This is the fifth in our series of articles of ways to invest in real estate.
In the previous article, we compared REITs with real estate funds of various kinds. In this article, we sharpen our focus to concentrate on real estate index funds. An index is a list of things; in this case, a list of REITs or other types of real estate investments. The salient feature of an index is that members are selected by the index sponsor based upon a set of criteria. Once created, indexes change only slowly, usually to add new members that match the index’s criteria or removing existing members that no longer exist or no longer satisfy the criteria. For example, if one REIT acquires another one, the target REIT would be removed from the index.
Real Estate Index Funds
Real estate index funds, in the form of mutual funds or exchange-traded funds (ETFs), own shares of each member of a particular real estate index. The amount of each holding corresponds to the relative market capitalization of each member — it is capitalization-weighted. (Market cap equals the number of outstanding shares times the price per share). For example, if the largest REIT in an index represented 10% of the total capitalization of all members, then 10% of the fund’s money would be invested in the largest REIT.
Real estate index funds share certain characteristics:
- Passively managed: Index funds are passively managed, meaning that there is no fund manager deciding what to buy and sell. Rather, the index fund is populated by matching the contents and market caps of the index.
- Low fees: Passively managed funds don’t have to pay for talented fund managers. Instead, they pass the savings to investors in the form of low fees. It’s not unusual for index funds to have annual fees below 0.25%.
- Stable: Real estate Index funds review their holdings only a few times per year (usually quarterly) to update and rebalance them. The review reflects changes to the underlying equity market for the index members.
- Low activity: The holdings of a real estate index fund change only when a member no longer exists and at the periodic rebalancing. This means that the fund’s internal trading costs are low and capital gains are a relatively small part of the fund’s total return.
- Publicly traded: Index ETFs are publicly traded in the secondary market at the current market price as determined by supply and demand. Index mutual funds are controlled by the mutual fund company, which publicly issues and redeems shares based on the day’s closing net asset value (NAV). You can trade index ETFs any time the exchange is open, but index mutual funds can be bought or sold only after the close of business. Thus, index ETFs are directly comparable to public REITs rather than non-traded and private REITs.
- Tax efficient: ETFs and mutual funds (and REITs!) are pass-through entities, meaning they pay no taxes. Instead, they pass income and capital gains to investors, who pay the taxes in their personal returns. Funds must pay out at least 90% of their earnings to investors to qualify for pass-through status. ETFs are managed to minimize capital gains. Naturally, you can hold public shares in a tax-sheltered account, such as an IRA or 401(k), that offers important tax benefits.
- Tracking error: Because index funds don’t try to continually match the underlying index, tracking error occurs. This is the difference between the fund’s value and that of the underlying index.
- Free-float methodology: Most REIT indexes use a free-float methodology to calculate the weight of each constituent. That is, it figures market cap by multiply share price by number of outstanding shares, but it excludes locked-in shares belonging to promoters, governments, insiders, etc.
The following table summarizes primary characteristics of index funds.
|Minimum investment||Low. You can buy a single ETF share. Some mutual funds have higher minimum investments.|
|Liquidity||High. Index funds are publicly available. ETFs offer instant liquidity; mutual funds offer daily liquidity.|
|Control||Low. You control what investments to make, but have no control over the underlying portfolios.|
|Diversification||Funds achieve higher diversification than a single REIT.|
|Leverage||High. Underlying REITs use debt for leverage. You can increase leverage by purchasing shares on margin.|
Three Major Real Estate Indexes
These are three major U.S. real estate indexes. Data is as of April 30, 2019.
This is an index of equity REITs, holding 153 constituents representing 99% of the U.S. REIT universe. The index is free-float adjusted and weighted by market capitalization. The largest constituent is Simon Property Group with a weight of 5.91%. Among the top five sub-industries, specialized REITs have the heaviest weight (18.9%), followed by residential REITs (17.81%), retail REITs (17.30%). office REITs (12.66%) and health care REITs (11.51%).
This index covers all publicly listed U.S. REITs with a market cap of at least $100 million, except for timber and infrastructure REITs. It is composed of 159 constituents. The Index is free-float adjusted, with a minimum free float of 5%. The largest constituent is Simon Property Group with a weight of 5.92%. Among the top five sub-industries, apartment REITs have the heaviest weight (13.79%), followed by health care REITs (11.58%), office REITs (10.66%), industrial REITs (10.42%) and data center REITs (8.17%).
This index tracks the performance of public REITs and REIT-like securities traded in the U.S. The index is market-weighted, float-adjusted and quarterly balanced. It contains 95 constituents. The largest constituent, Simon Property Group, has a weight of 7.87%. Among the top five sub-industries, industrial/office REITs have the heaviest weight (29.48%), followed by residential REITs (23.15%), retail REITs (17.03%), health care REITs (11.02%) and self-storage REITs (8.67%).
Real estate index funds are really multi-REIT funds passively managed according to an underlying index. Owning these ETFs and mutual funds is similar to owning multiple REITs. In effect, they provide a more diversified exposure to REITs. In other respects, real estate index funds closely resemble individual REITs.