ETF vs. REIT

Anyone new to the vast world of investing can attest to its complexity, even to the point of confusion. However, building your nest egg is key to retirement, so a basic understanding of different investments is essential. Exchange-traded funds (ETFs) and real estate investment trusts (REITs) are two unique investment types that can add years to your retirement account. Here’s what you need to know to find out whether ETFs or REITs could be best for your portfolio.

A financial advisor can help you develop a retirement savings plan that fits your budget, lifestyle, and long-term goals.

ETFs vs. REITs

An exchange-traded fund (ETF) puts your investment dollars together with dozens of other investors. Essentially, ETFs match the financial gains and losses of an industry, commodity or index. Unlike mutual funds, ETFs share prices change throughout the day and can be bought in the stock market any time before the stock exchange closes. Typically, ETF fees are minimal compared to other securities.

A real estate investment trust (REIT) is a corporation that creates income from the real estate it owns. This real estate can consist of properties such as hotels, individual homes or office buildings. Like ETFs, shares in REITs can usually be purchased in the stock market. However, some REITs are unavailable for public trading.

There are also REIT exchange-traded funds (ETFs), which are securities that mirror real estate on a broad scale. REIT ETFs combine a variety of REITs into one investment vehicle instead of putting money on just one firm in the real estate business. Diversifying among numerous REITs reduces risk while allowing investors to gain from the real estate market.

ETF vs. REIT: Major Differences

ETFs and REITs offer investors the ability to get healthy returns, but the prominent distinction between the two is how the funds are managed.

ETFs passively track the performance of an index or subset of the market and are not given hands-on treatment by a financial professional or company to leverage every investment dollar for maximum gain. Therefore, ETFs are usually inexpensive for the investor.

Conversely, REITs are profitable because a group of people oversees the funds and implements actions to buy, sell and develop real estate. As a result, REITs tend to yield higher returns and, by law, they must deliver 90% or more of the taxable revenue they earn to their shareholders. However, REITs can have higher risks.

ETF and REIT Withdrawals

Turning shares of ETFs and REITs into cash requires know-how, or the process can be problematic and costly. For example, an ETF held in an IRA is subject to the laws about IRAs, which include penalties for withdrawal before reaching age 59 1/2. Remember that regardless of when you want to liquidate your investments, withdrawals from both ETFs and REITs are subject to capital gains taxes.

Additionally, selling shares in an ETF can become complicated if the fund closes because of low investor activity or a narrow set of assets. In this case, investors in the ETF will either sell their shares to a market maker or receive a payout according to the ETF’s net asset value. If an ETF closes before your shares have appreciated, you probably won’t get the return on investment you intended when you bought the ETF shares.

Like ETFs, REITs can sit in an IRA and help build up your retirement fund. However, withdrawing cash from the fund before retirement can significantly reduce your long-term returns. Again, this is because you will have to pay the penalty for an early withdrawal.

In some cases, it can be trickier to liquidate REITs when compared to ETFs. This is because private REITs may not allow investors to sell their shares. Investors would either need to wait until the ban on selling shares is lifted (during which time the value of the REIT can decline, causing further losses) or sell at a steep discount.

Publicly traded REITs do not face this issue. Since they are traded on national and international stock exchanges, they can be bought and sold more easily.

When Should You Choose an ETF or a REIT?

ETFs offer the investor agility, lower cost and more protection against market instability. Since you can buy and sell ETFs throughout the day, you can make adjustments to your ETFs throughout the day. Additionally, ETFs are among the least expensive investment types. The low fees and variety of accounts that follow the performance of part of the market can also be attractive to investors who want to buy into a fund without committing hours of research into market niches.

Similar to ETFs, REITs can shield the investor from loss due to volatility, but for a different reason. REITs typically don’t closely follow the stock market’s performance. Therefore, a REIT can diversify an otherwise overly market-dependent portfolio while offering long-term gains.

That said, certain REITs may perform better over the long run. So, investors looking to make quick gains should do their research before committing. Numerous sources publish REITs’ historical returns and present performance. Therefore, you can research the type of REIT you are considering before investing.

Remember, when making any investment decision, it’s always wise to consult with a financial advisor. A financial advisor can help you weigh the pros and cons of all investment decisions.

ETFs vs. REITs: Dividend Yields

When it comes to generating income from your investments, both ETFs and REITs can be appealing, but they offer different yield profiles. Broad-market ETFs, such as those tracking the S&P 500, tend to have relatively modest dividend yields, often in the range of 1.5% to 2%. That’s because their payouts are tied to the dividends of the underlying companies, many of which reinvest profits or offer lower yields.

REITs, on the other hand, are legally required to distribute at least 90% of their taxable income to shareholders as dividends. As a result, REITs often yield significantly more, commonly 4% to 7% or even higher, depending on market conditions and the specific sector (e.g., commercial vs. residential real estate).

The trade-off? Higher yields typically come with higher risk. REITs can be more volatile and sensitive to interest rate changes, vacancy rates, and property values. While they may offer robust income potential, they’re not immune to downturns in the real estate market. ETFs, particularly those with diversified holdings, may provide more stability but with lower income in return.

Tax Considerations for ETFs vs. REITs

Taxes play a crucial role in your net investment returns, and understanding how ETFs and REITs are taxed can help you make smarter decisions. For starters, many ETFs pay qualified dividends, which are typically taxed at long-term capital gains rates, 15% or 20% depending on your income bracket. This can make ETFs more tax-efficient for investors in taxable accounts.

REITs, by contrast, generally pay non-qualified dividends, which are taxed as ordinary income. That means you could owe up to 37% in federal taxes on those distributions, depending on your income level. However, the Tax Cuts and Jobs Act allows many investors to deduct up to 20% of qualified REIT dividends, which helps reduce the tax burden slightly.

To minimize taxes, many investors choose to hold REITs in tax-advantaged accounts like IRAs or 401(k)s, where dividends can grow tax-deferred or even tax-free, depending on the account type. ETFs can also benefit from being placed in these accounts, especially if they focus on higher-dividend or income-generating strategies.

Additionally, capital gains taxes apply when you sell shares of either ETFs or REITs at a profit. If you’ve held the investment for more than one year, you’ll likely qualify for the long-term capital gains rate; otherwise, gains may be taxed as ordinary income.

Bottom Line

An ETF gives you an affordable way to follow the stock market or a particular part of the market. While REITs provide the stability and robust returns of real estate. Both will allow you to diversify your investments and make gains over time, albeit in different markets. However, these financial instruments can be difficult to liquidate in certain situations. If you’re thinking about including either or both of these in your investment strategy, partner with a financial advisor to ensure your investment plan is as strong as possible.

Tips to Plan for Your Retirement

Choosing investments for retirement can be challenging, which is why a financial advisor can save you time and enhance the end result. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Fidelity says your retirement investments should cover 45% of your pre-retirement income. Once you reach age 67, Social Security benefits could cover the rest. SmartAsset’s retirement calculator can help you estimate how much you’ll have saved by retirement.