct investment often results in lumpy or illiquid portfolios and idiosyncratic risks based on location or property type.

Real estate also requires active management and maintenance, which is labor-intensive and costly. Compared to managing traditional investments, managing a real estate allocation requires significant resources and planning.

As a result of these issues, institutions tend to gravitate toward real estate funds and funds of funds. These same advantages can be achieved by retail investors through REITs. While individual REITs often own several properties, even greater diversification can be achieved via REIT exchange-traded funds (ETFs), as well as real estate mutual funds that each invest in several different REITs.

Here are several ways for retail investors to access the return potential of real estate and obtain exposure to the asset class.

Direct Investment

This strategy relates to investors directly selecting specific properties and purchasing them as investments. Often, these will include income properties that generate rental income in addition to any increases in market value.

The great advantage of this strategy is control. Direct ownership of property allows for the development and execution of strategy, as well as direct influence over return. However, direct investment makes it very difficult to create a well-diversified real estate portfolio. It also involves becoming a landlord along with all the additional costs, risks, and management headaches that it can bring.

For most retail investors, the real estate allocation is not large enough to allow the purchase of enough properties for true diversification. It also increases exposure to the local property market, as well as property-type risks.

Homeownership

Many retail investors who have not considered real estate allocations for their investment portfolios fail to realize that they already may be investing in real estate by owning a home.

Not only do they already have real estate exposure, but most are also taking additional financial risks by having a home mortgage. For the most part, this exposure has been beneficial, helping many amass the capital required for retirement.

Real Estate Investment Trusts (REITs)

REIT shares represent private and public equity stock in companies that are structured as trusts that invest in real estate, mortgages, or other real estate collateralized investments. REITs typically own and operate real estate properties. These may include multifamily residential properties, grocery-anchored shopping centers, local retail properties and strip centers, malls, commercial office space, and hotels.

REITs are run by a board of directors that makes investment management decisions on behalf of the trust. REITs pay little or no federal income tax as long as they distribute 90% of taxable income as dividends to shareholders.

Even though the tax advantage increases after-tax cash flows, the inability of REITs to retain cash can significantly hamper growth and long-term appreciation. Apart from the tax advantage, REITs provide many of the same advantages and disadvantages as equities.

REIT managers provide strategic vision and make investment- and property-related decisions, thus addressing management-related issues for investors. The greatest disadvantages of REITs for retail investors are the difficulty of investing with limited capital and the significant amount of asset-specific knowledge and analysis required to select them and forecast their performance.

REIT investments have a much higher correlation to the overall stock market compared to real estate investments, which leads some to downplay their diversification characteristics. Volatility in the REIT market has also been higher than in direct real estate.

This is due to the influence of macroeconomic forces on REIT values and the fact that REIT stocks are continuously valued, while direct real estate is influenced more by local property markets and valued using the appraisal method, which tends to smooth investment returns.

Note

Investors who don’t have the desire, knowledge, or capital to buy land or property on their own can participate in the income and long-term growth potential of real estate via real estate funds.

Real Estate Mutual Funds

Real estate mutual funds themselves invest primarily in REITs and real estate operating companies using professional portfolio managers and expert research. They provide the ability to gain diversified exposure to real estate using a relatively small amount of capital.

Depending on their strategy and diversification goals, they provide investors with a much broader asset selection than can be achieved by buying REIT stocks alone, and they also provide the flexibility of easily moving from one fund to another.

Flexibility is also advantageous to the mutual fund investor because of the comparative ease in acquiring and disposing of assets on a systematic and regulated exchange, as opposed to direct investing, which is arduous and expensive. More speculative investors can tactically overweight certain property or regional exposure to maximize return.

Creating exposure to a broad base of mutual funds can also reduce transaction costs and commissions relative to buying individual REIT stocks.

Another significant advantage for retail investors is the analytical and research information provided by the funds on acquired assets, as well as management’s perspective on the viability and performance of real estate, as both specific investments and an asset class.

Mutual funds, however, may be less liquid and carry higher management fees than REITs or REIT ETFs. Although real estate mutual funds bring liquidity to a traditionally illiquid asset class, naysayers believe they cannot compare to direct investment in real estate.

Warning

Mortgage lending discrimination is illegal. If you think that you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps that you can take. One such step is to file a report with the Consumer Financial Protection Bureau (CFPB) or the U.S. Department of Housing and Urban Development (HUD).

Do All Real Estate Investment Trusts (REITs) Pay Dividends?

Yes, due to federal regulation, for a company to be classified as a real estate investment trust (REIT), it must distribute at least 90% of its taxable income as dividends to shareholders.

Do I Have to Pay Taxes on Rental Income?

If you are a landlord, yes, you will have to declare rental income and pay taxes on it. Note that rental income is often considered passive income. If you have expenses related to the property, such as utilities, repairs, or insurance, you may be able to deduct those expenses against the rental income.

How Much of My Portfolio Should I Allocate to Real Estate?

Most experts agree that holding some real estate (direct or indirect) is a good idea for many investors. The amount that you devote to real estate will depend on several factors, such as your risk tolerance, time horizon, liquidity needs, and other real estate holdings. For instance, if you already own your own home, real estate may actually take up a large chunk of your overall wealth.

Additionally, if you work in a real estate-related industry, your income and labor prospects are already linked to the real estate market. Overall, advisors recommend that 5% to 20% of a portfolio be devoted to real estate (with differences in opinion on whether to include your home equity).

The Bottom Line

Although retail investors can and should take into account homeownership when making their portfolio allocations, they might also consider additional, more liquid investments in real estate.

For those with the requisite trading skills and capital, REIT investing provides access to some of the benefits of real estate investing without the need for direct ownership. For others who are considering a smaller allocation, or for those who don’t want to be saddled with asset selection but require maximum diversification, real estate mutual funds would be an appropriate choice.