Real Estate Mutual Funds

Real Estate mutual funds invest in the stock of companies that derive their earnings directly from the real estate business or own substantial amounts of real estate, and in related businesses such as home building and building construction materials. Many Real Estate funds invest solely in the stocks of equity and mortgage REITs (Real Estate Investment Trusts).

Real Estate funds invest in companies that do just about anything you can think of that has anything to do with real estate, directly or indirectly. This includes companies that own large tracts of raw land or land currently in agricultural or forest production, office buildings, apartment complexes, shopping plazas and industrial parks, home builders, real estate developers, lumber companies, suppliers of building materials, REITs and diversified real estate companies.

REITs can be equity, mortgage or hybrid. Equity REITs own, operate and trade hard real estate assets. Mortgage REITs originate and/or trade commercial and private mortgages. The hybrids hold a blend of equity and mortgage investments.

REITs are unique in that they don't pay corporate income taxes but must distribute at least 90% of their taxable income to investors every year, which usually results in relatively high yields and makes them a good source of income, if you need it. If you don't need the income, then it's best to keep REITs and REIT mutual funds in tax-sheltered accounts.

Real Estate funds that invest in real estate or real estate-related companies and equity REITs are true real estate investments and tend to be less risky than those that invest in mortgage REITs. The mortgage REITs are more of a Financial Services/Fixed Income investment, although they are strongly influenced by the economics of the real estate sector. But as a real estate investment, mortgage REITs just don't make the grade. The same would apply to funds that invest in hybrid REITs, unless the portion of the funds portfolio invested in hybrids was small.

Real Estate mutual funds that invest in mortgage REITs tend to have higher yields than those that invest in equity REITs but they don't have the potential for capital gains that equity REITs provide. They do have the potential for capital gains attributable to falling interest rates, but those capital gains are essentially unearned gains and thus of a totally different nature than those earned by companies directly involved in the real estate business.

Equity REITs and the Real Estate mutual funds that invest in them offer the best of both worlds: high yield and capital gains attributable to investing in a scarce resource that is becoming relatively more scarce as the world's population grows and becomes more prosperous. Like Will Rogers said, "Buy land, they ain't makin' any more of it." Companies that specialize in real estate know when and where to buy and sell and at what price, thus giving you the opportunity to benefit from their expertise by investing in their companies.

Real Estate provides excellent diversification. The correlation of the Real Estate sector to the general market is very low and, as much of this sector is privately held rather than being publicly traded, adding Real Estate mutual funds to your portfolio is not likely to result in a significant over-weighting of the sector. And Real Estate funds have outperformed the general market long-term with about the same level of volatility.

Everyone's portfolio needs a Real Estate component. Your home may be your biggest investment, but it's an undiversified, relatively illiquid investment and it's your home. If you own rental real estate, that provides you with a little diversification, but not much. In that case you might want to stay away from Real Estate mutual funds that invest in apartment complexes or apartment buildings and concentrate on the various other commercial real estate investments.

You may be able to cover the Real Estate sector just as well by investing in one or more large, well-established and broadly diversified equity REITs rather than a Real Estate mutual fund, as a REIT with these attributes is very similar to a mutual fund. However, you'll have to pay commissions to buy and sell REITs, which would not be a consideration with a no load Real Estate mutual fund.

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