REITs vs. REIT ETFs – Two Paths to Real Estate Investment

They say that you can’t build true wealth without dipping your feet into the exciting real estate industry. Could be true, considering nearly 8% of world’s billionaires have listed real estate as their main source of wealth. Unless you have a lot of money to start your own property empire, the REITs vs. REIT ETFs question might come up at some point on your investment path.

Real Estate Investment Trusts have long been a favourite of investors looking to diversify their portfolios with real estate assets without the hassle of owning physical buildings. With the advent of REIT exchange-traded funds (ETFs), the landscape of real estate investment has expanded, offering both seasoned and novice investors a variety of entry points into the real estate market. But which option is right for you? In this comprehensive breakdown, we’ll explore the implications of investing in REITs vs. REIT ETFs, guiding new investors towards the path that best aligns with their financial goals and risk tolerance.

Understanding REITs

Before we venture into the comparison, it’s crucial to grasp what REITs are. REITs are companies that own, operate, or finance real estate that produces income. They pool investors’ money and distribute at least 90% of their taxable income to shareholders annually in the form of dividends. The benefits of REITs include high dividend yields and the potential for long-term capital appreciation.

Navigating the individual REIT market requires a deep understanding of the real estate sector and the specific dynamics of each REIT. New investors can sometimes find the sheer volume of REIT options daunting. For those with the time and expertise to research and manage their investment, direct investment in REITs can be highly rewarding.

Having said that, investing directly in REITs comes with some caveats. Market volatility, due to economic fluctuations or specific industry changes, can impact individual REITs more than a diversified portfolio, leading to higher risk. Additionally, the management of direct investments necessitates a level of ongoing diligence not required of passive investments in REIT ETFs.

The Rise of REIT ETFs

REIT ETFs, on the other hand, offer a more diversified and low-cost alternative to individual REIT stocks. These exchange-traded funds are designed to provide broad exposure to REITs across various market segments. By purchasing shares in a REIT ETF, investors gain instant diversification, spreading risk across numerous properties and market sectors.

The general premise of a physical ETF is that they invest directly in whatever asset or index they track. When considering a FTSE 100 tracker, the ETF allocates its investments into the stocks comprising the FTSE 100 Index, whereas a gold ETF channels funds into physical gold stored securely in a vault. However, it’s crucial to understand that investing in an ETF means acquiring a share of the ETF itself, rather than the actual underlying asset.

For novice investors, REIT ETFs provide a simple, ‘hands-off’ way to include real estate in their portfolios without the burden of managing a selection of individual REITs. Since these ETFs are passively managed, their fees tend to be lower than traditional mutual funds, helping to maximise returns.

You need to keep in mind that this passive approach can come at the expense of high-performing, boutique REITs that might not be included in the ETF’s basket. While diversification is a powerful risk-management tool, it also caps the portfolio’s potential for extraordinary growth. Additionally, the management of a REIT ETF, despite being largely passive, isn’t immune to poor performance. Economic downturns, for instance, can still affect the underlying REITs and subsequently the ETF’s performance.

Evaluating the pros and cons

When weighing direct REIT investment against REIT ETFs, it’s important to discern one’s investment horizon, risk tolerance, and dedication to portfolio management.

Direct REITs Investment

Direct investment in REITs is akin to buying individual company stocks. This strategy can be beneficial for investors who are comfortable with the associated risks and avid about conducting thorough research. Let’s look at the potential benefits and drawbacks of direct REIT investment vs REIT ETFs.

Direct REIT investment pros

Hand-Picked Portfolio: Investors can select specific REITs based on their preferences, from sector specialisation to geographic location.
Potential for High Growth: Selecting the right REITs can lead to higher-than-average capital appreciation compared to more diversified REIT ETFs. Investors have the opportunity to target specific sectors or companies they believe will outperform the broader market.
Ownership Control: Shareholders have a direct say in the management of the REIT through voting rights at annual meetings (caveat – you have to own quite a lot for your voice to actually influence the running of a REIT).
Control Over Portfolio Composition: Investors have more control over the composition of their portfolio, allowing for strategic allocation and diversification based on personal preferences, risk tolerance, and market conditions.
Possibility of Dividend Growth: Some individual REITs may offer higher dividend yields or potential for dividend growth compared to REIT ETFs, depending on the performance of the underlying assets. Looking at the REITlog index, there are constituents that pay 10% dividend or higher. Now, if you end up picking stocks that will both grow overtime and maintain the high dividend payout, this will give you a double edge – a growing investment and regular income. However, it can also go the other way – we see a lot of REITs that lose value and cut their dividends.
Opportunity for Active Management and other undervalued stock discovery methods: Investors who prefer the active management method or dividend discount model can conduct in-depth research and analysis to identify undervalued or high-growth REITs, rely on their analytical research and forecasts to make decisions on what REIT stocks to buy .

