Real estate is one of the most popular types of investments available, but because of the start-up costs and active involvement often required, it’s not the right fit for many investors. Real estate funds and REITs both address these roadblocks by allowing individuals to indirectly invest in real estate, but still reap many of the rewards.
In this article, we’ll explore the differences between real estate funds and REITs, and discuss how to choose which is right for you.
What Are the Differences Between Real Estate Funds and REITs?
The following table highlights the differences in distributions, taxes, and investment and income requirements between real estate funds and REITs.
|Real Estate Funds||REITs|
|Type of Investment||Diversified fund||Individual company|
|Distributions||Dividends and gains passed along to fund investors||90% of income distributed to shareholders|
|Tax Treatment||Taxes on dividends and gains||Taxes on dividends and gains|
|Investment and Income Requirements||None||75% of assets in real estate and cash, and derive 75% of income from real estate|
Type of Investment
One of the most critical differences between a real estate fund and an REIT is the type of investment they actually are.
A real estate fund is a pooled investment, often a mutual fund, that takes the money from its many investors and uses it to invest in a variety of securities. A real estate fund is a type of sector fund, which means it specifically invests in securities in a particular sector—in this case, real estate. Real estate investment trusts (REITs) often make up a considerable portion of those securities.
An REIT is a single company that owns and operates real estate such as apartment buildings, hotels, office buildings, and more. Investors can buy stock in the REIT, therefore becoming part owner of the company and its holdings.
Real estate funds and REITs come with similar benefits. Both allow investors to add real estate to their portfolios without the hands-on work of buying and maintaining a property.
Real estate funds and REITs make real estate investing more accessible since they eliminate the large upfront cost that would be required to purchase real estate on your own.
You might choose to invest in a real estate fund over an REIT because it creates a diversified portfolio. Rather than investing in a single company, you can invest in hundreds through a fund.
On the other hand, some people may prefer REITs over real estate funds. Investing directly in an REIT allows you to be selective of the company and the type of real estate you want to invest in. In other words, it gives you more control.
Real estate funds and REITs vary in how they distribute earnings to investors.
Mutual funds must distribute net gains to their shareholders at least once per year. These gains occur when the fund manager sells one of the securities in the fund at a profit.
For example, suppose a real estate fund invests in REIT ABC. While your shares of the fund include shares of ABC, the fund itself owns the shares of ABC. Say the fund sells its REIT ABC stake for more than it bought them. The fund will pass the gains to you. Typically, you can receive the payments as cash distributions or reinvest them in the fund.
Real estate funds can also disburse distributions via dividends. When companies that the fund invests in pay dividends, they pay them directly to the fund, which then passes them along to the investors.
REITs have to make distributions to investors, too, but they work a bit differently. A company that qualifies as an REIT must distribute at least 90% of its taxable income to its shareholders in the form of dividends. Many distribute 100% because of special tax treatment that allows them to deduct all of their dividends from their taxable income to avoid corporate taxes.
In addition to distributing at least 90% of their taxable income, REITs must meet a variety of other requirements. One of those requirements is having the bulk of their assets and revenue linked to real estate investments.
The tax treatment of real estate funds and REITs is similar in that, as with other investments, you’ll pay taxes on the dividends you receive, as well as any gains you earn when you sell a security for more than you purchased it.
The SEC requires REITs to pass along the majority of their taxable income to shareholders as dividends. Your dividends will usually be taxed as ordinary income (at your normal tax rate). If you sell your REIT stock for more than you bought it, you’ll pay capital gains taxes.
Mutual funds get different tax treatment. Just like REITs, you’ll pay taxes on dividends and capital gains. However, you may pay capital gains taxes on securities your fund sold, even if you haven’t personally sold your shares.
When a mutual fund sells one of its holdings for a capital gain, it passes those gains along to investors. Whether you reinvest those gains or receive payment for them, you’ll pay capital gains taxes on them. Your capital gains tax rate will depend on how long the fund held the security.
Investment and Income Requirements
Real estate funds and other mutual funds have fund managers who decide what the fund invests in, which is why these funds are considered “actively managed.”
Mutual funds release a prospectus, in which they inform investors about the fund’s goals and strategy, but, ultimately, individual investors can’t directly influence what a fund invests in.
REITs, on the other hand, are held to some standards as to what they invest in and derive their income from. To be considered an REIT, a company must invest at least 75% of its assets into real estate and cash and derive at least 75% of its income from real estate.
Which Is Right for You?
Both real estate funds and REITs present unique opportunities for individuals to invest in real estate without the upfront costs and hands-on work that comes with many traditional real estate investments. They have plenty of similarities, including their passive nature and the way investors can earn money.
Deciding between real estate funds and REITs is similar to deciding between stock mutual funds and individual stocks. Investing in REITs gives investors more control over which company and which type of real estate they want to invest in.
The National Association of Real Estate Investment Trusts (NAREIT) estimates that 50% of REIT shareholders own mutual funds and ETFs, while 21% invest in individual REIT firms.
On the other hand, real estate funds give investors the ability to diversify their real estate portfolios, possibly reducing their risk.
The Bottom Line
Real estate funds and REITs are both securities that allow investors to add real estate to their portfolios without directly buying real estate. They have some critical differences, including the type of investment they are, how distributions and taxes work, and what standards they’re held to as far as what they invest in. Before deciding which type of investment is right for you, be sure you understand how each type of investment works and the risks you take on.