REITs or REIT ETFs? Choosing the Right Option for Your Investment Goals

Real Estate Investment Trusts (REITs) and Exchange-Traded Funds (REIT ETFs) are two ways to invest in real estate without direct property ownership. Both options offer diversification and income opportunities, but they differ in structure, liquidity, and accessibility. 

This article will compare REITs and REIT ETFs to help investors make informed decisions based on their goals and risk tolerance.

What Are REITs and REIT ETFs?

REITs and REIT ETFs are both ways to get involved in real estate investments. 

REITs

REITs are companies that own, operate, or finance income-generating real estate and are required to distribute at least 90% of taxable income as dividends to investors. At least 75% of a REIT’s total assets must be invested in real estate, and at least 75% of gross income must come from real estate-related sources, including rents, mortgages, and gains from the sale of real property.

REIT Classifications
REITs are first categorized based on how they are offered to investors:

• Publicly Traded REITs: Listed on major stock exchanges and accessible to everyday investors.
  
• Public Non-Listed REITs (PNLRs): Registered with the SEC but not traded on public exchanges.
  
• Private REITs: Not publicly registered or traded; typically limited to accredited or institutional investors.

REIT Types by Investment Strategy

REITs are further classified by the type of real estate investments they hold:

• Equity REITs (eREITs): Own and manage rental properties, earning income from rent and property sales.
• Mortgage REITs (mREITs): Invest in mortgages and mortgage-backed securities, profiting from interest payments.
• Hybrid REITs: Combine equity and mortgage investments for diversification and flexibility.

REIT ETFs

An ETF is a pooled investment vehicle that invests in a basket of publicly traded REITs, such as stocks, bonds, and commodities, and divides ownership into shares. Through REIT ETFs, investors gain exposure to multiple REITs via a single investment. 

REIT ETFs expose investors to the same risk levels of the specific real estate markets, and this investment vehicle is passively managed. This means they’re designed to track a market index and provide broad exposure to the real estate sector. 

How REITs vs. REIT ETFs Work

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The U.S. real estate investment trust market size was $1.3 trillion in 2023 and is only projected to grow. These investment vehicles allow shareholders to participate in commercial real estate investments that deliver consistent results. 

REITs

Investors buy shares in a single REIT, gaining exposure to real estate assets and/or sectors like healthcare, industrial, and retail. Some REITs might be diversified in asset type or location, and REITs can add or remove real estate assets once they are already invested. 

Income is generated through rents, property appreciation, interest on loans, and sometimes property sales. 

REIT ETFs

Investors buy shares in an ETF that holds multiple REITs, offering diversification across various sectors and geographic regions. Income is generated from dividends of the underlying REITs. 

Key Differences Between REITs vs. REIT ETFs

Let’s consider REITs vs ETFs and their main differences. 

Benefits of Investing in REITs vs. REIT ETFs

While both REITs and REIT ETFs are more often professionally managed, there are varied benefits for each investment vehicle.

REITs

• Consistent Income Potential: REITs distribute a large portion of taxable income as dividends, often yielding higher returns than other equities. This provides investors with a reliable income stream, especially attractive for those in retirement
• Potential Inflation Hedge: Real estate, and consequently REITs, can serve as a hedge against inflation. During inflationary periods, property values and rental income tend to increase, potentially preserving the real value of an investment and providing a degree of protection against the erosion of purchasing power.

REIT ETFs

• Passive Investment Approach: Many REIT ETFs are passively managed, meaning they track a specific index. This can result in lower expense ratios compared to actively managed funds, making them a cost-effective option for gaining real estate exposure.
• High Trading Flexibility: Unlike direct property ownership or investments in some private REITs, REIT ETFs are traded on major stock exchanges. This provides investors with intraday liquidity and the ability to buy or sell shares easily, offering greater trading flexibility. 

Tax Implications of REITs vs. REIT ETFs

Investing in real estate in any capacity comes with tax implications that investors should be aware of.

• REITs: REITs are exempt from corporate taxes, and dividends are generally taxed as ordinary income. Potential for depreciation benefits (private REITs). 
• REIT ETFs: Dividends from underlying REITs are passed through to investors and taxed similarly. A real estate ETF may have lower administrative burdens for tax reporting. 

To go more in-depth, ordinary REIT dividends are taxed as regular income, while qualified dividends benefit from lower tax rates if they meet IRS criteria. Capital gain distributions occur when a REIT sells real estate assets and distributes the profits to shareholders, which may be taxed at preferential rates depending on the investor’s income level.

Return of capital (ROC) happens when a REIT distributes funds from an investor’s initial principal rather than profits. Unlike dividends or capital gains, ROC is not immediately taxable but instead lowers the investor’s cost basis in the REIT shares. Since capital gains tax is calculated on the difference between the asset’s sale price and its cost basis, this reduction can lead to a higher capital gains tax liability when the shares are eventually sold.

If you hold an ETF for more than a year, long-term capital gains tax applies at a rate of up to 23.8%, including the 3.8% Net Investment Income Tax (NIIT) for high earners. For ETFs held less than a year, gains are taxed at the ordinary income rate.

Your investment portfolio taxation can be complex, and working with a professional may simplify the process and result in minimized tax exposure.

Risks of REITs vs. REIT ETFs

Any time you gain exposure to commercial real estate assets, there are some risks. Investors should aim to select investment vehicles that align with their taxation reality, risk preference, and revenue goals. 

Risks Associated with REITs

• Property Concentration Risk: Individual REITs may concentrate their holdings in specific property types (e.g., retail, healthcare) or geographic areas. This can increase their vulnerability to downturns in those specific sectors or regions.
• Tenant Risk: Individual REITs rely on the ability of their tenants to pay rent. Tenant defaults or vacancies can significantly impact a REIT’s income.
• Leverage Risk: REITs often use leverage (borrowed money) to finance property acquisitions. Excessive leverage can amplify losses during economic downturns.

Risks Associated with REIT ETFs:

• Tracking Error: REIT ETFs aim to replicate the performance of a specific index. However, due to factors like fund expenses and portfolio adjustments, the ETF’s performance may not perfectly mirror the index’s return.
• Market Volatility: While REIT ETFs offer diversification, they are still traded on stock exchanges and are subject to overall market volatility. Significant market downturns can impact REIT ETF prices.
• Index Composition Risk: The composition of the underlying index can influence the ETF’s performance. Changes to the index methodology or concentration in specific sectors within the index can affect returns.

REITs vs. REIT ETFs: Which is Right for Your Goals?

REITs and REIT ETFs offer unique benefits and risks, making them suitable for different types of investors. REITs provide direct exposure to individual companies, offering the potential for higher returns and increased sector-specific volatility and specific risks. 

On the other hand, REIT ETFs offer broad diversification, lower volatility, and easier access, though fewer options for high returns and exposure to general market instability.

Consider your specific investment goals, risk tolerance, and portfolio needs when deciding on investment vehicles. 

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This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC