This is the fourth article in our series about ways to invest in real estate and focuses on real estate funds.
So far, we’ve contrasted REITs to direct ownership of property, crowdfunding, and mortgage-backed securities as ways to invest in real estate. Our next category is real estate funds, and they are remarkably similar to REITs. All are pass-through securities backed by a collection of real estate properties. However, certain differences distinguish each type of fund from REITs and from each other. The three fund types are:
- Private real estate investment funds
- Real estate exchange-traded funds
- Real estate mutual funds
Private Real Estate Investment Funds (PREIFs)
Private real estate investment funds are professionally managed private funds that invest directly in real estate properties. They are available to accredited (i.e., high-net-worth) investors and usually require a substantial minimum investment. They are most directly comparable to private REITs.
PREIFs differ from private REITs in several ways:
- Typically, PREIFs aim for capital gains as much as income. The model is to invest in properties for a fixed time period, such as five years, and then sell the properties for a capital gain. REITs usually concentrate on income rather than capital gains.
- Many PREIFs have relatively low fees compared to private REITs.
- Some PREIFs provide monthly dividends. Private REITs typically pay dividends quarterly.
- You purchase both types of private shares directly from the issuer through a private placement.
- American REIT investors are eligible for a 20% qualified business income deduction on REIT income. It is not clear whether PREIF investors are eligible for this deduction because the benefit does not extend to regular rental income. Check with your tax advisor for details.
Here is a comparison of PREIF and private REIT characteristics:
| CHARACTERISTIC | COMMENT |
|---|---|
| Minimum investment | High |
| Liquidity | Low. You must hold private shares for at least one year before you can sell them to the public. Even then, you must find a buyer and arrange the sale. |
| Control | Control Low. You control what investments to make, but have no control over the underlying real estate or mortgage portfolios. |
| Diversification | Variable. The number and sector(s) of properties owned by a REIT or PREIF can vary widely. |
| Leverage | High. Underlying properties use mortgages for leverage. You can increase the leverage by purchasing on margin, to the extent it is available for a private transaction. |
Real Estate Exchange-Traded Funds (ETFs):
Real estate ETFs own the shares of real estate corporations and REITs. Both ETFs and public REITs trade at their share price on public exchanges, just like normal corporate stock. Both have a fixed number of shares that can increase only through a secondary public offering. Both types of securities trade publicly in the secondary market on stock exchanges and can be shorted. As such, you can freely buy and sell shares at any time the exchange is open at the current market price. That price depends on supply and demand for the shares rather than net asset value (NAV), although the two should closely align.
ETFs can own REIT shares and shares of corporations in the real estate industry. Many ETFs are REIT index funds, meaning their portfolios mirror the contents of REIT indices, such as the FTSE Nareit All Equity REITs Index. Index ETFs are not actively managed and usually have extremely low fees. The only time an index ETF’s portfolio changes is when the index changes. In America, ETF income derived from REITs is eligible for the 20% qualified business income deduction. In addition, ETF structures protect investors from capital gains. Options trading is available for ETFs and REITs.
Here is a comparison of real estate ETF and public REIT characteristics:
- Lack the ETF redemption/creation feature that drives market prices toward NAV. This means that CEFs often trade at prices substantially different from their NAVs.
- Are not structured to protect investors from capital gains.
Here is a comparison of real estate CEFs and public REIT characteristics:
| Characteristic | Comment |
|---|---|
| Minimum investment | Low. You can buy a single share. |
| Liquidity | High. Both trade in active secondary market. |
| Control | Low. You control what investments to make, but have no control over the underlying portfolios. |
| Diversification | ETFs have high diversification because they own multiple REITs as well as corporate shares. A REIT has some diversification because it owns multiple properties, but usually in a single real estate sector. |
| Leverage | High. Underlying properties use mortgages for leverage. You can increase the leverage by purchasing shares on margin. However, ETFs cannot increase leverage by issuing debt or preferred shares, whereas REITs can. |
Real Estate Mutual Funds
Real estate mutual funds can be open- or closed-end. They can be actively or passively managed.
Real Estate Closed-End Funds (CEFs)
Closed-end funds are not vastly different from ETFs. They trade actively on the secondary market, own diversified real estate assets, and can be shorted. However, CEFs:
- Are usually actively managed rather than indexed.
- Lack the ETF redemption/creation feature that drives market prices toward NAV. This means that CEFs often trade at prices substantially different from their NAVs.
- Are not structured to protect investors from capital gains.
Here is a comparison of real estate CEFs and public REIT characteristics:
| CHARACTERISTIC | COMMENT |
|---|---|
| Minimum investment | Minimum investment Low. You can buy a single share. |
| Liquidity High. Both trade in active secondary market. | Liquidity High. Both trade in active secondary market. |
| Control | Low. You control what investments to make, but have no control over the underlying portfolios. |
| Diversification | Diversification CEFs can achieve higher diversification. |
| Leverage | High. Underlying properties use mortgages for leverage. You can increase the leverage by purchasing shares on margin. |
Real Estate Open-End Mutual Funds
These are funds that own the shares of corporations within the real estate sector, including REITs. Shares do not trade on secondary exchanges. Instead, you purchase or redeem shares directly with the mutual fund company after the market closes. The mutual fund company creates or cancels shares to match demand. Shares are valued at their NAVs and have no separate trading price. Mutual funds can own REITs, REIT-index ETFs, and corporations within the real estate industry. Normally, mutual funds never directly hold real estate property. Indexed mutual funds charge lower fees because they aren’t actively managed. Balanced funds are mutual funds that hold a variety of asset types, including shares of real estate corporations. Like ETFs, mutual fund income stemming from REITs is eligible for the 20% qualified business income deduction in the United States.
Here is a comparison of real estate open-end mutual funds and public REIT characteristics:
| CHARACTERISTIC | COMMENT |
|---|---|
| Minimum investment | Low. You can buy a single share. |
| Liquidity | High for REITs. Medium for open-end mutual funds, which trade only after closing at the day’s final NAV. |
| Control | Control Low. You control what investments to make, but have no control over the underlying portfolios. While you can short REITs, you can’t short mutual fund shares. However, inverse mutual funds mimic short positions of fund shares. |
| Diversification | Open-end mutual funds can achieve higher diversification. |
| Leverage | High to medium. Underlying properties use mortgages for leverage. You can increase the leverage by purchasing REIT shares on margin, but not open-end mutual fund shares. Some mutual fund companies offer double- or triple-leverage funds that multiply the gains and losses of the fund shares. |
Summary
REITs are available as private or public shares. Private REIT shares compete for accredited investors with private real estate investment funds. Private securities are less transparent than public ones and usually have much higher fees. The shares are illiquid, as you must hold them for at least one year before you can sell them publicly.
Public REITs compare closely to exchange-traded funds and mutual funds. REITs offer certain tax advantages to American investors. Public funds can achieve higher diversification, but REITs let you pick the real estate sectors in which you want to invest. You can create your own multi-REIT portfolio but have no control over fund portfolios. They have comparable fees, except for low-cost index funds, which have the lowest available fees.