Real Estate vs. Mutual Funds: An Overview

Investment trusts in real estate (REITs) and mutual funds that invest in real estate provide the possibility of diversification and an affordable, easy option for investors who are looking to invest in different areas of the property market. They are also an efficient vehicle for investing in this field rather than investing in and buying real property directly.

There is a variety of REITs and mutual funds in the real estate sector to pick from. Before you decide to invest in either instrument, you must know the major distinctions between them, along with their advantages and disadvantages.

KEY TAKEAWAYS

• Investment in real estate assets can allow you to diversify your portfolio and boost yields.
• REITs are securities with a similar structure to shares, which enable investors to access to either debt- or equity-based property portfolios. REITs generally invest directly in mortgages or real estate.
• REITs can be classified as mortgage, equity, or hybrid.
• Mutual funds for real estate are funds managed by a fund manager who invests in REIT stock, real estate indexes, and supplies or both.
• REITs are generally more tax-efficient and cost-effective than mutual funds for real estate.

REITs

A Real estate Investment Trust (REIT) is a trust, corporation, or organization that directly invests in real estate via mortgages or properties. They are traded on the stock exchange and can be purchased and sold as stocks. REITs are able to pay dividends as a part of their structure. REITs are obligated by the Internal Revenue Service (IRS) to spend the majority of their tax-deductible earnings (90 percent or more) to shareholders in dividends. REIT firms, however, don’t have to pay corporate income tax. 1

At least 75% of a REIT’s assets must come from real estate, and at the minimum, 70% of their total income has to come from mortgage interest, rents, or the selling of the real estate. 1

The three most popular kinds include equity REITs mor, mortgage REITs, and hybrid REITs. 2

Equity REITs

Equity REITs are investors who own property like office buildings, apartments, malls, shopping centers, and hotels. They earn their money mainly by the rents they receive from properties they own or have shares in.

An equity REIT could invest across a wide range of sectors or concentrate on a specific segment like hotels, warehouses, residential properties, spitals, and so on.

Equity REITs generally offer a steady income. Because they generate revenue by taking rent, their income is fairly easy to predict and tends to grow over time.

A majority of REITs are an equity-based kind. 3

Mortgage REITs

The Mortgage REITs (or mREITs) invest in commercial and residential mortgages. They loan money to mortgages or buy mortgages that are already in place and mortgage-backed securities (MBS). While equity REITs typically earn income via rent, mortgage REITs make money through the payment of interest on their investment in debt.

Mortgage REITs generally perform better than equity REITs in times when rates are rising.

Hybrid REITs

Hybrid REITs are a mix of mortgage REITs and equity. They also own property and collect rents, and they make investments in mortgage-related securities. Investing in hard and mortgage assets and hybrid REITs such as Two Harbors take a more well-balanced approach and could be profitable from both falling and rising rates of interest. In contrast, traditional equity-only or mortgage-only REITs may struggle.

It is important to note that there are a small number of REITs that are hybrid-listed.

REIT Performance

REITs typically perform better when interest rates are declining, and rents are increasing. Because they are dividend-paying stocks, REITs are evaluated as other stocks. However, there are some major distinctions due to the accounting method used to assess the property. Because REITs purchase property, as an example, it is possible to see more debt than other types of firms.

Capital market conditions are important, particularly the demand from institutions for REIT equity. In the short term, the order could overpower the fundamentals. For instance, REITs were quite profitable in 2001 as well as the second half of 2002 despite weak fundamentals since cash was flowing into the whole sector.

At the level of individual REITs, you should see good prospects for growth in revenues, including rent income and related services revenue and FFO. It is important to determine whether it is the case that a REIT has a specific approach to increasing the occupancy of its properties and rising rents.

The sector of industry is also crucial because REITs that are specialized will have returns that differ based on the type of property in their possession. The chart below shows REIT sector-specific returns in 2023 (YTD). Timber and data centers are doing well, but infrastructure and properties that are diversified are sagging.

Real Estate Mutual Funds

Mutual funds are professionally managed pools of investments that invest in a range of instruments, including bonds and stocks. Investors buy the mutual fund units or shares that are purchased or exchanged at the actual Net Asset Value (NAV). NAVs are calculated each day and are based on the close prices for the security within the portfolio of the fund.

Mutual funds that invest in real estate are in REITs and operating real estate firms using experienced portfolio managers as well as expert research. They offer the opportunity to have a diversified coverage of real estate with only a small amount of capital. Based on their strategy and goals for diversification, They provide investors with an array of assets that are much larger and can be obtained by purchasing REIT stocks in isolation. They also offer the possibility of moving between funds.

One benefit of consumers who invest in retail is that they can benefit from the analysis and research data that the fund provides. This could include information about the acquisition of assets as well as management’s views regarding the viability and effectiveness of particular real estate investments in the context of an investment class. Speculative investors may put their money into a family or group of funds that invest in real estate. They can do this by strategically over-weighting specific types of property or regions to boost the return.

The real estate funds may be either closed- or open-end and can be actively or actively managed.

Real Estate Mutual Fund Performance

Since they mostly invest in REITs, the real estate mutual fund’s performance is closely related to the REITs they own. Mutual funds can, however, have less liquidity, are less tax-friendly, and have higher management costs than REIT ETFs or REITs. While mutual funds that invest in real estate bring the liquidity of a previously inaccessible asset class, many critics feel they’re not as efficient as direct investments in real property.

Special Considerations

The REITs, as well as the real estate mutual funds, provide individuals with small capital access to focused or diversified real estate investments since they have very minimal investment requirements. If it’s diversification they offer, both kinds of funds are able to reduce the risk.

Based on the approach to investing, mutual funds that invest in real estate can be a more diverse investment option than REITs. This could reduce expenses for transactions for investors looking for more diversification in just the same or a handful of funds. Additionally, they can reap the benefits of a professional portfolio manager and research.

REITs can generate dividend income as well as the potential for capital appreciation for investors who invest in the medium to long term. Recall that REITs have to distribute at least 90% of their tax-deductible income to shareholders every year through dividends. 1

Value of property can rise during times of inflation when property prices and rents increase. REITs, as well as real estate mutual funds, could provide a possible hedge against the rising cost of inflation.

Additionally, both types of real estate funds offer liquidity in what is normally an asset class that is not liquid.

Drawbacks

As with all investments, there are risks associated with investing in REITs as well as the real estate funds of mutual funds. Returns cannot be guaranteed.

As with the majority of sector-specific funds that are focused on real estate, it could become more unstable than other funds that have more expansive investment timeframes, for example, funds that track on the S&P 500 index. When there is a dip in the market for real estate, funds that are in this industry are impacted. However, the reverse is the case in the real estate sector, which is in a boom.