REIT investment cons

Higher Risk: Investing in individual REIT stocks carries higher company-specific risk compared to diversified REIT ETFs. A single REIT’s underperformance or adverse events could significantly impact the overall portfolio.
Limited Diversification: Focusing investments in a limited number of REITs heightens exposure to market volatility and risks unique to specific companies. Very few investors will have a big enough budget to truly diversify. When we say diversify – we mean dozens of REIT stocks spread across different types of REIT.
Higher Trading Costs: Building a diversified portfolio with individual REITs can involve higher brokerage commissions and management fees. Including bid-ask spreads, especially for frequent trading.
Time-Intensive: The ongoing research, monitoring, and analysis of individual REITs require a significant time commitment. Also requires thorough research, industry knowledge, and ongoing monitoring to assess factors such as property performance, management quality, and market dynamics.

REIT ETFs

REIT ETFs provide investors with the benefits of diversification and the ease of a single investment.

Pros of investing in REIT ETFs

Diversification: A single investment offers exposure to a broad range of REITs, reducing the impact of underperformance by any one company. So you are holding a basket of REITs across various sectors and regions. Something you couldn’t achieve on your own unless you’re looking to build a substantially large investment portfolio.
Lower Entry Point: Investors can start with a lower amount of capital since buying a share in an ETF is often more affordable than building a diversified REIT portfolio.
Reduced Volatility: The diversified nature can smooth out the overall volatility of the real estate market, particularly in riskier sectors.
Convenience and Accessibility: Investing in REIT ETFs is convenient and accessible through brokerage accounts, offering exposure to the real estate sector without the need for extensive research or individual stock selection.
Liquidity: ETFs trade on stock exchanges throughout the trading day, providing liquidity for investors to buy or sell shares at prevailing market prices.

Cons to consider with REIT ETFs

Less Control: ETF investors cannot customise their portfolio by cherry-picking the REITs that appeal to them.
Management Fees: Although REIT ETFs generally have lower expense ratios compared to actively managed funds, minimizing management fees and expenses associated with portfolio turnover., investors have to take into consideration that ETF running costs are passed on to investors. When you’re investing directly, your only cost is your time spent on research and your brokerage fees.
Under-performers are Included: While the spread of risk is beneficial, it also means that high-quality REITs are balanced against those that might not perform as well.
Limited Control Over Holdings: Investors have limited control over the specific holdings within REIT ETFs, as fund managers determine the portfolio composition and asset allocation.
Potential Fund Underperformance: While REIT ETFs aim to track the performance of a benchmark index, they may underperform compared to actively managed funds or individual REITs during certain market conditions.
Dividend Yields may be Lower: REIT ETFs may offer lower dividend yields compared to individual high-yielding REIT stocks, as the dividend income is distributed across the entire portfolio.
Tracking Error: There’s a risk of tracking error where the ETF’s performance deviates from the underlying index due to factors such as fees, rebalancing, and market inefficiencies.

The Decision-Making Framework

To determine whether direct REIT investment or REIT ETFs is the right path, consider the following:

Investment Experience: How comfortable are you with selecting and managing individual investments?
Risk Tolerance: Are you willing to accept the potential risks of direct investment for a shot at higher rewards, or do you prefer the safer, more stable trajectory of a diversified ETF?
Time Commitment: How much time can you realistically dedicate to managing your REIT investments?
Financial Goals: Are you investing for retirement, to purchase a home, or for another specific reason? Each goal may favour one investment method over the other.

The Hybrid Approach

For many investors, a hybrid approach could offer the best of both worlds. Combining a core position in a REIT ETF with a smaller selection of individual, well-researched REITs can cater to different investment objectives. This strategy can be particularly effective at mitigating the risks associated with more volatile sectors while achieving a desired level of focus in other areas.

When adopting a hybrid approach, it’s essential to regularly review and rebalance the portfolio to ensure that the individual REITs’ and ETF’s performance aligns with your financial goals and risk appetite.

Determining whether to invest directly in REITs or opt for REIT ETFs hinges on individual circumstances and preferences. New investors can take comfort in the lower cost and diversified nature of REIT ETFs, while those with more experience may relish the opportunities and responsibilities that come with directly held REITs.

Both paths hold promise for building a sustainable investment portfolio. The key is to match the investment strategy with your unique profile and to stay informed about market developments that might affect your holdings. REITs and REIT ETFs represent accessible gateways into a sector renowned for its income potential, and with careful consideration, both can be formidable tools in an investor’s belt. Whether you choose the specificity of individual REITs or the ease of an ETF, the world of real estate investment is at your fingertips — ready for strategic exploration and growth.

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