A REIT or REIT mutual fund makes a great addition to a diversified portfolio of investments. Learn what a REIT is and several of the best REIT mutual funds.

REITs are an important asset class for a diversified portfolio of mutual fund investments. A REIT (Real Estate Investment Trust), as the name suggests, invests in real estate. This article will describe these investments, why they are an important consideration as you build your portfolio of investments, and some of the REIT mutual funds and ETFs that make REIT investing a snap. Also Read: Roofstock Review – Buy, Rent Out and Manage Investment Property

What is a REIT?

To qualify as a REIT, a company must satisfy three criteria:

1. It must invest most of its assets in real estate;
2. Its income must come mostly from real estate; and
3. It must pay out 90% of its taxable income to shareholders

Each of these criteria is important, but pay special attention to the last one. Because of this 90% payout requirement, you should consider at least two things before investing in a real estate investment trust:

1. They are often better held in a 401(k), IRA or other tax-deferred retirement account. In a taxable account, you’ll end up paying taxes on the dividends that REITs are forced to payout each year. And these dividends are taxed as ordinary income.
2. Because REITs can keep only 10% of their taxable earnings, they must borrow or sell more shares to raise capital. This isn’t a problem, per se, but REITs can be highly leveraged, which may increase risk.

Types of REITs

There are two major types of REITS–Mortgage REITs and Equity REITs.

• Mortgage REITs: As the name suggests, mortgage REITs invest in mortgages, not property.
• Equity REITs: These REITs own property such as apartment buildings, shopping centers, office buildings and industrial parks.

Most of the mutual funds focused on real estate investing are equity REITs.

REIT Mutual Funds

Mutual funds that invest in REITs often own REITs that focus on all of the above areas. As with other funds, REIT funds can be actively managed or based on an index. The primary index in the U.S. is the MSCI US REIT index. Examples of some REIT/real estate focused funds include the following (links are to the Morningstar snapshot of each fund):

• Vanguard REIT Index fund (VGSIX) (Disclosure: I own shares of this fund)
• Alpine International Real Estate (EGLRX)
• Fidelity International Real Estate (FIREX) (Disclosure: I own shares of this fund)
• Third Avenue Real Estate Value (TAREX)

There are many other REIT and real estate focused funds available. To determine what’s best for you, you’ll have to do your own research and seek professional advice if you so chose. The above funds, even the two I own, are listed here just to give you an idea of what’s available. One publicly traded REIT that is well regarded is the Realty Income (NYSE Ticker: O). This REIT pays a monthly dividend and has consistently paid dividends for over 500 months consecutively. I should add that the payment of dividends, by itself, doesn’t make it a sound investment. One must always consider the price of the investment compared to its intrinsic value. One of the advantages of a REIT fund as part of a diversified portfolio is that they often move in the opposite direction of the stock market. In technical jargon, REITs are not highly correlated to the stock market. That is, REITs tend to (not always) zig when the market zags.

My Asset Allocation

My portfolio consists of 10% in REITs. I use the Vanguard REIT Index fund, admiral shares, mentioned above. It provides an excellent diversification with an asset class with good long-term results. It’s also a recommended asset class by Paul Merriman. Listen to our podcast on REITs: REITs are a great way for everyday people to invest in commercial real estate and get above-average returns. Find out if you're ready to invest in REITs!

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