Is investing in an exchange-traded fund a smart way to invest in real estate? Housing has been a surprisingly unpredictable sector since the great real estate crash of 2007. As a result, new ways to invest in real estate have emerged, with housing-related ETFs being a prime example.
Until the housing bust, most publicly traded real estate investment vehicles were real estate investment trusts, or REITs, explains Charles Sizemore, chief investment officer of Dallas-based Sizemore Capital Management. REITs were almost always comprised of large buildings such as shopping centers, apartment buildings and office buildings, or baskets of nearly identical holdings
"The game plan is to rent them until the market heals, then sell them."
But as Sizemore explains, REITs also introduced market factors. Although the value of a REIT should track very closely with the value of the actual real estate it owns, the current value of REIT shares is actually set by market demand.
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When the housing bust hit, investors saw a chance to buy thousands of single-family homes. Until then, houses had been too small, too individual and too much work to manage for REITs to bother with, but the deals were too good pass up. Sizemore and other market analysts agree that without hedge funds and private investors creating portfolios of single-family homes (most of them foreclosures or nearly so), home values would have dropped even further.
In 2013, investors comprised 20 percent of single-family home sales tracked by the National Association of Realtors. "The game plan is to rent them until the market heals, then sell them," Sizemore says. One factor that is still evolving: how all those houses will be sold with minimal cost. Currently, institutional investors must continue to work with a patchwork of local agents and brokers, negotiating commissions as they go -- hardly a setup for smooth, cost-effective exits that maximize investor return.
Meanwhile, ETFs were gaining popularity due to their low-cost structure and tax advantages for some investors, and the inevitable mashup of ETFs and REITs occurred.
[Read: Everything You Need to Know About Exchange-Traded Funds.]
Just as the invention of REITs put one layer of distance between the value of the actual property and the market value of the investment, the ETF introduced yet another layer of market dynamics. The value of ETF shares are based first on the market value of that ETF, then on the market value of the individual REIT or housing-related shares, and only then on the actual property value. "It's very different from investing directly in real estate," says Gary Gastineau, founder of ETF Consultants Inc. of Bonita Springs, Florida.
"Other people's actions can affect your return," says Mark Cortazzo, senior partner with Macro Consulting Group in Parsippany, New Jersey. "If other property owners have to sell off to manage their portfolios, those market forces can drive down the value of property or property-based investments."
When you invest directly in real estate, "it's a long term and capital gain play -- a buy-and-hold conservative investment," Sizemore points out. It's best to think of a real estate ETF the same way, he advises, especially if you are aiming to get in on long-term demographic changes, such as the expectation that millennials will soon be buying their first homes.
If you are debating between investing in real estate directly or buying into a REIT or real estate ETF, don't overlook the tax advantages of direct ownership, Gastineau says. For many investors, tax deductions and capital gains taxes are integral to their expected return on real estate investments. Those factors are different from those you'd face investing in a real estate ETF.
[See: 6 Tips for Boomers Leaving Big Homes Behind.]
How does your own house fit into your portfolio? Isn't it an investment?
Not really, Sizemore says. "Your house represents a real estate risk but not an investment. Buying a house is a sensible thing to do if you intend to live in the house forever," he says. "Over 20 years, there might be some value if your mortgage remains the same while the economy grows and the property appreciates."
But houses are expensive, Sizemore points out. The actual return on your house is affected by unavoidable expenses such as property taxes, homeowner association fees, maintenance, insurance and other costs that, in effect, offset appreciation in property values.
A real estate investment produces income or appreciates in value after all costs are calculated. Not so with your house. "You have money tied up in it," Sizemore says. "You're not making income from it, so it's really not an investment."