Publicly-traded REIT index mutual funds and ETFs add can add far more cost-effective real estate exposure to your portfolio
If you really need to add real estate securities to your portfolio, the most sensible way to do so is to buy very low cost REIT index mutual funds or ETFs. This article will overview why and will help you find the lowest cost real estate mutual funds and ETFs.
Does your portfolio really need more real estate exposure?
First, an investor should evaluate whether to own any additional real estate sector investment securities or funds. When I say real estate securities, I am referring to real estate oriented portfolio holdings that are in addition to any primary residence, second home, vacation property, and/or directly held rental real estate properties that you might own.
Such additional real estate securities could include:
• Real estate investment trusts (REITs), which must distribute most of their earnings to owners. To avoid corporate level taxation, REITs must distribute at least 90% of earnings each year and most distribute 100%.
o REITs are either publicly traded on an exchange, or they are are non-traded. Non-traded REITs either are sold to investors by authorized brokers, or they are distributed to accredited investors via private offerings, called private placements.
• Real estate operating companies (REOCs), which are publicly traded corporations that have chosen not to function as a REIT. REOCs pay corporate taxes and they may reinvest earnings and/or distribute them. Such public REOCs are fewer in number and less well-known to investors than publicly-traded or non-traded REITs.
• Real estate mutual funds (MFs) or real estate exchange-traded funds (ETFs), which are publicly-traded diversified investment funds that invest primarily in REITs and/or REOCs, but might also invest in other real estate related convertible, equity, or debt securities.
Most individual investors are already heavily exposed to real estate in their overall asset portfolio. It is questionable whether most investors need to add even more real estate to their investment portfolios. Home equity is often the largest asset that a family owns. In addition, by owning stock and bond securities, individual investors automatically gain exposure to real estate owned by the firms issuing those bonds and stocks. Those owning rental real estate properties and second homes are even more heavily exposed.
Therefore, the first decision is “whether” to own more real estate, instead of “how” to do so. If the answer to the “whether” question is yes, then your decision hopefully implies that you understand and are comfortable with the heightened risks of a portfolio with a greater concentration in real estate.
Are you buying REITs solely for income?
If you are buying any kind of REIT security – index mutual fund, ETF, publicly-traded REIT, or non-traded REIT – primarily to get ongoing income, be careful and think first. Yes, REITs are designed to kick off a lot of ongoing income, but that is not necessarily always a good thing.
Consider the following points:
• If your goal is ongoing income to fund living expenses, there are numerous other ways for a portfolio to provide income without needing to skew your portfolio heavily toward individual sectors, such as real estate. Investors should focus on total returns (interest, dividends, and appreciation combined net of costs and taxes) rather than just paying attention to current income.
o Any investment position with a growing total return can be structured to provide ongoing income. Skewing your portfolio to hold securities with higher dividends, such as REITs, high-yield junk bonds, and dividend stocks often tends to reduce diversification, increase exposure to certain economic sectors, and increase overall portfolio risk.
• REIT income is taxed at graduated federal and state ordinary income tax rates. Thus, REIT distributions are relatively tax inefficient compared to other securities that generate long-term capital appreciation and qualified dividends that are taxed at lower federal long-term capital gains tax rates.
• Holding REIT securities in taxable accounts can be highly tax inefficient for those who have other current sources of ordinary income and are already in higher federal tax brackets. Asset tax location optimization would say you should hold REITs in your traditional tax-advantaged accounts (e.g. IRAs, 401ks, etc.), simply because they produce so much taxable ordinary income. If instead you hold REIT securities in your taxable accounts, this likely to be very inefficient compared to a more optimal asset tax location strategy.
• Some non-traded REITs appear to produce early distributions that really are not income from economic activities related to rental properties. Some non-traded REITs make distributions from contributed capital and from borrowing. The more that this is done; the more capital is removed from the REIT. While this questionable practice creates the appearance of early income, those distributions simply lack an economic basis.
o These distributions are just too-early returns of the capital that you contributed at the outset, and on which you paid a huge hidden commission! This dubious practice can significantly increase the risk concerning whether the REIT will be able to sustain distributions in the future. Less capital means less money in the REIT for acquiring or developing rent producing properties.
o As noted above, REITs tend to be relatively tax inefficient entities simply because legally they must distribute at least 90% of earnings that must be taxed at ordinary income tax rates. Almost all REITs distribute 100% of earnings, but some distribute more by borrowing and by dipping into contributed capital to keep up the illusion of a reliable income stream.
If you are being pitched a non-traded REIT and a big part of the sales job is the yield or percentage of expected future income, step back and think. If you were not so fixated on the advertised return percentage being waived around in the sales process, would you be more skeptical? Could you achieve a better total return at lower risk through a more diversified investment portfolio?
Remember that any appreciating and liquid investment can be set up to deliver income through a combination of dividend consumption and share sales. Those who will “only spend dividends” tend to ignore capital appreciation. Markets value the securities of economic enterprises based upon their overall expected future returns and not just the dividends that they have paid. Similar economic enterprises may differ in their distribution policies, and lower dividends mean higher capital appreciation for economically equivalent enterprises.
Never let any financial advisor sell you a non-traded REIT
Once aware the risks of owning more real estate, you should also become aware of the pitfalls associated with certain real estate investment products on the market. Research studies clearly indicate that very low cost index mutual funds and ETFs that track passively real estate securities indexes have produced superior performance with less price volatility or risk – especially when compared to individual non-traded REITs. Unfortunately, however, low cost diversified real estate investment funds do not provide very much compensation to brokers and financial advisors. Thus, they lack a big and highly motivated cheerleading squad.
At the other end of the real estate securities spectrum, non-traded individual REITs pay very large commissions and have an extensive network of sales agents banging drums and signing their praises. Unfortunately, those excessively high commissions are paid by those who can be enticed to invest in non-traded REITs.
These commissioned sales agents sing very loudly about the high income virtues of non-traded REITs. However, they are mum when it comes to telling you that you could instead invest in low cost real estate index funds and ETFs, which had historically achieved much higher returns with less risk. If you do not know any better, financial industry sales people will push you to buy the latest non-traded REIT that they have on the shelf to sell. If you encounter this situation, run the other way, as quickly as you can.
Non-traded REITs have extremely high hidden sales charges. Non-traded REIT managers have numerous direct conflicts of interest relative to their investors. There are significant problems with the measuring the current valuation of non-traded REITs since there is no real time market. In addition, because non-traded REITs have no active markets, so you cannot get out early without having to pay a large discount on what you are told in the fair market value of your holdings.
Publicly traded REITs avoid the large hidden sales commissions and other market fees charged by non-traded REITs. The interests of public REIT managers are much better aligned with the interests of their investors. Since there are active public markets for REITs, you know the current value of your holdings and you do not have to pay huge discounts to sell your holdings.
Furthermore, very low cost publicly traded REIT index mutual funds and ETFs offer broad diversification that cannot be achieved by owning individual traded or non-traded REITs. Such REIT index funds with very low costs are the market benchmark. Recent studies have demonstrated that you can get much better performance by owning such REIT index funds.
Let me be very clear. For those who intend to own real estate securities in addition to their primary residence, second home, vacation property, and/or directly held rental real estate properties, avoid private REITs. There is never a good reason to buy a REIT private placement security being sold by a financial advisor or broker. Publicly traded REIT securities and REIT investment funds are more likely to deliver better performance. You always have the alternative to invest in a publicly-traded REIT or REIT investment fund, so buy them and not private REITs.
Furthermore, since you have the choice of investing in low cost publicly traded REIT mutual funds and ETFs, you can easily and cost-effectively own a broadly diversified collection of REITs through such funds. With REIT mutual funds and ETFs, you can eliminate the risks associated with picking among individual REITs and thus you only subject yourself to the overall risks of the real estate market.
The lowest cost international and US real estate index mutual funds and ETFs
This information is here for investors who wish to add low cost, passively managed, and publicly traded real estate index mutual fund and ETF positions in their portfolios. The tables below provide lists of the lowest cost US and international index mutual funds and ETFs available on US exchanges.
These tables come from two ebooks that I publish and update quarterly:
• “A Wiser Road to Wealth: Buyer’s Guide to the Lowest Cost No Load Mutual Funds”
• “Low Cost ETFs for Buy & Hold Investors”
These ebooks explain how to invest in index funds and where to find the lowest cost, best index funds.
Low cost international and US real estate index mutual funds
Note that the average annual expense ratio for taxable real estate stock mutual funds is 1.5% per year. Funds with expense ratios only up to .5% have been included in this table.
* Always read the prospectus before buying any security. Understand all risks, benchmarks, restrictions, fees, trading costs and taxes.
Note that the Vanguard REIT Index Fund is the largest US focused publicly traded REIT index fund with the lowest costs. Investors with $3,000 can open an account in VGSIX directly with Vanguard and pay only .24% in management expenses per year. With $10,000 an investor can invest in the Admiral Share Class of the same fund and reduce their annual management expenses to .1% An ETF share class (ticker: VNQ) is also available with a .1% per year management expense ratio.
The Vanguard REIT Index Mutual Fund is useful as a benchmark, and it is directly investable by any investor. No advisor is needed or required. As an index fund, it tracks the MSCI US REIT Index, which currently is composed of about 137 publicly traded REITs accounting for 99% of the total market value of US public REITs.
The lowest cost international and US real estate exchange-traded funds (ETFs)
World and international real estate equity ETFs
* Always read the prospectus before buying any security. Understand all risks, benchmarks, restrictions, fees, trading costs and taxes.
US real estate equity ETFs
* Always read the prospectus before buying any security. Understand all risks, benchmarks, restrictions, fees, trading costs and taxes.
Since it is so easy to find the lowest cost, most diversified real estate index mutual funds and ETFs with a history of better performance and lower risk, saying no to non-traded REITs is much easier. Furthermore, while privately sold REITs hide the fact that up front they skim off between 12% and 15% of every dollar invested for commissions and other fees, low cost investment fund investors should note that 100 cents of each dollar invested to purchase shares will actually make it into the no-load index mutual funds and ETFs in this tables above.
This article was researched and written by Lawrence Russell, an independent financial planner in Pasadena, California. He has written hundreds of financial articles to help individuals understand how to plan and manage their personal finances and get ready for retirement. Larry is also the developer the VeriPlan retirement financial planning spreadsheet application for home use by those who wish to develop lifetime financial plans.
