REITs vs. Real Estate Mutual Funds (ESRT, TRREX)

Real estate investment trusts (REITs) and real estate mutual funds both offer diversification and an easy, affordable way for individual investors to invest in various segments of the real estate market. They also represent a more liquid vehicle for investment in this sector than owning or investing in real estate directly.

There exists a wide variety of REITs and real estate sector mutual funds to choose from. Before considering either type fo instrument, you need to understand the key differences between the two, as well as their pros and cons.

A REIT is a corporation, trust, or association that invests directly in real estate through properties or mortgages. They trade on a stock exchange and are bought and sold like stocks.

The three major types are equity REITs, mortgage REITs, and hybrid REITs. Equity REITs own and invest in properties such as apartments, office buildings, shopping malls, and hotels. Revenues are generated mainly from the rents of properties which they own or have a share in. The majority of REITs are equity. (For more, see: What are Risks of Real Estate Investment Trusts?)

Mortgage REITs invest in residential and commercial mortgages. These REITs loan money for mortgages, or purchase existing mortgages or mortgage-backed securities. Revenues are generated primarily by the interest earned on mortgage loans. (For more, see: REIT ETFs to Watch.)

Hybrid REITs are a combination of equity and mortgage REITs.

REITs pay dividends. They are required by the Internal Revenue Service (IRS) to pay out most of their taxable profits to shareholders via dividends. REIT companies don't pay corporate income tax. (For more, see: Top 10 REITs for 2015.)

Mutual funds are professionally managed pooled investments that invest in a variety of vehicles, such as stock and bonds. Investors purchase mutual fund shares, or units, which are bought or redeemed at the fund's current net asset value (NAV). NAVs are calculated once a day, and are based on the closing prices of the securities in the fund's portfolio. (For more, see: The Risks of Real Estate Sector Funds.)

Real estate mutual funds typically invest in REIT stocks, real estate related stocks, or a combination of both.

REITs and real estate mutual funds give individual investors with limited capital access to either diversified or concentrated real estate investments because they have relatively low investment minimums. When it is diversification they provide, the two types of funds help mitigate risk.

If you want to invest in New York City’s dynamic and notoriously pricey real estate market, for instance, consider the appropriately named Empire State Realty Trust Inc. (ESRT) – a REIT that can claim the iconic Empire State Building as one of its portfolio properties. Its portfolio totals six retail and 14 office properties in Manhattan and the New York City metropolitan area. (For more, see: Investing in New York City REITs.) Depending on their investment strategy, real estate mutual funds can be a more diversified investment vehicle than are REITs. This can cut down on transaction costs for those looking for greater diversification concentrated in one or a few funds. They also have the benefit of professional portfolio management and research.

T. Rowe Price Real Estate (TRREX) is an example of a (real estate) sector mutual fund with diverse holdings. Boasting some 40 holdings, it invests primarily in REITs as well as publicly traded real estate related companies. (For more, see: The Pros and Cons of Owning an Equity REIT vs. a Mortgage REIT?)

Real estate funds provide dividend income and the potential for capital appreciation for medium- to long-term investors. Remember, REITs must distribute at least 90% of taxable income to shareholders each year in the form of dividends. (For more, see: Analyzing REITs and REIT Performance.)

The value of real estate tends to increase during times of inflation, as property prices and rents go up. Therefore, REITs and real estate mutual funds can serve as a potential hedge against inflation.

Finally, both types of real estate funds provide liquidity in what is typically an illiquid asset class.

As with any investment, there are risks to investing in both REITs and real estate mutual funds. Returns are not guaranteed.

Also, as with all sector-specific funds, those that focus on real estate can be more volatile than funds with broader investment horizons, such as a fund tracking the Standard & Poor’s 500 index. In short, when the real estate market falters, funds in this sector suffer. Of course, the opposite is true when the real estate market is booming. (For more, see: What is the Difference Between a REIT and a Real Estate Fund?)

Rising interest rates can also affect the returns of real estate funds. For example, REITs rely on debt or borrowed money to acquire properties. When interest rates rise, so does the cost of borrowing, which can cuts into profits.

REITs and real estate mutual funds have their differences, but they are similar in that they both offer liquidity and an accessible way to get exposure to diversified real estate assets. For retail investors without significant capital, these real estate funds create an avenue for investing in a wide range of properties that might otherwise be out of reach. Long-term investors in particular have the potential to reap the rewards of dividend income and capital appreciation down the line. Before investing in either, make sure you understand the differences between the two, as well as the attendant risks and rewards. (For more, see: The Complete Guide to REITs.)