Real estate investment trust (REIT) exchange-traded funds (ETFs) are fantastic investment vehicles. Some of the best REIT ETFs are undervalued and poised to outperform many U.S. equities. They generally offer diversification, liquidity and dividends, yet there aren’t many investors trading these ETFs.

Why? For the same reason there aren’t nearly enough investors making options plays. Because they don’t understand them.

It’s a shame. Understanding these securities could be integral to your financial freedom. Today, we’ll explain how REITs work and show you the best REIT ETFs to watch.

What is a REIT?

A REIT is similar to an ETF or a mutual fund in that it pools investor money. Whereas a traditional fund is likely buying stocks or bonds, a REIT uses that money to invest in different real estate properties and assets.

The idea behind any investment is that the security will gain value over time. Just as real estate tends to grow more valuable over the years, so will a REIT. The REIT also collects rent from its tenants and that rent is distributed to investors in the form of a dividend. You can think of a REIT as a big landlord.

One advantage to investing in REIT ETFs is that they provide the kind of income you might receive investing in real estate plus the liquidity of securities like stocks and bonds. This is especially true when you pool the investment trusts together into an exchange-traded fund.

Another benefit is that REIT shareholders get real estate exposure without the headaches that come with being a landlord. REITs usually manage larger complexes like apartment buildings, warehouses, housing developments and hotels.

It is important to note that the risk profile for investing in a REIT is a bit different than direct real estate investment. On the one hand, the returns tend to be lower than if you actually purchased a building. Management and fund fees cut into returns. But on the other hand, you take on less risk.

Now that we understand what a REIT is, let’s take a look at the ETFs in particular. 

What is a REIT ETF?

While a REIT is a company that owns and operates real estate to produce income, a REIT ETF invests in REITs and other securities, and passively tracks indexes for the larger real estate market. An ETF helps protect investors even more from the downside risk of purchasing a real estate asset directly or even just one REIT. A REIT ETF is instant diversity.

Things to Research Before You Invest

• Assets Held – The old investment saying “buy what you know” comes into play here. You need to know what you’re buying. This means that you need to understand the underlying assets.
  
  The individual holdings of a particular ETF may include both REITs and REIT stocks. REIT stocks are equities that meet all of the requirements needed to be classed as a REIT.

• Fees – You know that feeling you get when you buy a concert ticket and Ticketmaster hits you with what feels like a billion additional fees above the face value price? Trust me, it’s not any more fun when it comes to investing in an ETF.
  
  Now, the good news is that many REITS tend to charge lower asset management fees than, say, mutual funds. Nevertheless, you have to be careful as this doesn’t hold in every instance.
  
  The best way to understand whether or not you are being ripped off by management fees is to compare a few similar REIT ETFs and look at the fee schedules. If one fund seems exorbitantly high, it probably is.
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• Management – I’ve always found when looking at stocks that a company is only as good as its management team. Lousy management can bring down a firm.
  
  Its similar with funds. If the fund manager is no good, you aren’t going to earn strong returns and may even lose significant money.
  
  Not all fund managers are created equal. They run the gamut from famous, large companies with sterling reputations to little-known companies that may vary in quality.

Because of these factors, and others, an individual REIT’s performance can vary widely. A REIT ETF will minimize that volatility by providing broader exposure. Investors should consider including the funds for a well-diversified portfolio. Here are the top four REIT ETFs to watch in 2020:

Best 4 REIT ETFs to Watch Right Now

No. 4: iShares Residential Real Estate Capped ETF (NYSE: REZ)

• Assets Under Management: $501 million
• Expense Ratio: 0.48%
• 5 Year Total Return (Cumulative): 9.12%

iShares is a giant in the ETF space, and we’ve featured two of its REIT ETFs here. The iShares Residential Real Estate Capped ETF is a smaller ETF, managing just $500 million in assets. But, as opposed to the more generalized REIT ETFs managed by Schwab and Vanguard, this is a specialized fund.

The iShares Residential Real Estate Capped ETF lets investors narrow their focus on the residential real estate market. This REIT has exposure to apartment buildings, multifamily properties, senior living communities and assisted living facilities. By specializing in residential real estate, investors avoid the risks specific to commercial real estate. The fund’s top holdings include Welltower (NYSE: WELL) (9% of holdings), Public Storage (NYSE: PSA) (8% of holdings), and Equity Residential (NYSE: EQR) (8% of holdings).

No. 3: Schwab U.S. REIT ETF (NYSE: SCHH)

• Assets Under Management: $6.1 billion
• Expense Ratio: 0.07%
• 5 Year Average Annual Total Return: 6.28%

The Schwab U.S. REIT ETF tracks some of the country’s biggest REITs. It holds REITs specializing in industrial properties, shopping malls, healthcare properties, self-storage facilities, residential homes and office buildings. The fund also holds about 115 stocks, which is fewer than the Vanguard Real Estate Index Fund ETF Shares’ 200 stocks.

This a straightforward fund. It is low-cost with a 0.07% expense ratio, which means bigger returns for investors. It is dedicated to REIT stocks and nothing else. There are no mortgage REITs to be found here. Like the iShares Residential, it has large stakes in Welltower, Public Storage and Equity Residential, along with significant holdings of companies like Prologis (NYSE: PLD) (8%) and Simon Property Group (NYSE: SPG).

No. 2: iShares Mortgage Real Estate Capped ETF (CBOE: REM)

• Assets Under Management: $1.47 billion
• Expense Ratio: 0.48%
• 5 Year Average Annual Total Return: 9.08%

The other three ETFs listed here own equity REITs. But the iShares Mortgage Real Estate Capped ETF, as its name suggests, owns primarily mortgage REITs. These work by buying mortgages and becoming the financier for real estate projects. They generate income by earning interest on those investments.

Mortgage ETFs tend to have very high dividend yields. In fact, dividends make up a huge portion of the iShares Mortgage Real Estate Capped ETF’s returns. This fund, and all mortgage REIT ETFs, are susceptible to volatility because of their dependency on interest rates. Mortgage REITs need to borrow money, so when the fed lowers interest rates, these funds will perform better.

The share point is currently down about 1 1/2 points from its past year high of $45.62. 

No. 1: Vanguard Real Estate Index Fund ETF Shares (NYSE: VNQ)

• Assets Under Management: $70.12 billion
• Expense Ratio: 0.12%
• 5 Year Total Average Annual Return: 7.16%

The Vanguard Real Estate Index Fund ETF Shares is simply the biggest and best REIT ETF on the market. Although the fund was beating the S&P 500 through November, it’s experienced a drop-off of late. Over the past year, it has grown by about 18.5%, compared with 26% for the broader market.

The Vanguard Real Estate Index Fund ETF Shares holds 185 different REIT stocks as of November 30. Retail, residential, healthcare and office REITs also make up a significant portion of the fund’s holdings.

Its holdings include some of the biggest players in the REIT industry like American Tower Corp. (NYSE: AMT), Simon Property Group (NYSE: SPG) and Equinix (Nasdaq: EQIX). Even more diversity comes from holdings such as hotel and resort REITS, industrial REITs, and even real estate operating companies.

Action Plan

All in all, REIT ETFs offer investors an easy way to get in on the lucrative world of real estate investing. And these are four of the best REIT ETFs in the business to watch as we go further into 2020. For more valuable information on ETF investing, check out our ETF investing page.